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The Mainstreaming Of Socially Responsible Investing

By: Gary Hawton

The world of ethical investing used to be so simple when the approach led to nothing more than screening out a few of the so-called ʻsinʼ stocks. Tobacco, alcohol, and pornography manufacturers were among the industries that were automatically excluded from these portfolios.

For retail investors, these funds provided a way to align their investments with their personal ethics and concerns. But for plan sponsors, the focus on excluding companies based solely on the product which they made was a cautionary flag. Could they meet their fiduciary responsibilities while excluding entire industries? For many, the answer was ʻNo.ʼ

But the world of ethical investing has moved a great distance from these humble beginnings to the point where even the phrase ʻethical investingʼ is rarely used. Instead, socially responsible investing (SRI) is likely the most popular descriptor of the industry as a whole and the screening process is moving away from referring to positive and negative screening and towards employing environmental, social, and governance (ESG) analysis of each company within the portfolioʼs universe.

Much of this has been a natural evolution for the industry. Many cite a religious group, the Quakers, as the original SRI investors as they chose to exclude items from their investment portfolio that ran counter to their belief system. From there, other groups chose to exclude certain industries and asked their money manager to implement these policies. Retail funds were created to meet some of this demand from the general public and the success of these funds led to pressure being put on the trustees of many pension funds. Some responded by applying certain pertinent criteria to their plan and others flatly refused to implement a SRI policy.

And that is where we sat for years in Canada – with a healthy, albeit small, retail SRI market, with some specialty pension plans choosing to reflect the beliefs of their members, but with the vast majority of public and private pension plans coming to the conclusion that SRI, as they understood it, was contrary to their fiduciary duty.

Thinking Is Changing

Much of this thinking is changing and more pension plan trustees are taking a fresh look at SRI. There have been two landmark events that have caused much of this re-analysis.

The first is a study by the law firm of Freshfields Bruckhaus Deringer, a leading international law firm. Its report, ʻA legal framework for the integration of environmental, social and governance issues into institutional investment,ʼ was commissioned by the United Nations Environment Programme Finance Initiative to answer several basic questions including “Are ESG considerations ʻvoluntarily permitted, legally required, or hampered by law and regulations ʼ by public and private pension funds primarily and insurance company reserves and mutual funds secondarily?”

The answer has reopened the discussion around the application of ESG analysis. The condensed response was “The links between ESG factors and financial performance are increasingly being recognized. On that basis, integrating ESG considerations into an investment analysis is clearly permissible and is arguably required in all jurisdictions.” It is becoming increasingly difficult for pension plan trustees to postpone their discussion of ESG application any longer when confronted with this report.

For those plans whose corporate mission statement would lean towards excluding entire industries because of the nature of the company (an anti-tobacco group), the report indicates that the trustees of this type of group may be duty-bound to not invest in a company whose product was contrary to the mission statement of the plan.

United Nations Principles

The second event which raised eyebrows was the unveiling of the United Nations Principles for Responsible Investing in early 2006. That the UN would produce such a document was not a surprise. That it lined up investment mangers with assets of more than $5 trillion to become signatories was a significant milestone. Included in this total are the CPP Investment Board and the Caisse de depot et placement du Quebec, representing two of the Canadian signatories.

The UN principles do not call for the exclusion of certain industries, nor do they mandate the manner in which ESG analysis is applied to a portfolio. Instead, they allow individual companies the opportunity to create their own response to the preamble “As institutional investors, we have a duty to act in the best long-term interests of our beneficiaries. In this fiduciary role, we believe that environmental, social, and corporate governance issues can affect the performance of investment portfolios (to varying degrees across companies, sectors, regions, asset classes, and through time). We also recognize that applying these principles may better align investors with the broader objectives of society.”

Companies and industries are no longer excluded merely because they are a ʻsin stock.ʼ Rather, under ESG analysis, the social and reputation risk associated with manufacturing that product is factored into the overall risk-reward scenario for that company. A decision is made as to whether a company is a good investment considering these issues which were previously seen as non-financial, but are now viewed as critical in computing the overall value of a company.

Closer Look

Plan sponsors need to take a closer look at how their investment managers are analyzing the environmental, social, and governance policies and practices within the firms in their portfolio. To rest on a previous assumption that these issues place the plan outside of legal boundaries may no longer be the case (and may never have been). The evolving definition of SRI from ethical investing to ESG analysis and the growing group of institutional money managers who are embracing the basics of ESG analysis is one reason to add this discussion to the next trusteeʼs meeting. The most recent legal opinions on the subject should be enough to make the discussion lively and in depth.

Gary Hawton is chief executive officer of Meritas Mutual Funds.

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