Change From Within
11 Nov, 2013
Perhaps you are familiar with the black and white photograph of a nine-year-old Vietnamese girl running down a road nude with a group of villagers in obvious distress. She painfully grimaces at the photographer as a dark cloud of smoke envelops the sky behind her. The sight of the emaciated pre-pubescent leaves the viewer frozen and unable to fathom what has happened. She has just survived an aerial bombing and her back burns with freshly dropped napalm.
The expression of agony on her face is considered one of the most haunting and iconic images of the Vietnam War; it serves as a reminder of the horrors unleashed by industrial warfare in the twentieth century. What is far less known, however, is that its publication led to nationwide protests against Dow Chemical, the manufacturer of napalm, and sounded the early stirrings of a new wave of sustainable and responsible investing that is steadily altering the landscape of modern investment management.
Sustainable and responsible investing (SRI) has seen dramatic growth over the last decade and is having an increasing influence on both institutional and retail investors. According to the United States Sustainable Investment Forum, money managers using environmental, social, and corporate governance criteria in their portfolio selection represented over $2.3 trillion in assets under management in 2001 and more than $3.7 trillion in 2012. Assets managed according to SRI principles have increased at a disproportionately higher rate than those that have not: since 1995, total assets under management increased by 376 percent, while SRl assets have increased by 486 percent.
Although no strict definition of its objectives exists, SRI encompasses a broad range of issues that influence corporate behaviour in the pursuit of social progress. Examples of initiatives include improving climate risk disclosure, adopting sustainable forestry practices, exposing human rights violations, requiring transparency for executive compensation, and pushing for reforms to corporate governance with a view of emboldening shareholder activism.
To achieve these ends, sustainable investors draw on a number of investing styles. Different approaches make use of positive screening , moving capital into companies with strong social and environmental standards; exclusionary screening; divesting portfolios of companies that violate ethical criteria; or a best-of-class approach, rewarding companies that are not necessarily lauded for their sustainability track record, but which exhibit higher levels of social responsibility than industry rivals. SRI has gained considerable momentum over the years as legendary hedge fund traders and frugal pensioners alike are pulled into its expanding sphere of influence. Despite the impressive results, serious doubts remain over the convictions of so-called sustainable investors.
Portfolios and investment funds get branded “sustainable and socially responsible” if they satisfy the vague and subjective requirement of having applied ethical criteria to the portfolio selection process. As can be imagined, this sets an extremely low bar for what gets the coveted title of “sustainable,” and makes it extremely easy for money managers to go through the motions of investing ethically without materially changing investing decisions or making tough choices. Simply self-reporting one’s adherence to socially responsible criteria is enough to stroke the egos of clients and win accolades from august international institutions. To actually ensure rigorous compliance for the awarding of the badge of sustainability is an entirely different matter, and one that remains a central challenge for advocates of responsible investing.
Skeptics have characterized socially responsible investors as idealistic followers of an elite-driven fad, blind to the supremacy of the profit motive, and naively convinced that mercenary capitalists will sacrifice their profits at the altar of high moral principles. They are not without reason. The revelation that many of the major financial institutions on Wall Street misled investors into purchasing toxic mortgage-backed securities pre-recession only reinforces the popular view of the financial industry as a snake pit of predatory psychopaths. Abundant cynicism notwithstanding, the question of whether pursuing sustainable investments comes at a monetary cost has not been adequately answered, though a brief exploration of the empirical literature yields interesting and surprising results.
The first SRI index, FTSE KLD 400, was created in 1990 to measure the performance of a broad allocation of socially responsible stocks; the equivalent Canadian index is the Jantzi Social Index (JSI). In both cases, each SRI index slightly outperformed its corresponding benchmark- the S&P 500 and the S&P/TXS Composite respectively. Considered alone this could be construed as settling the debate and suggests critics of sustainability have missed the forest for the trees in their free market theology.
This is not, however, the whole story. A study by Bartolomeo and Kurtz (2011) found that SRI indices outperformed the S&P 500 during the years 1992-1999 leading up to the tech bubble, but underperformed the S&P 500 in the subsequent period from 1999-2010. This, along with other findings, led to the conclusion that the superior performance of SRI indices was factor driven rather than indicative of any greater intrinsic value to sustainability. Higher market betas (measures of systematic risk), greater allocation to growth stocks, an overweighting in the IT sector, and general differences in investing styles and industry sizes were viewed as strong factors explaining the variations in performance. Seeking to further challenge the view that sustainable investing may lead to higher returns, a study by Schroder (2005) revealed that 20 of 29 SRI indices were riskier than their corresponding benchmarks and consequently underperformed when returns were looked at on a risk-adjusted basis
Ultimately, more time and data will be needed before definitive conclusions can be reached. For many though, the data currently available is considered sufficiently convincing to assert that sustainable investing should not be seen as harmful to returns. The Certified Financial Analyst (CFA) Institute has subscribed to this view and states: “Investors seeking superior performance have incurred no material benefits or costs from owning stocks in sustainable and socially responsible companies.” For the time being, outright hostility toward sustainable investing may be unfounded.
Perhaps the most staggering discoveries from a survey of the literature are the primary findings of two studies: Eccles, Ioannou and Serafeim (2013) of Harvard Business School and Blank and Daniel (2002). The former finds that portfolios composed only of high sustainability companies significantly outperform portfolios composed only of low sustainability companies, and the latter demonstrates how portfolios constructed using only socially and economically efficient companies significantly outperform common benchmarks like the S&P 500. In both cases, the differences could not be attributed to market risk, style bias, or investment strategy.
Eccles, Ioannou, and Serafeim propose that high sustainability companies are better able to attract human capital, establish more reliable supply chains, avoid costly conflicts with local communities, and invest more heavily in innovation to manage the pressures and constraints of social and environmental engagement. These characteristics are further enhanced by distinct governance structures common to high-sustainability companies. Boards are directly involved in sustainability issues, executive compensation is linked to social objectives, and higher levels of shareholder engagement are encouraged. All these attributes serve as indicators of premium, high quality companies with promising growth prospects and strong profitability. Blank and Daniel argue that this constitutes a mispricing of information that reflects the market’s under-appreciation of the significance and impact of a corporation’s ecological performance.
An overview of the literature seems to suggest that SRI strategies impose no monetary cost on the investor and have the capacity to generate superior returns. Hardened disciples of the efficient market hypothesis will argue that any advantage, if there is one, will be competed away as investors become aware of the potential benefits and adjust their behaviour accordingly. In any event, it is undeniable that the empirical data dispels the notion that investing purely for one’s wallet and investing for one’s conscience are mutually exclusive. The difficulties of ensuring compliance and setting rigorous requirements for the label of ‘sustainable,’ however, remain difficult and challenging areas for the future of sustainable investing. It appears that investment managers may have incentives to invest in socially responsible companies for no other reason than sheer financial gain.
Caution must be urged before rushing to final judgment. The passing of time allows for the analysis of new data and information as well as a more nuanced understanding of market behaviour. Investors have long been disparaged as being irrational. Perhaps they will also come to be chided for being irresponsible.