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The Evolution of Responsible Investing

Northern Trust

November 2007
 

Do institutional investors who want to do well while doing good need to make a tradeoff between investment performance and a social mission? Whereas first-generation socially responsible investment (SRI) products focused primarily on meeting social objectives, second- and third-generation products are being structured and marketed as vehicles allowing investors to meet both goals.

Historically, institutional investors have used SRI strategies to address ethical views in portfolios. But as SRI assets under management grow at a faster pace than non-SRI assets, more institutions are adopting strategies that reflect the belief that environmental, social and governance (ESG) factors can impact the financial performance of companies. As a result, approaches to responsible investing have evolved into second and third generations that weigh risk and return objectives more heavily. Selecting the appropriate SRI product requires an understanding of the fundamental differences in philosophy, objective and investment process of each unique strategy.

 

Gaining Ground Worldwide

Once relegated to the margins of investment strategies, SRI is quickly gaining traction around the world. Today, US$2.29 trillion, or 10% of assets under management, in the United States are invested under SRI guidelines, according to the Social Investment Forum. This represents a 258% increase since 1995. In Europe, the SRI market accounts for US$1 trillion, or up to 15% of European funds under management, according to a recent study by the European Social Investment Forum.

Drivers of growth come from all parts of the world and focus on the increasing relevance of ESG issues as they affect both corporations and society. A key development has been the United Nations’ Principles for Responsible Investment, which encourages investors to apply ESG factors in decision-making and ownership practices. Dozens of institutional investors have signed on, according to the UN, including California Public Employees’ Retirement System, with US$210 billion in assets; Caisse de dépˆot et placement du Québec, with C$216 billion in assets; and Norwegian Government Pension Fund, with assets of more than US$250 billion.

Jane Ambachtsheer, who leads Mercer’s global responsible investment consulting business, worked with the UN to help implement its responsible investing principles. She says there’s a growing consensus among institutional investors worldwide that incorporating ESG factors into investment decisions is relevant to a fund manager’s fiduciary responsibility.

Two crucial points set the parameters for the UN discussions in 2005, Ambachtsheer says. “The first was that the investors did believe that ESG issues had the potential to impact corporate performance,” she says. “The second is that they’re fiduciaries first – anything they did had to be within the context of fiduciary responsibility, meaning they have to maximise returns without undue risks.”

Another critical factor driving SRI growth is the quantity and methodology of SRI research. Until recently, only a few specialist firms, such as KLD Research & Analytics Inc and Institutional Shareholder Services Inc (ISS), provided this research. Analysts primarily worked to identify companies involved in controversial industries or activities. As sell-side research providers, such as Goldman Sachs, UBS and Citigroup, establish dedicated ESG research units, the nature of SRI research itself is changing. The next generation of research seeks to measure and quantify the effects of a company’s management of environmental, social and governance issues. As a result, investment approaches, and the very definition of SRI, are evolving to meet the growing demand for and access to ESG factor integration.

Defining It Then and Now

In its earliest form, responsible investing was based on moral or ethical beliefs and was driven primarily by faith-based and mission-based institutions. Often referred to as first-generation strategies, negative screens were used to restrict investment in “sin stocks” of firms involved in manufacturing or promoting alcohol, tobacco, adult entertainment, gambling and firearms. Negative screening continues to account for the majority of SRI assets, but new investment strategies reflect some changing beliefs among institutions.

Today’s evolving approach determines investment eligibility by more than involvement in an industry or activity. “New definitions of SRI are based on the belief that environmental, social and governance factors often can impact the financial performance of companies,” explains Priya Khetarpal, product manager at Northern Trust.

“As a result, these SRI strategies utilise more sophisticated research to select stocks based on optimising both social and investment objectives,” she says.

Positive screening, a second-generation strategy, seeks to support and purposely invest in companies whose social and environmental standards stand out among industry peers. “Many institutions use positive screens to identify companies with competitive advantages,” she says. “While there is no explicit strategy to generate excess returns, there is an implicit belief in the intangible benefit of managing social and environmental risks and opportunities.”

Another goal of positive screening techniques is to reward companies that are making visible commitments to responsible investing principles, such as increasing levels of diversity in management positions or increased disclosure of environmental management policies. As a result, the screens are viewed as a benchmark for improvement in an industry.

Another second-generation approach gaining momentum is shareholder advocacy. The primary elements of this approach include adopting SRI proxy-voting guidelines, filing shareholder resolutions and engaging in dialogue with companies to promote social and environmental responsibility. These strategies aim to improve company policies and practices regarding stakeholder accountability while promoting long-term shareholder value. According to the Social Investment Forum, assets controlled by institutional investors that have proposed shareholder resolutions on ESG issues since the 2003 proxy season have increased from US$448 billion to US$703 billion.

“Many investors consider shareholder advocacy to be an important part of any SRI implementation strategy because of the ability to make change,” Khetarpal notes. “Contrast that with negative screening techniques in which investors are unable to engage with those companies they’ve screened out.” As a result, shareholder advocacy strategies are more commonly used in portfolios with positive screens.

Third-generation strategies differ from second generation in that there is an explicit objective to use ESG factors to generate excess returns. Third-generation strategies represent a minority of SRI assets today, but Mercer’s research establishes that there is a growing consensus that corporate social performance can impact stock price.

According to Mercer’s 2005 survey of 183 investment managers, 75% of US institutional investors recently polled believe that incorporating environmental, social or governance factors can be material to investment performance. And 60% believe an SRI approach will reduce risk or improve returns. As analysts continue to build models to incorporate material ESG factors into valuations and alpha forecasts, the tradeoff between investment return and social return diminishes.

SRI Strategy Implications

Selecting among the proliferation of SRI strategies requires a sophisticated understanding of the impact to expected risk and return. The Domini 400 Social Index, launched by KLD in 1990, uses both negative and positive screens and has outperformed the S&P 500 Index since inception (see chart below). Thomas Kuh, managing director at KLD, says, “When we first launched the Domini Index, the assumption was that if you used these screens, you would certainly lose money. There are now people out there that would like to claim that if you use ESG screens, you’ll make money.”

The effects of ESG factor integration will largely depend on the objective, philosophy and investment process of each unique SRI strategy. Important considerations include:

  • Negative screens often create significant sector biases by divesting from entire industries. Newer strategies address this by overweighting or underweighting securities based on negative and positive screens.
  • ESG research providers use varying data sources, such as public documents, media reports, non-governmental organisation data or conversations with companies. This can result in significant differences in both positive and negative screens and, therefore, portfolio holdings.
  • The applicability and relevance of an SRI strategy will depend on the asset class. For example, shareholder advocacy cannot be implemented in a fixed-income portfolio because there is no ownership.
  • The investment strategy – including index, active and risk-controlled active – should be a component of product selection as it remains a significant determinant of excess returns.

Fully Integrated Strategies

The advent of second- and third-generation SRI strategies eliminates the tradeoff that investors previously had to make between investment objective and social mission. “Negatively screened products do offer simplicity and are widely available,” Khetarpal notes. “But investors should note and take advantage of the recent proliferation of next generation products that enable SRI implementation throughout an asset allocation strategy.”

She continues, “Building a fully integrated SRI strategy requires a detailed analysis of sources of ESG research, risk constraints, relevance of approach to an asset class, as well as other traditional metrics used to evaluate both passive and active investment strategies.”

As the quantity and methodology of ESG research increases, institutions interested in SRI should look for managers that offer more than an optional add-on of negative screens. The integration of ESG factors throughout the investment process represents the next generation of socially responsible investing.

CATEGORY

PHILOSOPHY

APPROACH

First Generation

Investment holdings should align with an institution’s mission; therefore, investment in companies involved in activities in conflict with a mission should be restricted.

  • Negative screening

Second Generation

Owners of capital should address environmental, social and governance issues to advocate and support social change.

  • Positive screening
  • Shareholder advocacy
  • Alternative weighting
  • Best-of-class stock selection

Third Generation

ESG issues can have a material impact on corporate performance; therefore, investing in companies that demonstrate superior management of ESG issues can generate alpha.

  • ESG data are integrated throughout the research and investment process to identify those companies that can outperform.

 

 

This article first appeared in Northern Trust's Point of View (January 2007). Reprinted with permission.  

 

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