30th June 2015
Most of us are increasingly aware of the social and environmental impacts of our daily lives; we may recycle, avoid buying products from certain companies and try to cut our carbon footprint. In reality though, we make compromises.
The challenges facing our world
There is no doubt that since the industrial revolution in the West in the eighteenth and nineteenth centuries, with its pollution, unbridled capitalism and social division, through to the current industrial and technical revolution in China and other emerging economies, we, as a species, have done immeasurable harm to the planet and each other. We face some immense challenges and risks that we can’t ignore. They are broad ranging in scope, probability and likely impact, and include things like energy price volatility, mass migration, the IS terrorist threat, nuclear proliferation, biodiversity loss, climate change, water and food scarcity, sweatshops and indentured labour. The challenges can be illustrated by a few, simple, yet alarming facts:
- in China, if you are a one-in-a-million person, there are 1,360 other people like you;
- the top 28% of India’s population by IQ is greater than the whole population of North America;
- by 2050 the world will have an additional 2 billion people, totalling 9 billion, looking to sustain themselves and improve the way they live with the same finite resources;
- in as little as 15 years, the demand for food, water and energy will rise by 35%, 40% and 50% respectively.
Making a difference through investment choices
Despite many peoples’ domestic attempts to ‘do their bit’ by recycling or reducing their carbon footprint, few seem to consider how their investing – that is to say the allocation of their capital – can make a difference. Fortunately, things are changing in this respect. It is estimated, for example, that today $1 out of every $6 under professional management in the US (around $6.6 trillion) incorporates socially responsible investing strategies.
Socially responsible investing – or SRI – is a catch-all term for investment strategies that focus on social or sustainability issues. Social issues broadly relate to issues such as diversity, human rights, consumer protection and animal welfare. Sustainability issues relate to building towards a sustainable use of resources for the world going forwards, and tackling environmental concerns such as climate change and hazardous waste management.
There is one unifying theme in socially responsible investing today which is that it is an investment discipline that takes into account the environmental, social and corporate governance criteria of companies around the world when investing money, with the aim of generating strong, long-term financial returns, whilst delivering a positive societal impact. These criteria have been abbreviated in the industry to ‘ESG’.
A potted history of SRI investing
In the early stages of this SRI investing, investment opportunities were often described as ‘ethical’ funds that avoided the key ‘six sins’: tobacco, alcohol, arms manufacturing, pornography, nuclear weapons and gambling. Over time, other opportunities arose to allocate capital in a way that reflected an investor’s personal values through funds that screened out other ‘bad’ companies and/or industries (from the perspective of the values espoused by the fund), or funds that only invested in ‘good’ companies.
The trouble is that it is very difficult to define ‘good’ and ‘bad’ in the grey world of commerce. Should a large engineering company with a small subsidiary manufacturing machine tools that could be used in manufacturing arms be classified as a ‘bad’ company? The difficulties of such an approach are self-evident.
The rise of ‘impact’ investing – that is to say investments made directly in support of projects such as the building of fresh water bore holes or helping impoverished communities to build small businesses via small direct loans (micro-finance) – has become a viable alternative. As someone wise once said: ‘it is better to teach a man to fish and help him to buy a rod, than to give him a fish’. The Big Issue is a great example of a social impact business, helping to get the homeless back into mainstream society. Other impact projects would be things like renewable energy funds and other environmental (or social) thematic funds.
A more recent development has been the construction of what have become known as ‘best-in-class’ SRI investments which do not make binary choices, but over-weight companies relative to their market capitalisation based on positive ESG criteria, or under-weight them if their criteria are poor. The implication is that firms who have better ESG credentials should outperform those that do not, in the long run.
A simple framework for thinking about SRI investing
So, how can investors sensibly integrate SRI investing into their own investment programmes?
Imagine a continuum with traditional investments at one end and philanthropy at the other. That was the traditional choice. In the middle, now sits impact investing. Traditional investments seek a return on capital, i.e. a market rate of return for market risks assumed. Philanthropists seek self-actualisation, sweetened by tax relief. The middle ground of impact investing seeks a return of capital, hopefully with some additional return – perhaps to be reinvested in more impact opportunities – but where the financial outcome is less easily defined in terms of expected returns, risk and relationship to other assets held.
For investors who feel strongly about sustainability and/or social issues, it probably makes good sense to incorporate a ‘best-in-class’, diversified SRI fund(s) into a traditional portfolio, accepting that not all asset classes lend themselves easily to SRI investing. On top of that, additional non-core allocations can be made to important issues and causes that are closely aligned with an investor’s firmly held values. It makes sense to steer away from a binary shopping list of activities/companies/sectors/countries that do not fit an idealist view of the world. The latter approach is likely to make the structuring of a sensible portfolio extremely difficult.
Each individual investor who invests in an SRI fund is allocating capital towards better firms and away from worse firms from an ESG perspective.
In the long run, as the impetus continues and the incorporation of ESG criteria into company analysis and stock selection decisions becomes mainstream, investors in passively managed index funds will participate in this reallocation of capital as the market capitalisation of favoured companies will rise relative to other less favoured companies with less sustainable strategies. In the shorter-term, passive investors can participate in the process of reallocation of capital through investment in passively managed SRI funds. Costs are likely to be a slightly higher than non-SRI funds on account of the additional work to capture, assess and rank the ESG criteria of firms. For some, this may be a price worth paying.
Other notes and risk warnings
This article is distributed for educational purposes and should not be considered investment advice or an offer of any product for sale. This article contains the opinions of the author but not necessarily the Firm and does not represent a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but is not guaranteed.
Past performance is not indicative of future results and no representation is made that the stated results will be replicated. Errors and omissions excepted.