Hedy Ratner, founder and co-president of the Women's Business Development Center, a non-profit group in Chicago dedicated to empowering women and minorities, wanted her personal investments to match her organization's values. "I believe that to put your money where your mouth is, you invest your money according to the principles and values that dictate your behavior," she says.
So when it came time to create a pension for her employees, as well as her own personal portfolio, she wanted to invest in companies that have a good track record in workplace diversity and labor relations. She also writes letters to their managements to encourage progress. Her list of investment guidelines for her advisor, Marc J. Lane Wealth Group, includes companies with a diverse board of directors, including women and minorities, employment of people with disabilities, good employee benefits including child and elder care, plus non-discriminatory policies for gays and lesbians. "Our goal is not just to have a safe and secure pension... this can also be a way to significantly change business and social policies."
Welcome to the new generation of socially responsible investors. In the past, they may have focused on shunning gun makers and tobacco companies, or maybe they invested in windmill farms. But today, their strategy is becoming much broader. It pushes the idea of sustainability, not just in the narrow environmental sense, but also in the sense of a company's long term potential to compete and succeed.
Unlike the old school of socially responsible investing (SRI), the new wave is being pushed by some decidedly non-idealistic investors who are responding to a slew of research and a growing conviction that SRI investing is simply good business.
Paul Hilton, director of Advanced Equities Research at Calvert Investments, sums up the evolving strategy: "In the old days it was all about exclusions and our job as analysts was to find the baddies. Now we're finding which companies are better positioned, which meet positive criteria, which have better risk profiles. People realize that investing in companies with better performance in issues of environmental, social and corporate governance (ESG) will help them identify companies with better financial performance, either because of less risk, or because they're better managed."
Others in this industry take it a step further, arguing that a company's ESG record is just as material as its financials. Further, they say that examining both is nothing less than an investment manager's fiduciary duty to his clients.
To illustrate the size and growth of this no-longer small niche, consider these numbers. SRI investments in the U.S. alone account for $2.7 trillion (about the size of the United Kingdom's entire economy and an increase of 324% from $639 billion in 1995.) In that same period, all assets under professional management climbed 259% to $25.1 trillion from $7 trillion. Another 2.7 trillion euros is invested overseas.
The lion's share of those assets are in institutional accounts, but the number of SRI retail mutual funds has grown as well, increasing 81% in the last decade to 152, with assets climbing by 73% to $29 billion, according to Morningstar. By comparison, in that time the total number of mutual funds has climbed 31%, and their assets have grown 47% to $6.07 trillion.
THEN AND NOW
Despite the impressive growth, the knock against SRI has long been that investors had to settle for lagging returns in exchange for assuaging their consciences. So-called "sin stocks," including purveyors of tobacco, alcohol, gambling and defense contractors, were banned from portfolios on moral or ethical grounds. And shutting out entire industries hurts performance, the critics said.
But the idea that SRI means only screening out offensive companies is changing. Instead, a more inclusive SRI approach is rapidly taking its place alongside the exclusionary style of the past, says Mary Jane McQuillen, a director and portfolio manager in the Socially Aware program at ClearBridge, a unit of Legg Mason with $45 million in assets under management.
Formerly Citigroup's asset management unit, ClearBridge has "sustainability researchers" with expertise in ESG issues working on its fundamental research team. Every stock is reviewed for its investment thesis and its sustainability profile. That means the sustainability of not only earnings growth, but also the environment, workplace and corporate governance, McQuillen says.
This analysis of companies through a combination of financial and ESG lenses, dubbed "integration" in the industry, is gaining traction. Other investment firms with a similar integrated infrastructure include Sustainable Asset Management (SAM), based in Switzerland and Generation Asset Management (co-founded by former Vice-President Al Gore, a leading voice in the climate change debate.)
Neuberger Berman also uses this type of analysis. "What we do is a very integrated process," says Ingrid Dyott, manager of the $760 million Neuberger Berman Socially Responsive Fund. "We're bottom-up investors and we think of it holistically, rather than in buckets." The 15-year-old fund boasts a four-star Morningstar rating and better risk-adjusted returns than its peer group. It is up 8.71% in the year to June 19 and is in the top 18th percentile of its large-cap blend peer group in that period, Morningstar notes.
In discussing her style, Dyott's first requirements sound much like those of any conventional portfolio manager. "We want durable business models with companies with some kind of competitive advantage and strong balance sheets," she says. Then comes the ESG. "We invest in managements that acknowledge that the stakeholders are not just shareholders, but employees as well, and are cognizant of the environment and the communities in which they operate. It's our fundamental belief, if you don't pay attention to these issues, it's a bad business."
The Neuberger Berman Socially Responsive Fund has 35 to 40 holdings, so Dyott and her team can closely monitor them all. They don't invest in any company until they have met with management. "Yes, we do due diligence," Dyott says. "But once we invest in a company, that's just the beginning of the process. We have frequent and targeted dialogue with companies on issues from business performance to social and environmental impact. We're trying to invest in good companies and encourage them to improve their disclosure and think about the environment issues, workplace diversity issues and have an open dialogue about improving what they have in place," Dyott says. She considers this dialogue her fiduciary duty because ESG issues are material.
David Russell, co-head of responsible investment for USS, the second-largest pension fund in the U.K. after British Telecom, with assets of 24 billion pounds sterling ($39.6 billion), also sees ESG issues as a fiduciary duty. He says his trustees decided a decade ago to watch companies' ESG issues closely because they had the potential to impact the value of their investments. He says that ESG issues require close monitoring because some may not be material to a company's performance now, but will likely affect it in the future. He cited climate change. The cost of carbon is material to a company's financial performance now, and can be modeled and built into investment decisions. But trying to assess how the changing climate will affect the way companies do business is trickier. "We'd never say we're an ethical or moral investor. We're a responsible investor," he says.
Despite the big money behind it, misconceptions about SRI abound. "I still run into people who think SRI is only about screening out," McQuillen says. "The typical investment consultant [thinks] that they can't recommend SRI to a client because it means screening. They're holding on to an old concept." McQuillen rattles off a list of common misconceptions of SRI that she hears from advisors: It's too restricted due to screening. It's not sufficiently diversified. Associated fees are too high. It's politically oriented (read: too left-leaning.)
But education surrounding the products is growing, she says. And with a slew of new products on the market, there's something for everyone. There are index funds tracking a bevy of SRI indices, as well as funds that try to track the broader market closely, but optimize performance by substituting a poor ESG performer with a stock in the same industry with similar characteristics. And of course there are old-fashioned actively managed funds run by stock pickers like Dyott.
Like any onslaught of new products, this one comes in response to retail demand. And major mainstream fund managers, including Wells Fargo, have tried to meet that demand by rolling out SRI products.
SRI practitioners note that interest in SRI spikes when there's a spate of corporate scandals. Recent years have featured fraud at Enron and Worldcom; Kathie Lee Gifford's clothing line for Wal-Mart shining a light on third world sweatshops; and the implosion of the financial services sector over the last 18 months.
But as with any other investment style, there is a wide range of quality within SRI. Funds run by savvy managers using rigorous analysis share shelf space with products churned out with little research infrastructure to back them up. Remember the boom in Internet funds in the late 1990s? Critics from the SRI world, including Calvert's Hilton, say some of today's Johnny-come-lately types lack the teams of analysts trained to assess ESG issues. "You'll see companies slapping a sustainability label on a product [after] just doing a quick screen on a certain industry," Hilton says.
So as with any other type of investment, advisors should know what's under the hood. Experienced SRI investors say advisors should ask if a fund has analysts who are trained in evaluating ESG issues. The good news is both training and new information are coming on board constantly, as analysts are entering the workforce with MBAs in environmental studies. Moreover, the CFA Institute now offers training in the area and puts out an entire guidebook on ESG. And Hilton notes that Bloomberg terminals have just introduced data on carbon disclosure and is now developing a new ESG product. Of course, the key is knowing how to evaluate the data.
McQuillen suggests that when shopping for an SRI fund manager, advisors ask how the manager runs the portfolio, and what research support they have at hand. She says: "If the answer is, 'I just buy research from KLD [Research & Analytics]' to us, that's not real integration," McQuillen says.
BY THE NUMBERS
Any discussion of SRI returns is tricky because while retail SRI funds have grown rapidly, institutional money still accounts for the majority of the assets and is not comprehensively tracked.
Also making it difficult to assess SRI performance is the fact that no two SRI funds use the same criteria. While the newer breed tends not to use negative screens, many of the old-line offerings still ban tobacco, alcohol, gambling and defense. In fact, some fixed income funds, including some of Calvert's, ban Treasurys, because they help finance the defense department.
What is more, what is anathema to one fund isn't a problem for another. Sharia funds, which invest according to Islamic law, shun alcohol, pornography, gambling and pork, but also banks because Sharia principles are against interest income. That knocks out not only bonds, but the stocks of nearly every type of financial institution, which tend to be owned in other SRI funds. Catholic funds focus on screening out companies involved in abortion, contraceptive products and embryonic/fetal stem cells. Also, funds' priorities for a company's performance differ. Some focus on a company's environmental record, while others home in on corporate governance.
Marc J. Lane, the financial advisor and attorney who specializes in SRI and who advises Hedy Ratner, builds his clients' portfolios himself. He is the author of the 2005 book "Profitable Socially Responsible Investing?" Lane says: "We don't think mutual funds really work in this area. You end up with a crazy quilt of screens that speak to no one's values in particular."
More critically for many advisors, the SRI retail funds post middle-of-the-pack performance. According to Morningstar data, they are about at the 50th percentile for their peer groups for a variety of time periods over the last decade (see chart below).
But because the universe is so varied between green funds, faith-based funds and even traditional SRI, Morningstar declines to average the funds' returns, saying the figure would not be meaningful.
Advocates say the middling retail mutual fund performance does not tell the whole story. This kind of investing requires more research, they say, which means higher costs, which dampen returns. In addition, the relatively small pools of money invested in the 1970s also tended to mean relatively higher fees. Those are coming down as the industry matures and gains economies of scale- and as more investor money comes in, proponents note.
The better way to gauge this market is by the various indices (although even this can be difficult because that field is crowded as well, and no two are alike.) But to pick two of the most prominent, the Dow Jones Sustainability World Index has dropped 29.51% since inception in August 1999 through May, compared to losses of 30.74% for the MSCI World Index. (Each firm puts out a raft of other SRI indices.)
The Domini Social 400 Index (now run by KLD Indexes) has returned 8.50% from inception in May 1990 until the end of May this year. That compares with a gain of 7.77% for the S&P 500.
An index selected by Goldman Sachs, called the GS Sustain Focus List, has outperformed the MSCI World Index by 18.6% since inception on June 22, 2007 through July 6. The list is compiled by the bank's dedicated ESG team, called GS Sustain, which covers all economic sectors, not simply the cleanest. It said in a report from June 2009: "We find a link between top performance on ESG and sustainable returns."
In the absence of data tracking the majority of the money invested in SRI there is a slew of academic studies aimed at measuring the financial performance of companies with good ESG records. In fact, the tangle of studies is so unwieldy that a United Nations group dedicated to sustainable corporate behavior commissioned Mercer to analyze all the research-a study of studies. The nearly 80-page "Demystifying Responsible Investment Performance," found a positive relationship between ESG factors and portfolio performance in half of the 20 studies, with seven more reporting a neutral effect and three showing a negative effect.
Even with increasing troops of ESG analysts doing hard research into corporate behavior, there are still skeptics. Nick Kaiser, manager of two of the top-performing faith-based funds, views ESG issues warily. He keeps an eye on ESG issues, "because companies that may say they have an environmental problem are just not a good investment. We're interested in return to shareholders, and if they have to clean up the environment for the next 40 years, the return won't be there."
But Kaiser is not impressed with companies that produce extensive ESG progress reports. "It's not a requirement that a company be running around telling people they're green. We're interested in companies that are working and profitable." Further, he is mistrustful of them because he says he can never be sure the companies are being truthful. "Having a corporate code of ethics-which probably isn't followed-is probably not enough to make that company profitable. Yes, I'd hope they weren't making profits in illegal ways. Not because it's, quote, bad, but because I believe at some point the prosecutor is going to show up on their doorstep, and I don't want to be a shareholder."
Kaiser admits screens can be a good thing, and forces a manager to scrutinize for quality. His Amana Growth and Amana Income Funds, both Sharia-compliant, avoid companies with more than a 5% earnings from interest income, and bars companies dealing in liquor, pornography, gambling and banking. His funds have been in the top 1% to 6% of his peer groups-that is, large-cap growth and large-cap value, respectively over the last decade. No small feat, given his avoidance of banks, at a time when financials were top performers.
A self-professed, old-school value investor, he doesn't like many of the darlings of managers of green funds, like solar power companies. He sees them as risky because they are young, with short track records and very little earnings as yet. "All that ESG stuff is nice, but we do it to avoid problems," Kaiser says. "First we have to make sure the businesses are real."