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The Actuary The magazine of the Institute & Faculty of Actuaries

Will SRI outperform mainstream investments?

Ethical investment has long been associated with negative screening and avoidance, restricting the investment universe and consequently increasing the level of volatility and poor performance. Avoiding companies purely on moral grounds is difficult to justify to pension trustees, and has often led to ridicule of funds that do so.

Sustainable development
However, socially responsible investment (SRI) attempts to address investors’ twin concerns of enhancing investment returns, and the ways in which companies affect the environment and people. Fund managers are attempting to look into the future and predict the way the economy will look, identifying trends and themes which will affect financial markets. In the past, those investors that predicted the industrial revolution, or, more recently, the Internet revolution, have benefited strongly. SRI fund mangers believe that we will see a seismic shift towards sustainable development in the 21st century, and are attempting to focus portfolios to capitalise on this change. The definition that guides the philosophy of sustainable development is:
Development that meets the needs of the present without compromising the ability of future generations to meet their own needs. (Bruntland Commission, 1987)
In essence, sustainable development embodies our twin concerns that society should progress, through increased quality of life, and that this progress is guaranteed for a long time into the future. The means to attain this is in ensuring that economic growth continues, but not at the expense of our environment, not through discrimination against particular sections of society.
Demonstrating a process which links social and environmental analysis to financial performance has been the greatest challenge to SRI fund managers trying to give pension trustees confidence that SRI is fully commensurate with fiduciary duties. An approach is to use a sustainability matrix to identify companies and sectors likely to be able to benefit, or adapt to sustainable development and therefore most likely to grow over the next few years.
A company will be rated A to E, according to whether its core business, what it does and what it makes, is helpful or harmful to society and the environment. A denotes a highly positive aspect, such as a wind turbine company or a company developing a cure for a major life-threatening disease; B has some positive contributions, such as a communications company; C is neutral; D is damaging, for example oil companies; E is running entirely in contradiction to the aims of sustainable development, eg making land mines.
On the X axis is the management rating, in judging how well the management understand the environmental and social impact of their business, and what they are doing to mitigate these 1 is the best and 5 is the worst.
The retail funds can only invest in companies rated C3 or better, although the matrix can be extended for institutional investors. We hope that the first incentive for companies is that they will want to be included in the investable universe.

Method of engagement
However, the aim is to give all companies a rating and engage with all of them. This is where the integration of the SRI team into the mainstream is crucial. Any pertinent social and environmental issues will be raised with the company, as these are seen as affecting long-term profitability and are a useful indicator of management quality. The SRI profile, with its rating, will then be handed over to the management, who are encouraged to make comments. It is thought that most company leaders find this input useful rather than threatening, although this depends on their rating! Above all, we believe that this reasoned method of engagement is more likely to prompt companies to improve their practices than the efforts of activists.

Fulfilling the promises
It is the government’s stated policy to name and shame companies which do not have a published environmental policy. The upshot seems to be that companies are already responding to this threat and are seeking advice as to how they should go about producing an environmental report.
The strong advice is to combine it with a corporate social responsibility report which covers issues of human rights. It is hoped that the number of FTSE 100 companies producing an environmental report will go from 40, as is currently the case, to nearly 100 within a few years. And, once companies start responding on environmental and social issues, it is far more likely that they will have to act to fulfil the promises they make.

Investor choice
Will SRI add value to the fund management process and performance? I believe that companies which are in the vanguard of sustainable development will be superior long-term performers, so by having a highly experienced SRI team to feed this extra information to the mainstream analysts, they are able to make better financial decisions.
A distinction can be made between the screened SRI funds and the mainstream funds. Investors have a choice as to whether they want to invest only in socially responsible companies, or whether they want to invest in the mainstream funds where these issues will be taken into account, but not used as an automatic screening mechanism. Investors will also know that their money is not being idle, but is being used to encourage companies to improve their environmental and social performance.

Vital role
The symbiosis between corporate social responsibility and strong financial performance is becoming ever more apparent. The days when fund managers were simply custodians of other people’s money are over. As major stakeholders in the future of the economy, a fund manager’s role is complex and vital.