By Matthew J. Kiernan
In recent months, state treasurers, pension fund trustees, money managers and other fiduciaries have all been taking a fresh, hard look at "socially responsible investing" and, increasingly, they are liking what they see.
The genesis of this new enthusiasm is the emergence of a much clearer distinction between two very different approaches to SRI that had previously been mixed together and confused.
That older, more established approach relies primarily on screening out "undesirable" companies, based on the investor's personal or collective organizational values. This "old-school" SRI has historically encountered tremendous resistance from mainstream institutional investors and their advisers, for at least three reasons:
• The enormous difficulty of crafting a single set of ethical norms to which a large, heterogeneous group of retirees and beneficiaries could all subscribe;
• The deep-seated (but rarely examined) belief that companies' social and environmental performance are at best irrelevant and at worst actually injurious to their financial returns; and
• The corollary view that, since returns are "inevitably" compromised, the imperatives of fiduciary responsibility demand that social and environmental factors be set to one side when investment decisions are made.
There is, however, a newer, quite different approach to SRI. Instead of attempting to make ethical value judgements, this approach, more accurately described as "sustainability" investing, views companies' ability to manage complex SRI issues primarily as a proxy and leading indicator for their overall management quality. Under this view, strong SRI performance can therefore become a potential source of competitive advantage, superior profitability, and share price out-performance.
I have considerable sympathy for this new school. After all, what sterner test of management quality is there than the ever-changing kaleidoscope of tightening regulations, shifting public and consumer expectations, and competing stakeholders created by business challenges as diversified as climate change, human rights and HIV/AIDS?
The case for using SRI performance as a proxy for management quality was nicely summarized in a recent United Nations report endorsed by Goldman Sachs & Co., Morgan Stanley & Co. and a number of other leading mainstream financial houses. The report said: "In a more globalized, interconnected and competitive world, the way that environmental, social and corporate governance issues are managed is part of companies' overall management quality needed to compete successfully. Companies that perform better with regards to these issues can increase shareholder value."
This emerging viewpoint has already been reflected in changes to pension fund legislation in the United Kingdom, much of continental Europe and Australia. This legislation now obliges fiduciaries to report on their plans for incorporating company SRI assessments into their investment strategies. The prudent fiduciary equation has effectively been turned on its head; fiduciaries are now viewed as derelict in their responsibilities if they do not ensure that environmental and social risks have been addressed.
In North America, despite the lack of any explicit legislation along similar lines, institutional shareholder activism on environmental and social issues is increasingly dramatically. Climate change has become the fastest-growing single category of shareholder resolutions in the United States. A dozen state treasurers have joined other public and Taft-Hartley fund leaders in forming the Investor Network on Climate Risk. The INCR has been pushing both financial regulators and industrial companies to disclose and address the potential investment risks of climate change. In California, Treasurer Phil Angelides has announced an ambitious "green wave" initiative, which proposes to invest $1.5 billion of California pension assets in environmentally enhanced investment vehicles. Contra Costa County Employees' Retirement Association has been operating a $175 million environmentally enhanced investment strategy for more than two years now.
There is a growing body of sophisticated investment research that would appear to validate the thinking behind both the INCR and the green wave initiatives. One of the most compelling was a study conducted in 2004 by a group of Dutch finance academics including Rob Bauer, who also is head of research for Stichting Pensioenfonds ABP, Heerlen, the Netherlands, one of the largest pension funds in the world. Mr. Bauer's research took great pains to eliminate the impact of each of the traditional drivers of investment returns, in order to focus exclusively on any financial impact of SRI factors. His conclusion: In the case of U.S. large-cap stocks, SRI factors had added roughly six percentage points per year. Similar findings have also emerged from a recent study undertaken at State Street Global Advisors' Advanced Research Center in Boston, and from a myriad of others. The SSgA center's study found an SRI-enhanced portfolio out-performed its benchmark by nearly seven percentage points per year, with roughly two percentage points of that directly attributable to SRI factors.
SRI factors will become even more critical to investors. Several powerful global megatrends are already at work to increase the "SRI risk premium" even further:
• Tightening national, regional and global regulatory requirements for stronger company performance and disclosure of non-traditional business and investment risks.
• The expansion and intensification of industrial competition into emerging markets, exponentially increasing the level of risk for both major corporations and investors from these new, non-traditional factors.
• Changing attitudes of both consumers and investors, substantially increasing the saliency and financial stakes of companies' environmental, social, and governance performance.
• A substantial broadening of what is considered legitimate fiduciary responsibility to include companies' performance on these new issues.
• Growing pressures from international non-governmental organizations, armed with unprecedented resources, access to company data, credibility and global communications capabilities.
• A growing inclination — and capability — among major institutional investors for shareholder activism in the governance of their portfolio companies on these issues.
Taken together, these trends form a virtually irresistible force that seems certain to transform the investment landscape for at least the next decade.
Matthew J. Kiernan is chief executive of Innovest Strategic Value Advisors, Richmond Hill, Ontario. Innovest is subadviser to the Contra Costa County (Calif.) Employees' Retirement Association for a sustainability enhanced portfolio; it also contributed to comments to the United Nations' report at the organization's request.