With one sixth of UK consumers demonstrating ethical and environmental concerns in their buying habits, it is no wonder SRI funds are becoming more mainstream
Socially Responsible Investment (SRI) is rapidly becoming a mainstream issue for investors in the UK and other countries. The first ethical funds were created in the 1970s but were very much the domain of private investors and charities, whose main concern was to exclude investing in companies in certain proscribed sectors such as armaments, pornography, tobacco and gambling.
As these issues gained wider publicity, the emphasis developed to include environmental factors ' the birth of green investing. At the same time, the research approach shifted from negative to positive screening, from pure exclusion to a strategy based on inclusion.
More recently, there has been a further broadening, with the introduction of the concept of responsibility in the investment process. This has particular application in the areas of the environment and human rights. Sustainability has become central to environmental concerns, for example. Investors will favour companies that seek to sustain the environment by switching their emphasis from extraction or consumption of fossil fuels to renewable fuels.
The growth of SRI was originally driven by the demands of the retail and charitable sectors. Today in the UK, there is around £3.7bn invested in more than 50 retail funds, while one sixth of UK consumers are keen to act in an ethically and environmentally aware manner in their buying habits. These statistics are at least matched in the USA and many European countries, where SRI issues are also developing fast.
Continental Europe has more than 200 retail SRI funds and government encouragement is growing: France has an SRI regulation covering employee savings plans, the Dutch government has introduced tax incentives and the Norwegian government requires its oil revenues to be invested on an SRI basis.
The SRI market is more established in the US and Canada and the fund management capabilities and research networks are better developed. It is estimated that more than $2 trillion is invested in a socially responsible manner in the US. This amount has grown by 82% since 1987 and represents 13% of all money under professional management.
Today, powerful forces have taken over as the chief driver of the SRI sector in the UK. In July last year, it became mandatory under an amendment to the 1995 Pensions Act for UK pension funds to state their policy on SRI issues in their Statement of Investment Principles. Since then, surveys have shown that 59% of funds have incorporated SRI into their investment policies, either through direct engagement or by instructing their fund managers to act on their behalf.
As a result, approximately 10% of occupational pension fund assets are now committed fully to pursuing SRI investment. While Britain has moved earlier than other governments in institutionalising these issues, France and Germany are shortly to adopt new regulations on ethical disclosure very similar to those in this country.
There is, however, a clear divergence of attitude and approach between the public and the private sectors. Private sector funds have thus far tended either to delegate the decision over SRI to their fund manager or request that their manager takes environmental, social and ethical concerns into account where such concerns are seen as financially relevant. Local authority funds, on the other hand, tend to retain ownership of their SRI policy and have favoured the approach of engagement, not necessarily via the fund manager.
In the public sector, BT, British Coal and the Universities Superannuation Scheme have already committed to operating ethical policies, while among local authorities, Nottinghamshire has been the standard bearer. Other funds, such as Norfolk, Lancashire, Aberdeen and, in the recent past, Bath & North Somerset, have carved out part of their funds for specialist mandates. It is not unreasonable to expect that SRI will be completely in the mainstream in the local government sector by 2003 or 2004 at the latest.
By then, verifiable performance records will be available and the issues of trustees' fiduciary responsibility for investment returns will be more quantifiable.
Unsurprisingly, given the pace of development, fund managers are seeking to build dedicated SRI resources.
Nevertheless, the degree of genuine resource and expertise is still limited and many investors rely on external research sources. This seems destined to change as fund trustees require proper diligence to be displayed in the management of their assets.
For the moment, many components of the investment management industry are watching and waiting, which is a reasonable response given that the area is dynamic in its ability to change and develop. Also, there is little hard evidence of the success or otherwise of SRI investment strategies, while pension fund trustees can still hide behind the defence of their ultimate fiduciary duties to their scheme members.
Further changes will come apace, not least from fresh legislation in this and related fields. The issue for industry practitioners, either on the buy or sell side, is that to participate requires an investment in additional resources. For fund managers, an investment in adequate resources is essential to achieve credibility as an SRI specialist, while at present most external research is only available from specialist independent organisations.
The main issue for analysts is crystallising around 'reputational risk', where there is already much evidence of SRI issues impacting shareholder value, both positively and negatively.
As the SRI market has grown, it has become increasingly complex in nature. A purely ethical investment approach has been replaced with a socially responsible perspective that encompasses a wide range of environmental and social concerns. As the issues have become more complex, so have the methodologies.
There are generally acknowledged to be three broad techniques in use: engagement, preference and screening. These may be used in combination.
Engagement is a strategy whereby an investment manager makes active contact with companies to seek an improvement in their behaviour with regard to ethical, social and environmental issues. Companies are then encouraged to pursue such policies and the investor will critically monitor performance in these areas.
Preference involves ranking companies according to how well they satisfy the ethical policy set by a fund's trustees or other beneficial owners. In this case, all companies are potentially available for investment but each will be ranked against pre-established criteria. It is in no one's interest to simply exclude companies point blank, since this will impact investment returns while putting no pressure on them to clean up their act.
The concept of preference is for investors to encourage companies to pursue ethically friendly policies, ultimately for their own benefit. Preference strategies are closely linked to positive screening approaches.
Screening remains the most common method used to construct an SRI portfolio. Investment managers create an investable universe by screening securities in or out of contention, depending on whether a company's activities meet with the investor's values on various grounds, such as moral, political, religious, social or environmental.
The first ethical funds only employed negative screens ' in other words, strictly excluding companies that breached investors' specified ethical values. Funds using negative screens were often designed for private individuals or charities.
These days, positive screening is seen as more suitable, particularly for pension funds where trustees' primary duty is a fiduciary one. Positive screens are often used in conjunction with preference strategies described above. Thus, companies that earn high rankings according to the fund's pre-set criteria may be included even if they fall in an inherently negative sector.
Many funds employ a mixture of positive and negative screens. Within each ethical topic, there will be sub-divisions where ranges of tolerances can be established.
One of the key influences behind the rate of growth of SRI from here will be the development of valid and robust investment performance records. The short time span currently available will inhibit action, particularly among private sector pension scheme trustees who remain concerned over their fiduciary responsibilities.
However, the recent introduction of the FTSE4Good index is likely to take these issues forward and will permit the introduction of specialist benchmarking.
In the meantime, the expected rapid growth of, and shift to, defined contribution pension plans will definitely see growth in SRI pooled pension funds as a member-led option. As more fund managers are obliged to build their in-house SRI capabilities, so their demands for specialised research will increase. The only problem for providers, at least at present, is the lack of obvious opportunities for premium pricing.
• First ethical funds were created in the 1970s.
• Research shifted from negative to positive screening.
• Growth of SRI originally driven by retail and charity sectors.
• Mandatory for UK pensions funds to state their SRI policy.
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