Financial services sector
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Monash Sustainability Enterprises and KPMG
The UK Social Investment Forum describes Socially Responsible Investment (SRI) as investment that combines investors' financial objectives with their commitment to social justice, economic development, peace and a healthy environment.
In broad terms, the SRI industry has grown out of community concerns that mainstream investment practices do not necessarily take social and environmental factors into account. Consequently, companies and their institutional shareholders are increasingly held to account where company activities result in harm to communities or where the integrity of natural systems is compromised. Research has shown that Australians, in general, place more weight on such issues than people of other countries (see Millennium Poll chart below).
The growing interest in SRI in recent years reflects several trends in industrialised countries including increased levels of education, rising awareness of social and environmental issues, increased availability of information through electronic and other media, and increased participation in share markets. These trends are likely to become more significant in coming years, and as a result industry experts expect that the SRI industry will continue to experience rapid growth.
Role of Large Companies in Society - The Millennium Poll
Source: Environics International, 1999
Recent entrants into the SRI industry provide a strong indication that SRI is moving to the mainstream. Westpac, AMP, Rothschild, ING, and Challenger have all introduced SRI funds in Australia in response to rising interest among institutional and private investors.
Several large superannuation trusts have made commitments to SRI including HESTA (Health Employees Superannuation Trust of Australia), UniSuper, and the CSS-PSS (Commonwealth and Public Sector Super Schemes). HESTA is the first fund to offer SRI as a member choice. A number of other superannuation trusts in Australia are currently exploring SRI options, with several expected to make announcements by the end of 2001.
Overseas, the SRI sector has experienced very rapid growth over the last few years. In the United States, approximately 1 in 8 dollars invested in the market is screened with some form of SRI criteria, and total funds under management in dedicated SRI funds exceeds US$30 billion.
Interest in SRI among UK pension funds has increased dramatically in the past 2 years. A survey of the 500 largest funds and 97 UK local authority pension funds in mid-2000 found that 59%, representing 78% of the assets surveyed, were incorporating SRI principles into their investment processes.
There is a compelling business case for investing in socially responsible companies, although some caution is required. A growing body of research provides evidence that socially responsible companies, on average, out perform their peers financially. While it is difficult to draw causal linkages, there appears to be a correlation between socially responsible practices and good overall business management.
One explanation is that socially responsible companies tend to have a close handle on changing customer and community expectations, and are able to respond more quickly to market opportunities where they emerge. In short, companies that manage their social and environmental issues effectively tend to be well-managed companies. There are potential risks in ascribing too much weight to social responsibility as a determinant of financial performance however, as the linkages are not yet well understood, and vary significantly across industry sectors. Nevertheless, it is likely that external factors will magnify pressure on companies to act more responsibly, and those that fail to recognise the business implications will under perform over time.
There are three broad strategies to SRI: screened portfolios, shareholder action, and cause-based investing. Increasingly, these strategies are combined with one another, and this trend is likely to continue as the SRI market matures.
'Screening' involves assessing a universe of stocks or assets against SRI criteria. This is a form of active portfolio management; essentially 'cherry-picking' companies which meet SRI performance requirements. Screening seeks to direct investment toward preferred companies or other assets, and away from companies whose practices are perceived to be undesirable. Screening may be undertaken by individual investors or as part of the funds management process.
Shareholder action involves a conscious process in which shareholders exercise their rights to raise issues with management either directly, or through a managed fund. The shareholder or investment institution seeks to persuade these companies to commit themselves to change and then monitors the implementation of any commitments made (see box below). Where shareholder action is pursued through a managed fund it is commonly referred to as responsible engagement.
|Friends, Ivory Sime, a UK-based fund manager is implementing a Responsible Engagement Overlay (reoTM) for pension funds and other investment clients. The reoTM is based on the belief that it is in the interests of investors to use their influence as shareholders to encourage companies to address major risks to their reputations, and in so doing, minimise risk to long term investment performance. Rather than buying and selling shares according to SRI criteria, the approach focuses on constructive dialogue with all companies in the investment universe to promote better practice. The overlay approach is particularly relevant to defined benefit schemes where high diversification is mandatory to meet fiduciary requirements.|
Cause-based investing is usually aimed at a particular social issue or cause. For example, fund managers may create a range of investment vehicles to focus investment on an area of perceived need such as rural development (see box below), or a specific environmental issue (eg. sustainable forestry). Cause-based investing may also include funds aimed at promoting clean technologies, such as renewable energy funds.
|The Local Government Superannuation Scheme in NSW has recently introduced a Regional Development Fund (RDF) to 'give something back' to rural Australia, and at the same time, achieve high investment returns. A private equity fund, the RDF directs investment toward projects that have the potential to promote social and economic development in rural areas. Proposals are screened on social and environmental grounds to ensure that business activities are sustainable.|
There are three methods typically applied to screen companies on SRI performance: negative screens, positive screens, and best-of-sector (or best in class). The three approaches are based on different investment styles, but may also be combined.
Negative screens have been applied in the ethical investment sector for decades, and involve exclusion of stocks on the basis of company involvement in specific types of activities (see box opposite). In general, the types of exclusions applied are tailored to the value sets of individual and institutional investors targeted by the fund manager. These may vary considerably from one fund to the next.
Negative screens are typically applied to companies involved in:
Some funds may exclude 'dirty' industries/sectors entirely (eg. chemical manufacture, mining). Other issues increasingly included in negative screens include production of genetically modified organisms (GMOs) and specific bio technologies.
Positive screens generally seek out investments in companies engaged in activities with positive social or environmental benefits. This may include both companies that demonstrate leadership on social and environmental criteria, and/or involvement in business activities that are seen to be inherently beneficial (see box below).
|AMP's Sustainable Future Funds apply positive screens to invest in companies that will form part of a socially and environmentally sustainable future. These include companies found in industries such as health care, transport, renewable energy, education, water management and recycling. Challenger's Socially Responsive Investment Fund applies positive screens to identify companies that show leadership in areas such as environmental management, ethical and responsible product development, corporate citizenship, governance and ethics, regulatory compliance, and human and labour rights.|
The best-of-sector approach has begun to be applied by some fund managers more recently. As implied by the name, this approach seeks out sector-leading performance on social and environmental criteria. It aims to invest across all industry sectors, but to select the best performing companies in each sector to provide incentives for lifting performance across all companies in the sector (see box below).
|Westpac Investment Management has used a best of sector approach for the Australian Eco Share Fund, an environmentally screened investment fund that invests across all ASX sector categories. The rating process identifies environmental performance criteria appropriate to each sector, and ranks company performance against these benchmarks. This ensures that 'apples are only compared with apples', and also provides clear targets for companies to aim for to achieve investable status. Strong emphasis is placed on engagement to communicate benchmarks and lift performance across all companies in the investment universe. Westpac is also applying the best-of sector approach to create a sustainability fund.|
Research has shown, in general, that SRI funds have performed better or at least in line with relevant benchmarks. Like any investment class, however, careful attention to risk is required. The type of SRI strategy adopted is important in this regard, and the strategy should align with the risk requirements of investors, fund members, and investment managers.
Robust and rigorous SRI research is essential, married with strong financial analysis and investment management practices. If these conditions are achieved, the likelihood of achieving strong risk/return performance is maximised (see Westpac Eco Index Financial Performance chart below).
Westpac Eco Index Financial Performance
Companies that exhibit above-average SRI performance are also likely to perform well over the long-term, as socially-responsible practices are generally aimed at positioning the company for the future. In this regard, SRI is well suited to superannuation investments.
The basic rules of investment management apply equally to SRI investment: greater diversification means less risk. A highly diversified SRI portfolio will protect investments against market fluctuations. Risk and return characteristics can be tailored to client needs if a higher tolerance for risk is acceptable. In principle, this is no different than any other investment category.
Negative and positive screens tend to bias investment toward some industry sectors (eg. technology, telecommunications, health care) over others (eg. resources, chemicals). This may lead to greater volatility in performance, with a higher likelihood that performance will be significantly above or below the relevant benchmark at a given time.
Best-of-sector approaches tend to track share indices more closely, as they invest in all industry sectors, and cushion performance against business cycles. Some out performance may be achieved, but this is unlikely to be significantly higher than the benchmark. Risk is generally lower than with positive and negatively screened portfolios however. Overlay approaches are least risky, but will only deliver performance in line with the benchmark (ie. as per a passively managed fund).
A wide variety of criteria may be applied to SRI strategies. In general these cover the following areas:
Specific issues addressed by different SRI research organisations vary considerably.
SRI funds may use either in-house research or may commission independent research from third parties. SRI researchers typically obtain information directly from the companies, government records and other publicly available information, the media, and from non-government organisations.
The SRI research process can be very involved, particularly with large multi-national corporations with sites all over the world. Research processes must be robust to ensure that complete and accurate information is obtained.
The growth in the 'mainstream' SRI market has increased demand for high quality, rigorous research. In response to this demand, SRI research has become highly professional, and is increasingly based on scientific methods. Indicators used to measure the environmental performance of companies, for example, are becoming more standardised over time, enabling more objective comparisons to be made between companies. For example, companies can be compared on their performance toward reduction of greenhouse gas emissions or generation of specific wastes.
Recent surveys conducted in Australia indicate strong demand for SRI investment options. A survey of 1000 investors conducted by Resnik and KPMG in 2000 found that 76% would like to know where their superannuation is currently invested, and 69% would consider an SRI option if it was made available to them. A separate study conducted by Monash University in 2000 found that 87% would consider an SRI option. Additionally, a survey conducted by the Australian Institute of Superannuation Trustees in early 2001 found that 73% of trustees believe that SRI is a legitimate investment class.
Importantly, the Monash study found that 92% of investors felt that financial performance should not be the only criterion for selecting investments. Both surveys found that most investors would be willing to accept slightly reduced returns for SRI investments. However, support for SRI tapers off if investment returns are significantly lower.
The level of demand for SRI will vary depending on the specific characteristics of investors including education level, gender, age, and other factors. To better understand member interest, a number of Australian superannuation trusts have recently undertaken their own internal surveys or focus group research.
The issues raised by investors interested in SRI vary with individual values. However, recent research by Monash has shown a high level of consensus around issues that 'affect everyone'. Prominent among these are protection of the environment and human rights (see Importance of Specific Social Issues chart opposite). In general, there is less consensus around issues that relate to personal lifestyle choices (ie. tobacco, alcohol, gambling), although concern for each of these issues remains high.
Importance of Specific Social Issues
There is no reason why SRI cannot be applied to any asset class, although the majority of activity in the SRI sector to date has focused on equity investments. SRI is beginning to be applied to private equity and venture capital investments, and a small number of fixed interest SRI products have begun to emerge. Property investments also lend themselves to SRI screening.
More activity in these asset classes can be expected in the coming years as demand for balanced SRI investment funds increases. These pooled vehicles are likely to incorporate all major asset classes (see SRI Screens and Asset Types chart opposite).
Another important and related trend is the growing emphasis on providing incentive for 'positive change' (eg. Improving environmental performance across all operations, energy efficiency, etc) rather than punishing companies for involvement in activities that are perceived to cause harm. Concern about specific issues such as uranium mining and logging of old-growth forests is still very high however.
SRI Screens and Asset Types
Further information can be obtained from:
The Australian Institute of Superannuation Trustees
The Ethical Investment Association Australia
Information on SRI developments in the Australian market can be found in the SRI journal Ethical Investor, and the Ethical Investor web site,
Socially Responsible Investing by Amy Domini (Dearborn, 2001)
Ethical Investment by Ross Knowles (Choice Books, 2000)
This information guide was produced by Monash Sustainability Enterprises with the assistance of KPMG and with the support of the Commonwealth Government through Environment Australia and the Australian Institute of Superannuation Trustees. July 2001
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