Socially Responsible Investment: A global perspective

The Commonwealth Group assesses the current state of industry best practice regarding what has been historically termed ethical investing.

Thursday, April 5th 2001, 6:12PM

This paper describes the Commonwealth Group's assessment of the current state of industry best practice regarding what has been historically termed 'ethical investing' and which has more recently evolved into the much broader concepts of 'socially responsible' or 'sustainable' investment practices.

We believe that the industry best practice is very close to formally incorporating SRI as a core part of the philosophy and practice of funds management.

The Commonwealth Group shares the view of the recent Allen Consulting Group Report on SRI in Australia that SRI is in a transition phase, both domestically and internationally.

An increasing number of SRI type funds have been launched in both New Zealand and Australia in recent weeks.

Many of Commonwealth Group's investment management clients, for example large public and industry superannuation funds, are becoming increasingly interested in the environmental and social issues associated with their investments. In Australia, this interest is also manifesting itself in an increasing trend towards shareholder activism and targeted investment.

What is socially responsible investment?
Although there is no clear universal definition of what SRI is, there are principal themes common to most definitions. The concept clearly contemplates an investment management based activity that involves consideration of non-financial factors in investment decision-making.

The range of SRI criteria differs widely amongst commentators. However, there is a consensus for environmental and social considerations. Including 'ethical' factors under SRI is problematic because of the subjective nature of the term, although many commentators do so.

At its core, the SRI process requires researching corporate social performance and then benchmarking this data against standards set by reference to a nominated party. The end objective is to provide a more accurate assessment of the risks associated with the future performance, and hence the value of, a particular corporation with reference to its peers on a global basis.

Crucially, SRI does not necessarily incorporate a screening process, where investment in corporations is either excluded (i.e. negatively screened) or included (i.e. positively screened) based on the SRI research and benchmarking processes.

More recently, the terms 'sustainable' and 'sustainability' have been used as an approach to investment management based on these concepts.

The theoretical argument supporting moving away from the use of terms such as 'social' and 'ethical', to using the term 'sustainable' is usefully summarised by author Mark Mansley in a recent article in Sustainable Business Investor :

"Typically, fund managers are expected to perform on a quarter-by-quarter basis. At a political level, there has long been concern that attention on short-term financial returns may not be in the best interests of the economy in the long-term.

So how does sustainable development help resolve this dilemma and provide a tool for linking short-term and long-term investment practices? …For short-term investment strategies to deliver the best long-term returns, it is necessary that …. meeting short-term investment objectives does not compromise …. investment returns in the future.

This [argument]…is essentially the same as the most common and powerful definition of sustainable development, from 1987 the Brundtland Report, which is "a pattern of development or progress that: "meets the need of the present without compromising the ability of future generations to meet their needs."

There is an emerging view amongst major investors that 'sustainability' questions are relevant to security analysis and stock selection, and that investment managers should take this into account in managing client portfolios.

There is widespread evidence that companies are starting to acknowledge that the management of activities, including environmental, social and ethical considerations can positively impact corporate financial performance.

Further, there is empirical evidence to suggest that the financial performance of companies with sustainable corporate behavior is superior to that of companies that do not sustainably manage their business .

In response, investment managers are beginning to develop sustainability value criteria for analysing firms against a range of benchmarks, and to establish processes for engaging companies in a dialogue.

Socially Responsible Overlay (SRO) - A more balanced approach to SRI
Historically, trustees and investment managers have been confronted with a dilemma that still characterises the ethical/SRI debate: how is it possible to determine and define what is 'ethical' or 'socially responsible' with reference to heterogeneous groups of investors?

The question that then arises is how can the view of the trustees or investment manager on these matters be employed in overlaying investment decisions that they might make on investors' behalf?

The Commonwealth Group believes a potential solution is what has been termed a responsible engagement overlay (REO) process. This was pioneered in the United Kingdom by a leading fund manager, Friends Ivory & Sime.

The objective of REO is to reflect the social or sustainability factors of the trustees in the investment decision-making process by engaging in a dialogue with those companies that fail to meet acceptable standards.

A Commonwealth Group member - Commonwealth Investment Management - is, in conjunction with an Australian research house, currently developing its own version of REO, or a socially responsible overlay (SRO) process, for use by a large public sector institutional client.

There are three distinct advantages in employing a REO or SRO approach.

First, a SRO process does not generally involve, other than in extreme circumstances, disinvestment from a company. SRO is concerned with identifying those companies that are not meeting acceptable behavioral standards as judged by their investors. These companies are then engaged in a dialogue to assist them understand how investors' concerns might be best addressed, and their performance improved.

This is an important consideration where trustees have mandated investment managers to follow an index fund style of investment management, where disinvestment from a stock is simply not an option. Furthermore, actual disinvestment may place the trustees and investment managers at risk of breaching their fiduciary duties in taking non-financial issues into consideration in their decision-making.

A second argument is that its impact is indirect. By reducing the extent of unsustainable corporate conduct over time, the objective is to have a positive longer-term influence on financial returns.

Third, SRO is non-confrontational. Companies and fund managers are engaged in a dialogue. In contrast to more traditional approaches involving negative and positive screening, the SRO process results in no dichotomy of classification. Companies that are engaged with are treated no differently than other companies in the investment portfolio.

The UK and US experience suggests that companies are more responsive to requests by their current investors to change their behavior than if they are excluded from an investment portfolio.

In many senses, SRO is a pragmatic approach designed to achieve behavioral change, in the belief that change will more commonly result from meaningful dialogue, and that such change will produce more durable and significant results.

Commonwealth Group & SRI
The developing debate around SRI, and more generally sustainable corporate practices, is a meaningful one. Commonwealth Investment Management is pursuing ways to develop the research capability and systems to facilitate the consistent inclusion of SRI / sustainability factors into our investment decision-making process across all asset classes and clients.

Correspondence
All correspondence in relation to this discussion paper may be directed to, or a full version of the original discussion paper may be obtained from: