Three avenues are being explored to counter these prejudices and ‘prove’ that sustainability factors add value to the investment process:
- A top-down / quantitative approach
- A bottom-up / fundamental approach
- Fund performance
(These are also the two different approaches to ‘integrated analysis’)
Quantitative ‘proofs’ – fighting fire with penicillin
Numerous academic studies have been conducted into the performance of SRI funds relative to their conventional peers. Notable studies are listed at SRI Studies with the best each year being awarded the Moskowitz prize. Most recently the United Nations Environment Programme Finance Initiative (UNEP FI) commissioned Mercer to produce a study on Demystifying Responsible Investment Performance.
While the inputs for the studies vary, they typically seek quantitative correlation between sustainability inputs (datapoints or ratings) and financial effects (investment ratios or stock performance).
The Mercer study reviewed 20 academic studies and categorised them according to whether the sustainability effect was found to have a positive, neutral or negative effect on investment performance. 10 of the studies found the effect to be positive, 7 neutral and 3 negative. This ratio is broadly in line with similar SRI studies over a long period of time: that any SRI effect is either positive or neutral/non-existent. Put another way, sustainability investment either outperforms or, at worst, performs in line with conventional investment.
However, these quantitative ‘proofs’ have made little headway in convincing mainstream investment practitioners – largely because the research has been conducted on terms that do not resonate with the audience that they are trying to convince:
- They seek academic ‘proofs’ not investable ‘ideas’
- They look backwards at what has happened – not forwards to what may happen
- They use ‘top-down’ techniques - not the bottom-up fundamental ones that are valued by the investment managers that the ‘proofs’ aim to convince
- These are targeted at a minority investment style – quantitative fund management
- None of the studies consider whether any ‘sustainability effect’ is ‘already in the price’ – and give no purchase for investigating further
- They seek correlation only – not causality
More significantly, however, the industry is relying on intricate, quantitative and academically-rigorous studies to tackle gut-based prejudices. SRI analysts are, perhaps, overcompensating for their non-financial background by reaching for the most intricate and quantitative methods available. It is like using penicillin to fight fire.
Fundamental (bottom-up) ‘proofs’
The ‘fundamental’ approach, by contrast, aims to prove the performance pudding through the eating – that is to say, it aims to generate a stream of investment ideas (that are material, actionable, timely and effectively communicated) and to apply these to the process of stock selection.
This approach will never produce neat, generally-applicable, easily-presentable ‘proofs’ (so is of little use to the media or to conference presenters). Indeed, it does not aim to. Instead of ‘proving’ an abstract case about SRI performance, the bottom-up approach looks to convince mainstream investor clients, colleagues and companies that it can generate investment outperformance in exactly the same way and on exactly the same terms as all other investment approaches – by identifying anomalies in valuation and generating investment ideas.
This approach integrates much more closely with other techniques for generating investment outperformance and is therefore more convincing to investment colleagues, to clients and to companies. It is also gets closer to the capabilities of SRI analysts and to the issues faced by companies.
At present the only measure we have of this approach is the anecdotal evidence that SRI analysts are presenting a greater number of investable ideas to their mainstream colleagues and seeing a greater uptake of them and that more explicit sustainability elements are featuring in broker recommendations. We do not, however, yet have evidence on how these ideas and recommendations have performed.
Fund performance
Of course, the ultimate test of SRI’s ability to outperform comes from the performance of SRI funds. Where such analysis has been undertaken, it has tended to support a ‘perform-in-line’ / ‘marginal outperform’ conclusion. However, in the absence of any comprehensive global study that controls for variations in fund domicile, investment style, benchmark index, fund sector, SRI strategy etc. we would prefer to leave the market to be the best judge of this.
