Following the debate on adopting ‘socially responsible investment’ strategies for pension funds in the past months, as recently highlighted in a publication by Bank Sarasin, ‘Returns on equity in relation to environmental and social criteria’. We are confident that investment opportunities are feasible without sacrificing the best interest of trustees.
The main task of pension funds is to act in the best interest of trustees. But addressing the bottom line can result in not adopting non-financial risk considerations if it could lead to a significant financial deficit to the fund.
For UK pension funds, for example there is an amendment to the Statement of Investment Principles (applying from July 2000), which will require pension funds to disclose their ethical policy statement. The pension industry is principally interested in developing ‘socially responsible investment’ (SRI) vehicles.
Over the past few years, the concept of SRIs has also become established in traditional financial circles. There is a growing market for financial investments that not only take into account conventional criteria used in financial analysis, but also consciously invest in companies that are environmental and social leaders. These investments are often implicitly or even explicitly marketed with the argument that investments in companies that are of this type also promise higher returns.
Our study* examines the hypothesis that the shares of companies who adopt environmentally and socially compatible business practices provide a return that is systematically higher than the overall capital market. ‘Sustainable investment’ means investments in companies that are leaders in their respective sectors – both from an environmental and social standpoint. This approach allows, for example, investments in positively- rated oil and chemical companies, although they have a relatively high exposure to environmental risks.
To prove a statistical correlation between the environmental and social rating of a company and its financial performance, the relevant parameters have firstly to be defined. For some years now we have been awarding systematic ratings for companies’ environmental and social performance.
To measure the financial performance, the continuous yield of the selected stocks from mid-May 1997 to mid-May 1999 was used. This period seemed appropriate, as a complete and consistent sustainability assessment had only been available for this time. The observation periods were therefore effectively overlapped for the independent (sustainability ratings) and dependent variables (equity yields). From this, we were able to provide analysis far beyond the usual backtracking exercise so common when selling new funds.
A regression of 65 European securities on which a ‘socially responsible’ overlay was applied, was carried out.
The results of this study has lead to the following conclusions:
o There was a statistically significant positive correlation between environmental performance and the financial return on equities in sectors where environmental performance is relevant in the public perception – for example, chemicals, energy and pharmaceuticals;
o Companies with a very negative environmental rating showed an expected return that was substantially lower than the market return anticipated by the CAPM model (alpha: -0.1). The expected yield achieved by companies with only a moderately negative environmental rating was slightly better than the worst rated group, but was still lower (alpha: -0.05) than the average risk-adjusted yield typical for the market;
o By contrast, investments in the shares of companies with a positive environmental performance showed an expected yield that was slightly higher (alpha: 0.04) than the expected market return, while the shares of companies with an extremely good environmental rating produced returns substantially higher than the usual market yields (: alpha 0.33);
o A regression of company yields against their social performance was performed, but the model was unable to produce a statistically significant explanation for the pattern of financial return. Neither the overall model nor the individual coefficients were significant.
A rather conservative overall conclusion of this study is that taking environmental and social screening considerations into account during the stock selection process for investment funds, by means of a screened overlay, potentially will not sacrifice financial performance.
In the wake of the requirements set out by pension funds to act in the best interest of trustees and in the light of the outcome of this study, it is therefore argued that the performance of an investment fund need not be adversely affected by socially responsible investment criteria, but that prudent financial asset management will remain the most important investment criterion.
We see a good opportunity in developing socially responsible investment products for the UK pensions funds. This would be obtained by using an ‘ethical or sustainability’ overlay for existing investment funds available to institutional investors and by adopting weighing models on the basis of positive or negative company sustainability ratings.
Erik van Buuren is a sustainability analyst at Bank Sarasin in Basle
*Socially Responsible Investment – A Statistical Analysis of Returns, by C. Butz and A. Plattner, Bank Sarasin & Co., October 1999, Basel, Switzerland