There is both good and bad news about ‘socially responsible’ investing (SRI) in the UK and Europe. The good news is that SRI has achieved 100% plus annual growth rates over the past several years. The bad news is that the principal factor driving this explosive growth – the outstanding (30%+ per annum) performance of several US SRI funds over the last three years – appears to be built on intellectual foundations of sand. The future of meaningful SRI in Europe is anything but bright until these conceptual deficiencies are rectified.
A careful look at both the portfolio construction and the real sources of the excess returns of the US funds reveals a highly disquieting picture for fans of traditional SRI. First, two of the five largest holdings in several top-performing US funds are Wal-Mart and Microsoft. Last time we checked, one could purchase firearms directly over the counter at Wal-Mart, and the US Department of Justice had successfully convicted Microsoft for predatory and monopolistic business practices. So much for SRI funds’ seeking out the corporate equivalents of Mother Theresa or Mahatma Gandhi.
In addition to the selection of some highly dubious but financially successful companies, the out-performance of the top US SRI funds appears to owe more to overweight positions in semiconductor and technology stocks than to any intrinsically value-creating qualities of the portfolio companies’ allegedly superior social characteristics. With the recent downdraft in technology stocks last year, star performers are now returning an average of minus 9.4% this year to date. So what is the future for SRI?
In theory at least, SRI has evolved a great deal since its popularisation in the 1970’s. Initially, SRI consisted almost exclusively of negative screening: weeding out the stocks of companies with activities deemed harmful to society. But this becomes an extremely slippery slope; ‘harmful’ according to whom? Depending on ideology or even geographic location, one person’s ‘social responsibility’ is ethically repugnant to another. The very same pharmaceutical company eschewed in the UK for animal testing nestles quite nicely in many a US SRI portfolio. Where does one draw the line, and who does the drawing?
The next stage in the evolution of SRI occurred when some campaigners recognised they could often have more leverage over corporate behavior as shareholders than as absentee boycotters. As a result, proxy voting and so-called constructive dialogue with the senior management of portfolio companies were added to the arsenals of leading SRI fund managers. (Neither of these activities has heretofore generated much credibility or impact, but never mind.)
Many SRI proponents believe the movement reached its intellectual apotheosis in the late 1990’s with the advent of the ‘triple bottom line’ concept. This approach advocates explicitly addressing social and environmental factors as well as purely financial ones. While intuitively appealing, the triple bottom line concept raises as many questions as it answers. What relative financial weight should each of the three dimensions receive in evaluating an investment? On what basis? Assessing companies’ social, environmental, and financial performance is all well and good, but what does it all add up to? Most investors I know want one bottom line, not three. And what about the frequent occasions when one of the three ‘bottom lines’ conflicts directly with another? What final, actionable judgment are investors to make?
Despite the many changes in the 30+ year history of SRI, one attribute has remained steadfast: the company ‘research’ on which SRI investment decisions are made is, on the whole, shoddy, arbitrary, and anecdotal. There is little if any analysis of the underlying competitive dynamics of a given industry sector. Nor is any analysis demonstrating which social performance indicators are most closely associated with excess returns. There is precious little evidence that superior social performance even helps generate excess returns in the first place; on the contrary, there is a growing body of evidence that it doesn’t.1
In our view, SRI has been suffering from an acute, 30-year shortage of analytical rigour. Until this analytical vacuum is rectified, there is little likelihood that European institutional investors will embrace SRI in anything but the most cosmetic fashion. If SRI thinking is ever to influence the mainstream capital markets, its financial benefits must be demonstrated much more clearly and convincingly.
But where will the necessary rigour and innovation come from? Not, I fear, from the traditional SRI asset management houses. Most are too inbred and heavily invested in the status quo to have either the necessary tools or motivation. Perhaps surprisingly the next wave of real innovation in SRI will likely come from the very mainstream investment houses which are relative newcomers to the game. The staid, old-line firms are the only ones with the requisite combination of constructive scepticism, perspective and hard-headed analytical rigour and to get the job done. And they will do it not by creating new SRI ‘products’ at the margins, but by integrating social and environmental considerations into all of their investment analysis and strategies.
When all is said and done, SRI presents a Zen-like paradox: it will only be completely successful when it ceases to exist altogether, and becomes as routine a part of mainstream securities analysis as P/E ratios and earnings momentum. And that day will come. Social issues are becoming more and more relevant to companies’ financial performance, even if the markets have yet to recognise it. By the time they do, let’s hope that the SRI movement has acquired some more rigorous intellectual underpinnings.
Matthew Kiernan is executive managing director at Innovest Strategic Value Advisors, in Toronto.
1 See for example, Bank Sarasin, SRI: A Statistical Analysis of Returns 1999; Kurtz, L., ‘The Impact of Social Screening on Growth-Oriented Investment Strategies’, Journal of Performance Measurement, 1997; and Guerard, J., ‘Is there a Cost to being Socially Responsible in Investing?’, Journal of Investing, 1997.