Socially responsible investing (SRI) - Part One: the thinking behind SRI

In this 3-part commentary John Berry will overview socially responsible investing. Part One looks at what it is and how it’s evolving.

Wednesday, February 8th 2017, 1:49PM

by Pathfinder Asset Management

The follow up commentaries will consider whether SRI is a serious investor trend (or a fringe fad), whether there a cost for doing good (i.e. lower returns or higher fees) and what products are available in NZ for SRI investing.

SRI – what is it?
Many investors want to align how their capital is invested with their personal values. This means they are still investing (it’s not philanthropy) but their process takes account of wider non-financial issues. For the purposes of this commentary we’ll adopt a very concise definition of responsible investing¹:

“any investment strategy which considers both financial return and positive societal impact.”

It sounds simple. The high level principle is clear, but filling in the detail is hard work. Most people would agree they don’t want to invest in companies that do harm². However, this seems to be the only part broadly agreed.

The next steps are very personal and each investor will have a different answer. What is the harm you want to avoid? Should you withdraw your capital or make capital available but at the same time encourage change? Would you tolerate a lower portfolio return as a price for avoiding companies whose operations you cannot support? Do you believe “well behaved” companies perform better, the same or worse than “badly behaved” companies?

Ethical investing
Until relatively recently the common focus has been to define activities or revenue sources you don’t want to invest in. This is called a “negative screen” and could mean, for example, excluding companies with tobacco or gambling revenues from a portfolio. This has practical issues particularly around identifying what’s excluded, for example:

Which revenue sources do you exclude? Tobacco is bad for health in any quantity, but what about alcohol? Do you exclude one, both or neither? If you are happy to drink a glass of wine after work is it then a contradiction to not want any investment exposure to the alcohol industry? Or do you need to be more nuanced and single out what you judge as the “worst” activities such as alcohol companies producing alco-pop drinks and targeting their marketing at teenagers?
How direct does the activity have to be? Excluding revenue from gambling cuts out casinos, but what about a stationery chain that earns some revenue from selling lottery tickets or a bank with casino clients? With nuclear missiles (armaments industry) is the problem manufacture of the warhead or the full missile delivery system? (Note: the NZ Super Fund excludes manufacturers of the warhead but not missile system components).
Is there a revenue threshold or zero tolerance? Many ethical investors will be pragmatic and tolerate a small amount of income from the undesireable source if it a “non-core” activity. If you are excluding tobacco, would you invest in a retail chain where 2% of revenue comes from cigarettes? To take a zero tolerance view could massively reduce your investible universe.

Beyond exclusions
Ethical investment strategies have progressed beyond the largely quantitative screening of exclusions. Other strategies can positively incorporate personal values, religious beliefs and social impact goals. The terms used include:

“Sustainable theme” investing, which is investing in ideas making the planet a better place. These include clean energy and water treatment.
“Norms-based” investing, which is guided by international treaties on what is acceptable. This is an approach adopted by the NZ Super Fund. By way of example, for a NZ investor norms based investing excludes cluster munitions manufacturers (NZ is one of over 100 countries that have joined the UN’s Convention on Cluster Munitions).
“Engagement” is not excluding companies but rather voting, engaging and lobbying as a shareholder for change. A White Paper from the NZ Super Fund³ points to a study concluding that ESG engagement delivered a 1.8% excess return to a portfolio. However, they also note that engagement was time consuming (taking on average 500 days) and had a low success rate (only 1 in 5 engagements were successful).
“Impact investing” has a focus on generating social or environmental benefits as well as a financial return. Impact investing is generally very targeted, such as providing affordable housing or healthcare in a specific area. This means social outcomes can be clearly measured.

ESG integration
More recently the ethical evolution has turned to “ESG integration”. Here companies are reviewed on environmental, social and governance (ESG) factors and this is integrated into the investment decision process. The strategy can use positive screens to actively seek out top performing companies based on their ESG scores. This goes beyond merely checking that environmental and labour policies are in place, it also includes reviewing operational incidents, environmental impacts, effectiveness of governance and product recalls.

The late American economist Milton Friedman argued strongly against companies needing to be socially responsible. He said “there is one and only one social responsibility of business — to use its resources and engage in activities designed to increase its profits…”4 Is the profit motive as the sole corporate driver now out of touch, or is there at least some possible common ground with investing along ESG lines?

The commonality is that mismanaging any ESG factor can lead to significant financial consequences. Brand damage, litigation, new regulations, higher insurance costs, operational downtime and planning constraints are all business costs. The positive flipside is that a company promoting ESG factors can enhance its brand, employee satisfaction (productivity) and customer loyalty. ESG matters in the modern world even to a business solely driven by profit.

Final thoughts
SRI has evolved from revenue exclusion filters to more in-depth ESG integration. The NZ Super Fund believe that positive ESG investing “may be more effective than exclusionary screening for enhancing portfolio returns.”³ ESG investing may provide a benefit, not a cost, to portfolios. We’ll look at this more deeply in the next commentary.

To finish up it is worth noting that 44% of the 1,001 KiwiSaver investors in RIAA’s 2016 survey said they gave at least a 50/50 weighting to financial factors and personal values when considering how to invest retirement savings. A similar number said over a 5-year period a fund investing responsibly would deliver the same or better performance than a conventional fund. If the survey’s sample of KiwiSaver investors reflects the wider universe of investors in NZ, this tells us close to half NZ investors believe responsible investment is both important and does not hurt returns. Are investor preferences taking responsible investment mainstream in NZ?

Notes:
¹ AMP Capital, “ESG – Busting the Myths”, September 2016
² According to the Responsible Investment Association (RIAA) 2016 KiwiSaver Survey, 5% of the 1,001 respondents said that for KiwiSaver managers environmental, social, governance and/or ethical factors have no importance alongside financial analysis. A further 14% ascribed some (but little importance) to ESG factors. The remaining 81% assigned average to high importance to ESG.
³ NZ Super Fund: White Paper titled ““How we invest: why we believe responsible investing pays off” by Anne-Maree O’Connor, David Rae and Rishab Sethi, November 2015.
4 Friedman’s comment is not quite as harsh as it first sounds. The full quote (from www.goodreads.com/quotes) includes a reference to corporates working within an acceptable framework - “There is one and only one social responsibility of business – to use its resources and engage in activities designed to increase its profits so long as it stays within the rules of the game, which is to say, engages in open and free competition without deception or fraud”. His view as an economist is that company shareholders and not the corporate itself should decide how to allocate spending on social causes.

John Berry is a founder of Pathfinder Asset Management Limited and is an independent director of Punakaiki Fund Limited. This commentary is not personalised investment advice - seek investment advice from an Authorised Financial Adviser before making investment decisions.

Pathfinder is an independent boutique fund manager based in Auckland. We value transparency, social responsibility and aligning interests with our investors. We are also advocates of reducing the complexity of investment products for NZ investors. www.pfam.co.nz

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