Nowadays, we hear a lot about “sustainability,” but what does it truly mean for investors? What can we learn about sustainability that can both benefit environmental and societal causes but also result in successful financial outcomes?
Sustainability means to meet present needs without compromising the ability of future generations to meet their needs. The concept encompasses social welfare, protection of the environment, efficient use of natural resources, and economic well-being.
Research conducted by Marc J. Lane for his landmark book Profitable Socially Responsible Investing? An Institutional Investor’s Guide found economic benefits in sustainability. Marc first looked at the process of “negative screening” in investing – that is, excluding from an investor’s portfolio the stocks of companies in certain specified industries that some investors choose to avoid: alcohol, tobacco, gambling, and defense. While some mutual funds have used negative screening by industry to develop portfolios that they consider socially responsible, this method fails to take into account the broader view of sustainability.
In fact, during the period covered by the book’s study, the four controversial industries realized higher average returns than the Standard & Poor’s 500 index (S&P 500), while having smaller betas (a measurement of systematic risk) than the overall market. Thus, if socially responsible investing portfolios had focused on excluding these four industries from their portfolios, investors would have seen their risk-adjusted returns suffer.
Marc's research went beyond negatively screening stocks by industry by investigating the success of “behavioral social screening.” This meant that portfolios would be socially screened based on three specific value-based corporate behavioral criteria involving company practices in the areas of (1) diversity and employee relations, (2) human rights, and (3) the environment. Such portfolios would be compared to the universe of 2,884 component stocks from the Russell 3000 index for which data were available for the period under study.
For the behavioral social screening, companies were rated according to point scales in the fields of social justice (consisting of diversity and employee relations and human rights) and the environment.
In the area of diversity and employee relations, a company would gain one point each for having a minority or female CEO, offering family-friendly benefits (such as flextime and daycare), employing the disabled, awarding contracts to minorities and women, having a diverse board, having a progressive gay/lesbian policy, having a positive record of promoting women and minorities, having positive union relations, making cash contributions to a profit sharing plan, encouraging employee ownership through stock plans, and providing attractive retirement and other employee benefits, while three points would be scored for appearing on a “best companies to work for” list. Meanwhile, a company could lose one point each for being a party to diversity or employee relations controversies, for having women or minorities excluded from the board or management, if there were concerns about the company’s relations with unions, for having safety controversies, for having workforce reductions, or if there were concerns about retirement benefits.
In the area of human rights, a company would gain one point each for having notable labor rights initiatives and having good relations with native peoples, but would lose one point each if there were labor rights concerns, for dealing with countries with notorious human rights records, or if there were concerns about its dealings with native peoples.
In the area of the environment, a company would gain one point each for manufacturing or selling products or services that benefit the environment, for having good environmental communication and reporting, for demanding good environmental practices and policies by its suppliers, by helping prevent pollution, by recycling, and by using or promoting alternative fuels. The company would lose one point if it was a poor environmental performer with respect to each of climate change, regulatory problems, hazardous waste, toxic emissions, agricultural chemicals, and chemicals affecting the ozone.
To ensure that companies would be judged against their peers, the 2,884 stocks under consideration were classified into 57 industries according to Standard & Poor’s industry classification system. Within each industry, the top 5%, the top 20%, and the top 50% of companies according to the social justice and environmental criteria were selected for the behavioral social screening portfolios.
Marc found that the top 5% behavioral social screening portfolios, whether selected based on environmental criteria, on diversity and employee relations criteria, on human rights criteria, or on social justice criteria (combining diversity and employee relations with human rights), outperformed the benchmark of 2,884 stocks in the research universe. The same held true for the top 20% behavioral social screening portfolios and the top 50% behavioral social screening portfolios. Even on a risk-adjusted basis, these portfolios all outperformed the benchmark.
Marc Lane’s research for Profitable Socially Responsible Investing? was not the only study which found positive relationships between social responsibility and favorable investment returns. For example, Herbert D. Blank and his co-authors’ research studied companies which ranked highly in “eco-efficiency,” defined as “the theorized tendency of companies that meet environmental challenges perspicaciously to deliver superior profitability.” Blank’s study utilized company ratings from Innovest Strategic Value Advisors’ EcoValue 21 system, under which companies within each industry were ranked from best to worst using 62 variables, such as tons of carbon dioxide gas released per dollar of profit.
Blank and his co-authors found that the top-rated companies as measured by eco-efficiency outperformed the benchmark of all rated companies in each year of his study, and that the total volatility of the portfolio consisting of the top-rated companies was less than that for the universe of all rated companies, thus suggesting that the top-rated companies did not derive their above-average returns by assuming above-average risks.
Why might eco-efficient companies outperform the market? Blank suggested that companies with higher eco-efficiency might not only be able to better manage downside risk, but also to identify and capture upside opportunities for additional profit and competitive advantage. In short, eco-efficiency might be an indicator of the quality of a company’s management and its ability to deal with unknown challenges.
Meir Statman and Denys Glushkov also compared the performance of companies which rated as “best in class” for social responsibility to the universe of all rated companies. Statman and Glushkov used data which rated companies as to strengths and concerns in the following areas: corporate governance, community, diversity, employee relations, environment, human rights, and products. Because some industries (such as retail stores) tended to have better ratings than other industries (such as oil), Statman and Glushkov rated companies relative to others within their industries to determine the “best in class” for each industry. They found that, in general, stocks of companies with high social responsibility scores yielded higher returns than stocks of companies with low scores. By contrast, they also found that socially responsible investment portfolios which were based on excluding companies from particular “shunned” industries –tobacco, alcohol, gambling, firearms, military, and nuclear operations – tended to have a return disadvantage relative to conventional portfolios, echoing the results of the “negative screening” study in Marc Lane’s book.
Another study, by Alex Edmans, focused on the companies listed among “The 100 Best Companies to Work For in America” (a list first published as a book in 1984 and 1993, which later became an annually updated feature in Fortune magazine starting in 1998). Edmans found that over the period from 1984 through 2009, listed companies outperformed their benchmarks by a statistically significant margin. His study included a quote from an equity analyst saying, “[Costco’s] management is focused on … employees to the detriment of shareholders. To me, why would I want to buy a stock like that?” followed by a quote from Costco’s co-founder Jim Sinegal saying, “I happen to believe that in order to reward the shareholder in the long term, you have to please your customers and workers.” As Edmans’ study suggests, the anonymous equity analyst’s view appears to be a short-sighted one.
Why might good corporate social responsibility result in improved financial performance? A report by RBC Global Asset Management lists a number of factors which may contribute to better financial performance. Companies with better social responsibility may be better able to attract and retain good employees. They may achieve more productive workforces. They may have more loyal customers and thus achieve higher sales. Their brand value and reputation may be enhanced. They may have better relations with governments and communities. They may have lower litigation and environmental costs. And they may be better at risk and crisis management.
Moreover, one might reasonably argue that those companies whose management is accountable to all stakeholders is less likely to suffer class actions and regulatory complaints. And those managers may be likely to outperform their peers in spotting problems around the corner as well as opportunities they might successfully pursue.
With this in mind, an investor may want to follow the practice of Advocacy Investing® – a strategy in which investors seek to promote their social and environmental values without increasing their portfolios’ volatility or sacrificing investment returns, while also making sure to make their voices heard by providing their proxy votes for their companies’ annual meetings to support the causes they believe in. For more information about Advocacy Investing, please contact Marc J. Lane at [email protected] or visit www.advocacyinvesting.com.
The world's first social impact bond, or SIB, was introduced in 2010 to fund innovative social programs that realistically might reduce recidivism by ex-offenders in Peterborough, England, and, with it, the public costs of housing and feeding repeat offenders. Prudently building on the strengths of that initiative, Illinois Gov. Pat Quinn is rolling out SIBs to help solve some of the state's most vexing social problems.
A SIB isn't a traditional bond where investors are guaranteed a fixed return but a contract among a government agency that agrees to pay for improved social outcomes, a private financing intermediary and private investors. SIBs shift the risk of experimenting with promising but untested intervention strategies from government to private capital markets, with public funds expended only after targeted social benefits have been achieved.
Peterborough's problem was daunting: Sixty percent of prisoners serving short-term sentences historically had gone on to re-offend within a year after their release. But policymakers were confident that a solution was within their reach. They attracted private investment to pay experienced social service agencies to provide intensive, multidisciplinary support to short-term prisoners, preparing them to re-enter society and succeed outside the penal system.
The government decided which goals would be supported, but exactly how those goals would be achieved was left to the private sector. It was the investors, through a bond-issuing organization, who ultimately endorsed the allocation of investment proceeds — how much would be invested in job training, drug rehabilitation and other interventions.
If the Peterborough plan eventually shrinks recidivism rates by 7.5 percent or more, the government will repay the investors' capital and share the taxpayers' savings with them, delivering up to a 13 percent return. If the target isn't hit, the investment will have failed and the government will owe the investors nothing.
Illinois' SIB effort was spearheaded by the state's Task Force on Social Innovation, Entrepreneurship and Enterprise — the governor's think tank on social issues, which I am privileged to chair — with support from Harvard University's John F. Kennedy School of Government, the Rockefeller Foundation and the Aurora-based Dunham Fund. A request for information issued by the Office of Management and Budget on May 13 yielded responses from service providers eager not only to reduce recidivism here but also to create jobs, revitalize communities, improve public health outcomes, curb youth violence, cut high school dropout rates and alleviate poverty.
Now the governor has issued a request for proposals intended to spur better outcomes for Illinois' most at-risk youth — by increasing placement stability and reducing re-arrests for youth in the state's Department of Children and Family Services, and by improving educational achievement and living-wage employment opportunities justice-involved youth most likely to re-offend upon returning to their communities.
Kudos to Mr. Quinn for bringing SIBs to Illinois. May they soon start delivering on their promise.- See more at: http://www.chicagobusiness.com/article/20131007/OPINION/131009850/a-new-kind-of-futures-contract-for-illinois#sthash.ThgxeiFt.dpuf
Joshua S. Kreitzer is a Senior Associate Attorney with The Law Offices of Marc J. Lane, a Professional Corporation. Mr. Kreitzer is a graduate of Northwestern University (J.D.), the University of South Florida (M.A.), and Harvard University (B.A.)
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