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Walk before you can run

Although most people in the investment industry agree pension funds are becoming more interested in SRI, there are many different ways of approaching it. From choosing how strictly they should judge companies they invest in, to defining why they want SRI in the first place, pension funds face a series of decisions.
The first step for any pension fund in the initial stages of considering including some form of SRI in its investment structure is to look to see what the requirements are from an external point of view.
“They should have a look at their local regulations to see what they demand of them, in terms of disclosure,” says Helena Colle, co-ordinator of SRI matters at Dexia Asset Management.
“What do their stakeholders expect of them, and do they have particular ethical concerns?” she says. After this, a pension fund should take into consideration its fiduciary responsibility, which includes taking into account the long term risks involved in investment – not simply the narrow view of immediate risks of short-term downturns in share prices.
These long-term risks include social and environmental risks which might eventually affect corporate results, says Colle. “Also there is corporate governance risk, which has been shown to have an effect on financial performance,” she says.
In SRI, a pension fund may end up filtering out various potential investments based on the credentials of the companies issuing the stock. But rather than simply excluding shares and finding out later on what effect this has on investment results, this can be tested in advance. “Funds can ask the asset manager to show how a strict or less strict filter would impact on the financial risk-characteristics of the portfolio,” says Colle.
Instead of dedicating just a small portion of overall assets to SRI, she says it makes more sense to determine what level of overall tracking error the fund is prepared to tolerate as a result of SRI. “It’s more reasonable to apply the same filter to all the assets.
“If you want to avoid the worst offenders, it wouldn’t have much impact on the investment universe,” she says, while a higher level of exclusions might make more difference.
Pension funds can either choose a best-in-class approach, whereby a certain percentage of the best companies, in ethical and environmental terms, is selected or they could say they are only concerned about the big offenders, and take a negative screening approach. The best-in-class approach not only contains non-traditional risks but also allows the funds to single out those companies which are best positioned to exploit the opportunities related to environmental and social issues.
When approaching the whole area of socially responsible and sustainable investment, pension funds need to be clear about what their aims are. Those coming to it for the first time are very often doing it simply to cover themselves.
“When it comes to SRI policy, the first question is why are you doing this?” says Eric Elfgren, head of institutional international clients at Sustainable Asset Management (SAM)in Zurich. “Regrettably, the vast majority… are just doing something to avoid criticism.
“If you really want to do it, you should start with why, and what you want to be expressed,” he says. Having arrived at these concrete aims, then the pension fund is in a better position to be able to make decisions such as whether or not it is better to outsource the management, and then distinguishing between those asset managers who are serious about SRI, and those who are simply making the right marketing noises.
If they want to be serious about SRI, they need to decide whether their reasons are that they want their values to be expressed through the investment choices, or if, for example, they believe there are returns to be gained through this method of investing.
“More and more pension funds are moving in that direction,” says Gelfgren. Increasingly, it is becoming recognised that just avoiding criticism is not enough.
From a pure returns points of view, various corporate scandals provide some firm arguments in favour of SRI. SAM cites the examples of ABB, a global leader in power and automation technologies. It says the company would certainly agree that neglecting health and safety issues can be extremely detrimental to a company’s financial health. A couple of years ago, it almost went out of business because of lawsuits related to asbestos.
And bad governance at Enron and WorldCom contributed significantly to two of the biggest corporate bankruptcies in recent years.
Ethos is a Swiss organisation fully owned by more than 80 Swiss pension funds. It was set up seven years ago to offer SRI products and take on voting responsibilities on behalf of the pension funds.
In a recent high-profile move, Ethos put forward a proposal at the Nestlé annual general meeting to prevent chief executive Peter Brabeck taking on the extra role of chairman. Even though the motion was rejected
by 50.5% with 35.9% in favour,
Ethos had said that 15-20% support would send a “great message to the board”.

Ethos gives its voting recommendation to pension funds, and they can then either vote themselves, or request Ethos to do it for them. “The question of voting is now coming on the agenda of most pension funds in Switzerland,” says Jean Laville, chief investment officer at Ethos.
Christoph Butz, sustainable investment expert at Pictet Asset Management in Geneva says a more sustainable world is certainly in the long-term interest of pension funds and their members. But because the fact is that SRI will probably not outperform - at least not in the short term - the most honest approach is to deliver as much sustainability as possible for a reasonable predefined risk.
“However, this is only possible with sophisticated quantitative techniques,” he says, “and I think this is the road we have to take.”
Large pension funds certainly have the necessary resources and expertise to implement an SRI strategy completely on their own, but this is often not practicable for smaller funds.
“But also for larger pension funds, it might finally be more efficient to profit from the experience which has been accumulated by others, and buy an appropriate concept on the market,” Butz says. But pension funds should never buy a ‘black box’, he says. “An external manager should be expected to be completely transparent about how sustainability criteria are taken into account in the portfolio construction and what the exact level of risk is that is borne by the client by the choice of a specific SRI strategy.”
As to whether engagement is better than negative screening, Butz says the answer depends on your point of view. “For an asset manager it is certainly more convenient, because there are no restrictions for his portfolio managing activities,” he says.
“The whole SRI value-added comes from trying to influence companies by other means than selling or buying their stocks.” But then there is the risk that a lot of talk will not lead to any tangible results, which is expensive and ultimately also frustrating for both sides, he says. But this does not have to be the case.
“Negative screening is more straightforward in that a negative appreciation of a company is at once sanctioned,” he says. “It is certainly also less expensive to implement and for certain investment universes - ie, emerging markets - it might be very difficult to implement a credible engagement process.” So negative screening would be better, if positive screening - which would be the best choice - is not possible.
When choosing SRI products, Butz says that in principle there are absolute and relative SRI products. Absolute products, he says, focus on sustainable sectors and companies such as solar, environmental technology and so on. These funds appeal to retail investors because the underlying concept is straightforward. But they are automatically more risky, because only a small part of the entire investment universe is available for investment, which translates into a high risk compared to a broad market benchmark.
So for institutional investors, it could be better to invest in a relative or best-in-class product. In these products, the leading companies in every sector are selected.
“This has two advantages,” says Butz. “First, through the broader investment universe the risk is much lower and, second, it makes sense from a sustainable point of view to ‘reward’ the good companies even in problematic sectors, because after all, it is in those sectors where improvements will have the largest impact.”

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