The Enron scandal and Railtrack debacle have proved just how important it is to investigate a company's socio-political and environmental performance in addition to its financial achievements
Socially responsible investment, which combines financial objectives with social, ethical and environmental issues, continues to gain ground around the world.
There are now ethical or SRI funds widely marketed in the US and Canada, Europe, Japan and Australia. An industry in the UK that had the backing of just a few million pounds 10 years ago now claims to represent the interests of hundreds of thousands of investors with many billions of funds under management in savings and retirement plans.
Henderson Global Investors, one of a number of fund managers with teams specialising in socially responsible investment, now has over £1bn managed in this way.
According to research from the SIRI Group, SRI is one of the most dynamic and rapidly growing activities in the investment funds industry in Europe. The study reported that the number of retail SRI funds across the EU increased by 58% to 251 between January 2000 and June 2001. This was despite the difficulties faced by the financial sector across Europe during that period.
Market analyst Mintel disclosed that ethical investment more than doubled its share of overall retail investment sales in the UK between the end of 1999 and the end of 2001. Our own experience as manager of the NPI Global Care ethical fund range, is that these funds saw 50% a year new business growth every year for six years, with funds under management growing from just £15m to over £600m in a short space of time.
So what exactly is happening? To the casual observer, it must seem that either a bandwagon has appeared, which everyone is jumping on to, or investors are developing a conscience.
A more likely reason, however, is enlightened self-interest. It is clear that growing awareness of environmental and social issues is creating business opportunities, and that recent events have shown how business ethics (or a lack of them) can impact on corporations.
A central element of the investment process of the SRI team at Hendersons is that there are a number of key social and political themes that will drive economic development in the future. These are the big issues, the themes that will not go away even if there is economic uncertainty in the shorter term.
They include major issues such as climate change and the increasing demand for renewable energy solutions, and the demographic pattern of developed economies where an ageing population creates massive opportunities in healthcare.
The consumer demand and political will to find technological and infrastructure solutions to pressures such as congestion and pollution also provide investment potential.
Extracting the maximum value out of sectors like these requires specialist research, not only of the financial aspects of a company but also the social and political environment in which a company operates. This is what SRI funds do so well and this is one of the reasons why the outlook for proactive and well-resourced SRI funds is so positive.
The key test for any business or product is whether it does the job it sets out to do. And in the case of SRI, the key test is financial returns. Are the returns as good as, worse or better than conventional funds?
Significantly, there is plenty of evidence to prove that there is no performance penalty for SRI. In the US during 2001, 63% of all screened SRI funds in the US earned the highest grading from Lipper or Morningstar.
Of the five major SRI funds in the US over $100m in size, four of them received the highest Lipper or Morningstar rating. All of this was achieved in the teeth of a major economic downturn.
There have been a number of new pieces of research emerging from the likes of UBS Warburg, ABN Amro and others such as Mistra, a research foundation funded by the Swedish Government. The analysts within these companies have turned their attention to SRI, in order to find out the facts about performance. With no vested interests or any desire to necessarily endorse SRI, their findings are very interesting.
ABN Amro Global Consulting concluded in a 130 page report published in September 2001that the balance of empirical evidence supports the view that SRI has generally not led to a long-run risk-adjusted underperformance versus a conventional approach. Reports from UBS Warburg and Mistra concur with this view.
Taking the conclusions of the available research together, the report by Mistra describes the broad opinion that, at worst, stock selection using social screens has no negative financial performance and, at best, has a measurable positive impact.
These results clearly give the cynics over SRI something to think about.
It is clear that many of the disciplines of SRI have genuine mainstream applications for investment managers. In the 21st century the manner in which a company operates is as important as the products and services it delivers, and Enron is a case in point.
Enron was seen by some as a champion of corporate responsibility, funding renewable energy projects and producing glossy environmental reports. And yet none of the SRI funds managed by Henderson invested in Enron, as they had a poor record for labour practices in developing countries, and involvement in controversial projects in India.
The question to be asked now is whether or not the way that a company conducts itself provides a proxy for the style and behaviour of management.
In the case of Enron, hindsight tells us that its problems in India were indications of its style of management. The challenge now is to learn from this and develop SRI as a powerful tool for risk management.
Fund managers have traditionally focused on the economics of a company. At Hendersons, these skills are augmented by social and environmental analysis, conducted by people with a background in political and environmental think tanks and non-governmental organisations.
As a result, a company is assessed on all aspects of its business, environmental and socio-political, as well as financial. The characteristic wider analysis of key trends and companies' performance therefore gives SRI an edge. Although there is a short supply in the market, the skills set required is highly relevant to the modern investment decision making process.
The disciplines involved in SRI will prove invaluable for mainstream fund managers. Over the next few years SRI will be a legitimate part of mainstream investment management, and every fund management company will adopt its disciplines. Why? Because it makes financial sense.
Analysing a company's financial performance provides one perspective of its investment potential. Analysing its social and environmental performance provides a bigger picture view, and helps in the understanding of risk.
SRI is a more detailed and holistic approach to looking at companies. Issues such as labour relations, corporate accountability and responsibility, the value of the brand and its reputation, are all sources of business value. Misjudging them can be a big mistake, as recent events demonstrate.
The City is beginning to understand that economic, social and political development go hand in hand. More companies are building up capabilities and recruiting people with specialist knowledge.
Corporate responsibility, or the lack of it, has a critical part to play in share price performance. If a company's reputation is wrecked, then the City feels the pain. The blind pursuit of profit alone can, and will, cause some major problems like Enron to occur.
This is why SRI is here to stay. Those who doubt it better take a hard look at the Enrons and the Railtracks, and understand that sometimes, financial analysis on its own is not enough.
Ethical investment more than doubled its share of overall retail sales in the UK between end of 1999 and end of 2001.
In the US during 2001, 63% of all screened SRI funds earned the highest grading from Lipper or Morningstar.
Corporate responsibility, or the lack of it, has a critical part to play in share price performance.
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