The following all undermine, unjustifiably in our view, the argument that SRI can perform in-line with and even outperform conventional investment:
- SRI is all about ‘screening’
- Restricted universe => restricted performance
- SRI is primarily about achieving an ‘ethical return’
- There is an inherent conflict between ‘doing good’ and ‘doing well’
- SRI only looks to address downside risk
- A prejudice exaccerbated by using debt tools in a equity world
SRI is all about screening
Most objections to SRI performance emanate from the perception that SRI is confined to screening. As we highlight above, SRI now extends to 20 different strategies – all of which have different risk-return characteristics from each other. Some of these diverge substantially from their mainstream comparators, while others mirror precisely the investment characteristics of ‘conventional’ investment. For example:
- ‘Sustainable theme investing’ involves concentrated portfolios of typically smaller companies which (even if the trends that it tracks are secular, long-term market outperformers) may be considerably more volatile than the wider market.
- ‘Constructive engagement’, by contrast, merely seeks to exert influence upon companies that are already held within a fund; the SRI element of the process does not generate ‘buy’ or ‘sell’ instructions and the strategy, therefore, has no investment impact at all*.
- ‘Ethical / negative’ screening fund performance will naturally suffer / benefit from the performance of sectors that are excluded (unless, as is often the case, this exposure is hedged in other ways); where exclusions are few, performance is likely to be in line with the market; where they are numerous, performance can deviate substantially
- ‘Integrated analysis’ – aims to generate investable ideas from the analysis of environmental and social information. However, as these ideas are processed through the same analysis and selection process as all other investment ideas, these will only affect the portfolios performance if their merits (as judged by the portfolio manager) outweigh those of more conventionally-generated investment ideas
(* Some contend that the purpose of constructive engagement is to improve the business (and thence investment) performance of companies held. There is merit in this argument, but outside major activist corporate governance interventions, practical evidence is rare.)
Restricted universe => restricted performance
Received investment ‘wisdom’ often argues that restricting an investment universe increases risk and reduces opportunities for performance. The counter arguments which are that:
- SRI funds invest into fundamental secular trends towards higher standards of environmental and social sustainability and will outperform as these trends develop
- Strong environmental and social performance are indicators of high quality management – and may therefore be lead indicators of investment performance
- Reductions in universe size enhance a fund manager’s focus on the stocks that he/she can hold
- All fund managers effectively operate to a restricted list. While the restrictions of SRI fund managers are formalised, their ‘mainstream’ counterparts are restricted by the fact that their brains can only focus on a given number of companies at any one time
- Restrictions in an investment universe imposed by sustainability considerations can be compensated for in other areas – a manager of a global SRI fund has many more stock opportunities than a manager of an ‘unrestricted’ UK fund)
SRI is primarily about achieving an ‘ethical return’
Although the ‘ethical return’ is what distinguishes SRI funds from their mainstream counterparts, this does not necessarily (or even often) make it the dominant factor within these funds.
Outperforming the market is as important to SRI fund managers as it is to conventional fund managers. Whilst there may be some retail investors who would trade financial return for a higher ethical return, there are very few fund managers who will give them this opportunity.
SRI managers will typically argue that investment performance is their dominant priority and will contest (as below) the suggestion that there need be a conflict between this and sustainability performance.
There is an inherent conflict between ‘doing good’ and ‘doing well’
Not necessarily! Sometimes there is a conflict between ‘doing good’ and ‘doing well’; sometimes there is a synergy between the two. The context within which a company or investor operates is critical.
Proponents of SRI will, of course, argue that as the scientific, political, economic and civil case for sustainable development builds, the legislative, regulatory and customer context is ever more likely to reward companies and investors that do good. Furthermore, as more investors become aware of this, premium
Even where this is not the case, it must be noted that an active manager of SRI funds can exploit the synergies where he/she can identify them– but is not bound to ‘do good’ if it would compromise the fund’s investment performance.
SRI only looks to avoid downside risk
Environmentalists are often regarded as miserable Cassandras who focus only on what can go wrong. However, it is a mistake to assume that just because environmental scientists paint a gloomy picture of the future, environmental investment analysts are exclusively focussed on avoiding downside risk.
Smart analysts should recognise that ‘sustainable development’ is simply a process of change and that pro-active companies should be able to adapt faster to changing circumstances and perceptions than consumers, politicians and their peers – such that they benefit from changed patterns of behaviour, regulation and purchasing and financially outperform their peers in the process.
Although SRI analysts should focus as much on identifying opportunities and share price upside as they should on evaluating and avoiding downside risk, it has to be acknowledged that the SRI industry has not always helped itself in three respects:
- SRI investors can be too ready to slip back into the language of ‘risk avoidance’ rather than that of ‘opportunity capture’ when discussing sustainability and investment
- When they do talk about upside potential they are too quick to select their examples from the obvious sectors of alternative/renewable energy, water treatment and waste management instead of selecting less obvious (and therefore more compelling) examples from sectors such as food retail, autos, chemicals, mining etc.
- Finally, the SRI industry focus on ratings which are really ‘debt market’ tools that have been artificially imposed on equity markets reinforce prejudices about ‘downside risk’
Debt tools in an equity world
‘Ratings’ are used in debt markets, to indicate the likelihood of default. They grade the possibility of a fundamentally binary outcome (‘default’ or ‘no default’) where the outcome is neutral or negative.
Equity markets, by contrast, need to consider upside-potential as well as downside-risk. They also need to evaluate the quantum of that upside or downside in closer detail. Although equity recommendations are often grouped into BUY/HOLD/SELL or OUTPERFORM/UNDERPERFORM categories, these are merely broad indicators of much more specific target prices.
The use of ‘ratings’ in SRI can therefore serve to perpetuate a prejudice among equity investors that environmental and social issues are predominantly about avoiding downside risk.
