The different criteria and methods used in determining suitability of investments have evolved over time and vary significantly across SRI products
Despite its growing popularity, many investors still view socially responsible investment (SRI) funds as homogenous, self-righteous vehicles. This is only partially correct. While some funds probably do have a ‘holier-than-thou’ attitude, the different criteria and methods used in determining suitability of investments have evolved over time and vary significantly across products.
Where did the SRI concept come from?
The original driving force behind SRI arose as a result of religious organisations’ wish to have investment portfolios that reflected their core beliefs. These funds tended to adopt a ‘negative’ screening process, which often prohibited investment in those companies involved in sectors such as tobacco, alcohol or armaments. During the 1990s, as SRI moved towards the mainstream, many funds began to incorporate positive screening into the investment process.
Positive screening looks to find those companies who promote social and/or environmental sustainability. Determining suitability often relies upon scoring a company against some pre-determined criteria or analysing performance against the company’s industry peers to find the ‘best-in-class’. However, such an approach can make it difficult to construct a balanced portfolio.
Many SRI funds that rely upon positive screening are inherently biased towards stocks with higher market capitalisations. While this may be intuitively obvious, it remains a factor that many SRI fund managers fail to acknowledge. If a fund requires the achievement of a minimum score in a screening process, or a company to have industry-leading reporting capabilities, this is bound to favour those companies with greater resources. BP has a market capitalisation in excess of £100bn and, despite the difficulties faced during the year, is expected to report net income of around £15bn for 2009. It should therefore come as no great surprise that BP’s social and environmental reporting is excellent. Alongside a 28-page sustainability report, BP’s website offers a wealth of information relating to environmental performance, health and safety performance and the company’s involvement in the local communities where it operates. It is likely to score well on most SRI criteria. In contrast, Gulfsands Petroleum has a market capitalisation of just over £300m and expected net income for 2009 of around £35m. Understandably, its social and environmental reporting does not have the same depth as BP’s.
They do, however, provide information relating to a number of key issues that SRI investors consider important. Smaller companies, like Gulfsands, will often not be considered for investment in SRI funds because they fail to meet some pre-specified target or fall short of matching the industry leaders. The difference in resources, in terms of both money and personnel, makes it near impossible for this gap to be closed.
Problems with positive
Another problem found when adopting a positive screening approach is it is difficult to compare performances across differing sectors. The environmental impact of a large-cap mining company is likely to be far greater than that of a similarly sized IT-company. However, it is often companies in the ‘dirtiest’ sectors that have the most detailed environmental policies and reporting standards. An environmental scoring approach, which awards credit for policies and reporting on key performance indicators, often results in companies that have a greater negative environmental impact receiving a higher score. This can be countered by classifying industries into low, medium and high-risk categories, and adjusting the relevant criteria to reflect this. However, a company with a low environmental impact may still have a sizeable impact on the communities where it operates. Even within an industry the potential risks can vary greatly: a small off-shore North Sea oil producer will have a very different social impact to one based in Africa. Every company is different and faces unique social and environmental challenges depending on how and where it operates. Adjusting positive screening criteria to recognise each company’s specific considerations is not a realistic option when the investable universe runs into the thousands.
As a consequence of these size and sector biases, many companies continually fail to be considered for investment by socially responsible investors. Since SRI funds still only account for less than 10% of total assets under management, it is unlikely the investor relations departments of these companies will be overly concerned. However, it is the companies with the poorest records and weakest reporting capabilities that require the most help in improving. If they are continually ignored and provided with little assistance by those experienced in developing social and environmental policies, we cannot expect them to improve.
Credit where credit is due
Companies that have excellent social and environmental policies and performance deserve all the credit they receive. SRI funds that utilise positive screening rightly reward this but also frequently fail to address their own fundamental biases. Incorporating an engagement overlay, which involves investors entering discussions with the company in an attempt to improve corporate behaviour, addresses many of these problems. By doing this, SRI analysts can maintain their positive screening process, still reward the best performers, but also incorporate those companies that are typically neglected. One such method would be to set investments realistic goals for improvement within a fixed timeframe. If the company does not wish to enter the engagement process or fails to make sufficient improvements, the company can be excluded from future investment. After all, you can lead a horse to water but you cannot make it drink!
A radical suggestion would be to have an SRI fund which focuses solely on engagement and improving the social and environmental behaviour of its holdings. After all, tobacco, alcohol and gambling companies all have a social and environmental impact too. However, this risks blurring the line between mainstream funds and SRI products. Most investors in SRI funds still expect screening of one form or another to take place. Yet, if the engagement process can help improve social and environmental behaviour is this not a more effective use of resources?
Craig Jeruzal, socially responsible & corporate governance analyst, SVM All Europe SRI fund
