This article appeared in Finance Magazine

Socially responsible investment ‚€‘ the future of investment?
Socially Responsible Investment (SRI) has evolved considerably since the early days of ‚€ėethical investment‚€ô, and is becoming a more accepted mainstream option, illustrated by the Church of Ireland‚€ôs recent decision to sell ‚ā¨5 million of CRH shares because of its involvement in the construction of the Israeli security wall in the West Bank, Ellen Bailey of Mercer Investment Consulting writes.
Socially responsible investment (SRI) is differentiated from mainstream investment management by its use of non-financial criteria when selecting investments. The type of non-financial criteria involved depends on the objectives of the fund and range from single issue exclusions to broad ranging policies. While SRI is traditionally associated with ethical investment, it has been evolving into a diverse product area. In this article, we look at the evolution of SRI into three distinct investment approaches: the traditional ethical approach, the neutral impact approach and the return enhancing approach. In addition, shareholder engagement is forming an important element of more recent approaches to SRI and we look at this as well as the position of pension fund trustees in relation to SRI issues generally.
Ellen Bailey
Ellen Bailey


Ethical investment
The traditional ethical investment approach involves the systematic avoidance of investment in targeted companies, industries or countries for moral or ethical reasons and is often referred to as negative screening. This approach has largely been the domain of retail and charity investors rather than large institutional pension funds and is also used by entities with a strong ethos where investing in particular types of companies would be counter to their corporate objectives. A hospital, for example, may be concerned about investing assets in a fund that invests in tobacco companies. For other investors however, the drawback with this approach is that it reduces the available investment universe and therefore potentially restricts investments returns. While this may be acceptable for some investors, it is unlikely to be acceptable for many mainstream investors including pension fund trustees.

Neutral impact approach
A ‚€ėneutral impact‚€ô approach to SRI is where the fund mirrors the risk-return characteristics of traditional portfolios but adopts SRI issues as a principal part of its investment criteria. Unlike the negative screening approach, this approach does not systematically avoid companies or sectors (although negative screening may still be used where some factors are believed to have a material impact on performance). Rather, companies are assessed on SRI-related issues and leaders on these issues are identified within their sector, a process often referred to as positive screening. Companies deemed to be socially responsible are overweighted while socially irresponsible companies are underweighted (often called ‚€ėbest in class‚€ô investing). In other words, very simplistically, the least ‚€ėbad‚€ô companies in a particular sector are adopted. The SRI investor‚€ôs insights on non-financial issues can ultimately end up being reflected in stock price performance. The thesis behind the neutral impact approach is that this happens often enough that the investor is financially compensated for using non-financial selection criteria and the overall effect on the portfolio‚€ôs return and risk characteristics is therefore neutral.

Return enhancing approach
The third generation approach to SRI investment looks at a company‚€ôs record on environmental, social and governance (ESG) issues and uses it as a means of identifying potential out-performance. This approach is based on the philosophy that these ESG, or non-financial criteria, can have a material impact on long-term corporate performance and that superior management of ESG issues can be a proxy for good management. By being aware of all factors that could impact a company‚€ôs performance, investors can better manage risk and generate value creation opportunities.

In general, all three approaches to SRI are represented amongst international providers and investors can select the approach which most closely matches their own SRI investment objectives.

Engagement
Shareholder engagement on SRI issues is a further means open to investors of encouraging good corporate social responsibility. It is often used in tandem with the three approaches outlined above or as a separate means of furthering the investor‚€ôs SRI objectives. Engagement uses ongoing dialogue between investors and management and the leverage available through the exercise of voting rights to encourage companies to improve their ESG record.

One indication of the growth in this area has been the decision by certain large investors, including large pension funds, to reclaim their voting rights from their investment managers and to bring the exercise of voting rights within their own internal functions. The perceived benefits associated with such an approach include the opportunity to vote consistently across all holdings, adopt an active policy of shareholder engagement and ease in reporting to stakeholders on how and why votes are cast. For larger investors, who cannot dedicate significant resources to this area, outsourcing of this function to specialists in the form of engagement overlay, is now available.

Engagement overlay products first became available in early 2000, and to date, have been a largely UK phenomenon. These services are typically provided by asset managers that have already developed engagement capabilities for their existing funds. The focus of engagement varies from corporate governance to environmental and social issues and is predominantly concentrated on large-cap equity asset classes. While the fees for these services are generally low, comparable to custody fees, they typically incorporate a minimum fee level which can make it less attractive for small and medium sized investors. For larger funds, this product allows them to manage engagement on their existing portfolios while not directly impacting on their investment management arrangements.

Role of pension fund trustees
One of the main barriers to SRI for pension funds is the role of the trustee and the potential breach of their duties if they adopt an SRI approach. Trustees are bound to exercise their powers in the best interests of beneficiaries and this is generally interpreted to mean the financial best interests of beneficiaries. Given the more recently developed approaches to SRI, the issue of sacrificing returns for ethical principles is less of a problem for trustees than before. Financial pressures on defined benefit pension schemes in recent years have of course, been the main concern for most trustees but for those who wish to incorporate socially responsible objectives into pension fund investment, SRI investing is becoming a practical option.

One of the significant developments in SRI investing is the requirement introduced in July 1999 in the UK, for pension funds to disclose the extent to which they consider social, ethical or environmental (SEE) issues in their investment process. This has proven to be a significant step and has inspired similar moves elsewhere in Europe. In practice in the UK, the requirement to consider SEE issues and their role in the investment process has led to a move towards increased engagement and the consideration of ESG issues by investment managers. There are now a range of UK investment managers with well developed SRI capabilities particularly in relation to UK equities.

In conclusion
Education remains a key issue for the SRI industry. For many, socially responsible investment still conjures up visions of negatively screened funds with a particular ‚€ėagenda‚€ô to pursue. In fact, this approach is only adopted by a comparatively small amount of assets under management in SRI funds. The combination of increasing interest in SRI, coupled with new, more acceptable mainstream approaches for its implementation, appears likely to result in the rapid growth of SRI assets under management over the coming years. Increasing awareness of the impact of ESG issues on company performance is also likely to encourage the further integration of SRI teams and their mainstream investment colleagues and confirm SRI‚€ôs place in the wider investment process.
Ellen Bailey is senior investment consultant with Mercer Investment Consulting
This article appeared in the November 2005 edition of Finance Magazine.