Socially responsible investing is more complex than simply distinguishing ‘good’ companies from ‘bad’ companies, writes Bruce Smith.
Over the past couple of decades there has been a clear and growing movement towards the consideration of social responsibility when it comes to investment.
Some government funds have recently instructed their fund managers to avoid some industries like tobacco when investing.
Public funds are increasingly looking for ways to provide options for investors who wish to avoid investing in “bad” or controversial companies.
There is a valid criticism of the financial markets that stock analysis focuses too much on the numbers and not enough on the impact the company has on society or the environment.
Some also point to the importance of governance: the ethics of a board or whether a company is run to benefit all shareholders equally rather than a single class.
As a result, the concept of taking into account environmental, social or governance factors (ESG) has grown in recent years to the extent that it is now fairly commonplace: the number of professional investors not taking these factors into account would today be far outweighed by the number who do. It’s fair to say that responsible investing is mainstream (see Figure 1).
Socially Responsible Investing (SRI) is more than just ESG.
However it is loosely defined and can include ethical funds, sustainability funds and environmental funds.
Sometimes even funds which merely say they consider ESG are portrayed as being socially responsible. SRI can be a controversial term as it implies that funds and fund managers who do not operate in the SRI space are irresponsible.
Socially Responsible Investing generally refers to an investment strategy that selects stocks based on social outcomes as well as financial returns, but all are set up differently.
Some SRI funds have negative screens, rules by which certain industries or companies are ruled out as potential investments.
Some have a negative screen but with a threshold: as long as the “bad” operation is less than a certain proportion of the company’s total revenues or earnings then it’s okay to invest.
Others have positive screens, where they look for companies in certain industries or with a track record of doing good in particular areas, like a property company “greening” its buildings.
Some merely look for best of breed which means the fund can invest in a bad industry as long as the company itself is better than its peers. Some have a combination of some or all of these things.
It makes sense to combine a negative screen and a positive screen.
For example, by using a negative screen to exclude any companies with direct exposure to certain industries including alcohol, tobacco, gambling, armaments and the logging of old growth forests.
This process cuts out about a tenth of the ASX300 by market cap, including some of Australia’s largest and best-known companies.
For example, both Woolworths and Wesfarmers – two companies considered blue-chip by most unconstrained investors – fall outside many socially responsible guidelines as both operate large numbers of electronic gaming machines, among other things.
The positive screen looks for companies with appealing attributes. An example of this is its investment in Meridian Energy, a NZ power company which largely produces renewable energy.
One challenge that excluding stocks presents is that it skews the available investment universe away from the normal benchmarks such as the ASX300.
Most of the excluded companies are considered to be “defensive”, so when the market is having one of its periodic bouts of weakness, responsible funds unable to own those defensive stocks might underperform.
While the obvious resolution is to compensate for the excluded stocks by replacing them with acceptable companies with similar operations or return characteristics, picking the ideal replacement stock is tricky and there is rarely a perfect substitute.
To continue the example, an investment in supermarket supplier Metcash as a proxy for Woolworths and/or Wesfarmers in recent years would have led to the fund underperforming badly.
Does responsibility equal performance?
There is a case made by some SRI managers that responsible funds should outperform more broadly-based or unrestricted funds over the long term, but the evidence for this is limited, to be generous.
There will of course be periods in which this will be the case, but a constrained fund will often struggle to outperform an unconstrained fund.
After all, the constraints mean there are a number of companies in which you are not able to invest, and from time to time some of those companies will do really well.
For example, any fund portraying itself as socially responsible is unlikely to invest in gambling companies, yet casino-operator Crown Resorts has been a stellar performer in recent years.
We believe that the skill of the manager is a bigger determinant of fund returns than whether or not it is responsible.
So how should financial advisers choose a good manager? Within the industry, one of the tools used to measure manager skill is its Information Ratio.
The Information Ratio (IR) is a risk/return measure: the return the manager achieves for the degree of volatility.
To calculate the IR, divide the fund’s alpha (its above-market performance) by its tracking error (its volatility around the benchmark) over a period of at least three years.
It is a common mistake for people assessing equity funds to only focus on the tracking error, in the belief that taking risk is the only determinant of outperformance, while ignoring the manager’s record of getting its calls right.
An information ratio of 1 is generally considered to be very good; however our SRI fund’s information ratio over the three years to December 2013 (1.5) is a little lower than for our unconstrained fund (2.2), illustrating that responsible funds will not necessarily outperform unconstrained funds.
The road less travelled
Which is the best way to go?
Investors and the general public are increasingly asking what impact their money is having.
The popularity and growing interest in SRI (or broader SRI concepts under other names) is a testament to the popularity of thinking differently about investment outcomes.
The question the investment community should be asking is: Are my investors purely interested in getting the highest possible return?
If so, an SRI fund may not be the best option. Constraints placed on an investment universe lead to a different outcome to a fund investing in an unconstrained universe – it may be better or worse, but it will be different.
Some “bad” companies sometimes provide very good returns and a good fund manager without SRI constraints can take advantage of that.
But if investors are looking at the big picture, over the very long term it would be reasonable to expect that companies operating in a way that damages society or the environment will not prosper – and maybe even not survive.
Upcoming generations and shifting attitudes towards investment outcomes and social returns, as opposed to pure financial returns, will be the compass that will increasingly point us towards a more socially responsible style of investing.
Bruce Smith is a principal at Alphinity Investment Management.
