The debate about the efficacy of ethical and socially responsible investment has moved on. Successive corporate scandals have seen to that. It is now taken for granted that institutional investors should play a role in monitoring the companies in which they invest, and attempt to exercise influence to improve performance where necessary
In view of this new consensus on the merits of SRI, fund promoters are clamouring to offer their own variations of the SRI themed fund. Many of them are little more than hybrid index funds. As well as being a low-fees option, the passive SRI approach is supposed to reduce the variation in performance between an ethical universe of stocks and a conventional index. However, an ethical index, by definition, will include an element of stock selection, which makes choice of benchmark a more than usually critical decision when choosing an SRSI fund.
The SRSI funds market is further complicated by the different ethical boundaries that each fund sets. Despite the growth in the number of SRSI funds, there remains a lack of a well-developed framework for comparison of SRSI products – we still need to see more clearly defined sub-sectors. Do you, for example, avoid companies which are known polluters but which nonetheless spend huge sums on finding alternative sources of energy? Not everyone would agree on that point.
Piet Sprengers, director of the Dutch SRSI organisation VBDO says: “Since we started looking at institutional investors in 2001, the impression is definitely that interest is growing. There is a lot happening. It’s just that at the moment it’s quite small scale and not properly coordinated. I would like to see the pension funds sharing information and research and developing initiatives together.”
One fund manager that has been at the forefront of the SRSI and corporate governance movement is Baillie Gifford. As an active SRSI fund manager, BG established a committee of institutional investors, the ‘Responsible investors network’, to facilitate the development of corporate engagement on social, environmental and ethical matters. The group currently has 25 members with aggregate funds under management of over £1trn (E1.5trn).
Their attitude is that meaningful engagement is only possible for large groups of investors. This means the specialist managers who are operating an engagement policy that reviews social and environmental risk across their full portfolio, in the same way that the largest pension funds carry out a constant monitoring programme on their invested companies.
The bigger SRSI managers such as Henderson and Friends Provident/ISSIS AM have well-developed internal checks and balances. Henderson’s Horizon Global Sustainable Investments Fund is subject to regular internal audits to ensure compliance with the fund investment criteria. These are supplemented by annual audits by Henderson's compliance team to test systems and processes. The work of the SRSI team is supported by an advisory committee, which consists of five independent experts in the fields of business, social responsibility and the environment. The committee meets with the SRSI team three times a year and keeps the team abreast of the rapidly evolving corporate responsibility and sustainable development agenda.
Baillie Gifford considers it is important to engage with the right companies on the right issues. To this end it has developed a rating system which combines companies’ social and environmental records with a measure of BG’s aggregate ownership. This helps the fund manager to establish a dialogue with those holdings that are the most significant and concentrate efforts where they can be most effective. BG has around 60 company meetings per year dealing only with SRSI and corporate governance. Its SRSI investment statement says: “We encourage company directors to monitor and address the material social and environmental risks and opportunities facing their businesses. We believe that this process can contribute to the long-term value of our clients’ investments. Such active dialogue also gives us valuable information on the quality of a company’s management and the extent to which it is focused on shareholders’ interests, which can assist us in selecting and appraising investments.”
The Friends Ivory & Sime/ISIS AM Responsible Engagement Overlay service is becoming popular as a result of some large mandates that are incorporating it. REO is specifically designed to address areas such as the environment, climate change, labour standards and human rights. It was created by ISIS in order to meet pension fund requirements and has been designed carefully to ensure that it protects the fiduciary obligations of trustees.
Although charities have played an important role in driving the institutional SRSI market in the UK, growing evidence indicates that pension funds and similar retirement systems have taken a leading role in developing the European SRSI market, whether engagement and simple exclusions are taken into account or not.
Given that the overwhelming proportion of SRSI amongst institutions in Europe is made up by Dutch and British pensions, the most meaningful anecdotal evidence comes from these areas. Other countries in Europe are reportedly taking SRSI seriously in formulation of investment policy, but it remains a marginal initiative.
Investment performance-wise, institutions need not be concerned with any significant downside. One of the arguments used against ethical funds is that they can be more volatile and in certain market conditions, will underperform. Evidence is beginning to emerge that many ethically screened investments may be less volatile than the average equity fund. This runs counter to conventional wisdom, which claims that ethical funds should be more volatile because they tend to have a greater proportion of their investments in smaller companies. The reality is that an investment fund of appeal to a pension scheme is not going to be investing in technology and biotech stocks that are by their nature, speculative plays. Some ethical investment institutions are now introducing funds specifically for the more risk-averse investor. This is where the growth of assets is likely to come for pension investors.
In a November 2003 report, AMP Henderson surveyed the financial performance of 14 SRSI mutual funds in Australia to arrive at the median performance of SRSI managers down under. The study found that the median SRSI manager outperformed the most relevant benchmark, the S&P/ASX 200, over the one, two, three, and five-year periods, through September 30, 2003. The report acknowledges SRSI underperformance in the year 2002. The report attributed the strong one and two-year SRSI median performance to Australian SRSI’s small cap and growth biases.
In the US, of 21 screened funds tracked by the Social Investment Forum with $100m (E81.5m) or more in assets, 15 received top performance commendation from one or both of the tracking firms through 2003. Elsewhere, 33 of the total funds universe of 53 socially screened funds tracked by Lipper and Morningstar received top marks from one or both of the firms. And in another indicator of competitiveness, a 2003 survey of socially responsible mutual funds found that average expenses are similar to those charged for unscreened funds, and, in some cases, are lower.
Ultimately, it is the investment managers, working closely to develop industry standards and actively engaging with companies, who will drive the growth of SRSI. Tony Colman, chairman of the recent All Party Parliamentary Group on SRSI in the UK says the group’s report provides invaluable challenges to all those interested in pension fund SRSI and shareholder activism: “Perhaps it’s time for fund managers to seriously rise to the Myners’ challenge and allocate more of the City’s human capital to activism rather than the closet index-hugging that so often delivers poor net performance relative to the risks of equity investment. “Trustees should demand that their investment consultants help them find fund managers with robust activism records, and ensure that their training providers (often the same consultants) have sufficient knowledge to help them understand how they can respond to latest investment thinking. Finally, members of schemes should demand to be consulted, especially members of pension schemes who shoulder the investment risks themselves.”