Once a niche field, socially responsible investing is big business today, accounting for more than a quarter of assets under management globally. Can investors change the world by changing their investment practices? And can you do well by doing good, or does limiting your investing universe mean sacrificing investment returns?
When the first ethical fund was launched in Britain in 1984, City traders nicknamed it Brazil, the joke being you’d have to be nuts to invest in it.
Today, attitudes are very different. Last year, BlackRock, the world’s largest asset manager, called on global companies to give more weight to environmental, social and governance issues. Globally, almost $23 trillion, or 26 per cent of all professionally managed assets, is now invested in “responsible investment strategies”, according to the Global Sustainable Investment Alliance. Almost 1,700 institutions – including the Ireland Strategic Investment Fund, Ireland’s sovereign wealth fund – have signed the United Nations’ Principles for Responsible Investment.
The definition of what constitutes responsible investing has grown more elastic over time.
In the past, the sector was primarily used by religious and charitable bodies looking to avoid exposure to controversial sectors such as tobacco and armaments. Negative screening practices remain important, although increasingly funds are opting for a policy of engagement. For example, the aforementioned UN guidelines to which Ireland’s sovereign wealth fund subscribes do not rule out investing in certain sectors or companies; rather, shareholders are asked to work towards improving companies’ environmental, social and governance policies.
Too elastic?
Some might argue the definition is a little too elastic. Last September, four of the world’s largest fund houses – BlackRock, Invesco, BNY Mellon and Vanguard – came under fire after it emerged they voted against investor-led climate change resolutions at two US oil companies’ AGMs. All four are signatories to the UN principles, which described their stance as “disappointing”.
The following month, fund giant Morningstar cautioned that almost half of all UK funds that are marketed as socially responsible are average or worse than conventional funds as regards their ethical criteria. JPMorgan Asset Management, one of the firms named in Morningstar’s report, responded by saying socially responsible investing “means different things to different investors”, adding that its fund “may not suit what many clients may be looking for”.
Others argue you don't have to be unethical to invest in unethical industries. Last month, Citigroup analyst Vikram Rai recommended buying tobacco bonds, saying they could yield returns in the "high teens" for investors this year. Admitting many clients viewed tobacco as a "morally objectionable sector", Rai defended his stance, writing: "Will an increase in cigarette shipments be beneficial for outstanding tobacco bonds? Yes, it will. But, will investing in tobacco bonds somehow cause an increase in cigarette shipments and indirectly exhort people to smoke more? No, it will not."
A survey of quantitative analysts at a Morgan Stanley conference last November showed a large majority viewed socially responsible investing as little more than marketing. Others, like Prof Meir Statman, an expert in behavioural investing, say investors who buy values-based funds instead of ordinary index funds are little different to people "who wave banners in the confines of their homes, declaring to themselves that they oppose contraceptives, poor labour practices or nuclear plants". This "banner waving", according to Statman, "does little to decrease the use of contraceptives, poor labour practices or nuclear plants."
‘Complicity’
The counter-argument, one advanced by Norway’s Government Pension Fund Global, the largest sovereign wealth fund in the world, is that owning shares in questionable companies “may be regarded as complicity” in their actions. The Norwegian fund, well known for not investing in tobacco, manufacturers of “particularly inhumane” arms, and other controversial companies, has been busy divesting from fossil fuel companies in recent years.
Ireland’s sovereign wealth fund is less strict, although it too employs negative screening practices. Investing in weaponry and mines is banned while the fund divested its remaining stakes in tobacco companies last December.
Divestment, say advocates, can stigmatise companies and sectors, resulting in lower share prices and a higher cost of capital that reduces their ability to raise money. One such example is the tobacco sector, which tends to trade at lower valuation multiples than would otherwise be the case.
As for the question of doing well while doing good, the research is “inconclusive”, according to a 2015 paper by Eugene Kiernan of Dublin-based Appian Asset Management. Both advocates and sceptics can point to studies that support their view, but the results can be distorted by the outperformance or underperformance of different sectors over different periods of time.
Some research suggests socially responsible investing is neither a help nor a hindrance, says Kiernan, although recent studies may suggest socially responsible investing can help yield superior risk-adjusted returns.
One reason is that good handling of environmental, social and governance issues is "often a signal of operational excellence", as BlackRock's Larry Fink argued last year. Some research suggests companies that employ more sustainable practices are more likely to outperform over the long term.
Policies designed to curb climate change, warned governor of the Bank of England Mark Carney in 2015, could result in fossil fuel companies becoming worthless, triggering "huge investor "losses". Companies that fall short of regulatory and legal standards can be punished severely, as Volkswagen shareholders discovered in 2015, when the share price almost halved after it admitted cheating emissions tests.
An April survey conducted by State Street Global Advisors found three-quarters of respondents said they invested in environmental, social and governance strategies because these factors play a role in a company’s broader financial performance.
Engaging with companies can pay off, according to research conducted by financial historian Prof Elroy Dimson, who heads the advisory committee of Norway's sovereign wealth fund. Dimson's data shows a company's stock price tends to rise if institutional investors persuade it to improve its environmental, social and governance practices.
The costs of virtue
However, AQR hedge fund manager Cliff Asness is unconvinced by the "do good and make the same return or more" argument. It's a "very basic thing" that investment constraints must hinder investment returns, says Asness. "If they help, they aren't constraints, they are what you want to do anyway."
Refusing to own “sin stocks” raises their cost of capital and lowers their stock price, says Asness, ultimately attracting “sinners”, who benefit from lower valuations and higher dividend yields. The obvious example here is the tobacco industry, which has historically been the best-performing stock market sector.
While research conducted by Meir Statman has found little difference in performance between actively-managed socially-responsible investing funds and their non-socially responsible investing cousins, it did find most responsible funds lag index funds as a result of higher expenses. The differential is not huge and socially-responsible investing investors may deem it to be a price worth paying.
Like Asness, Statman is sceptical towards the notion that you can beat the market by screening out certain sectors of the investment universe. An alternative approach, he suggests, is to buy very low-cost index funds and support the charities or causes you believe in via direct donations.
For its part, AQR offers ethical portfolios for its investors who desire and believe in them, says Cliff Asness. “We just won’t oversell negative screening as a free lunch”.
