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Traditional Investments Attract Increased Scrutiny

By: Jane Ambachtsheer & Brian Dayes

In November 2004, the fiduciaries for several New York City pension funds – NYC Employees’Retirement SystemT, eachers’Retirement System, Police Pension Fund, Fire Department Pension Fund, and the Board of Education Retirement System – submitted shareholder resolutions calling for a major NYSE-listed mining firm to review its policies concerning toxic waste disposal at one of its foreign mining operations. The resolutions urged management to “review” policies with reference to potential environmental and public health risks. NYC Comptroller William Thompson, Jr. explained, “as shareholders, we are concerned about the reputational risks and share value …”

The Securities and Exchange Commission (SEC) supported the mining firm’s bid to omit this shareholder resolution, despite the collective NYC pension plans’significant equity investment in the firm. In March 2005, a foreign government filed a lawsuit worth hundreds of millions of dollars against the firm, claiming environmental and health damages. In April 2005, several of the firm’s executives were ordered to appear before a prosecutor in a foreign government’s Supreme Court for criminal investigation. Such is the new and evolving face of socially responsible investing.

This is but one example of how socially responsible investing is permeating the consciousness of institutional investors demonstrating that attention to and analysis of extrafinancial issues are beginning to be viewed as complements to the traditional rigours of financial analysis, thereby enhancing the fulfillment of fiduciary duty, not impeding it. A May 2005 report released by the Canadian Social Investment Organization estimates that socially responsible investment (SRI) in Canada has grown to $65.5 billion – a 27 per cent increase in the last two years1 – and that SRI assets managed by institutions are estimated at $25.4 billion (up from $24.1 billion in 2002).

In 2005, Canadian investors filed 25 shareholder proposals on social responsibility and sustainability issues, more than double the number a year earlier.2 In 2002, the Canada Pension Plan Investment Board adopted a Social Investment Policy that declared responsible corporate behaviour usually contributes positively to investment returns in the long term.3

Further to these developments, many Canadian investment managers expect that active ownership, screening, and the integration of e n v i r o n m e n t a l , social, and corporate governance (ESG) performance indicators into the investment process will become common practice (see Chart 1). As the investment industry adapts to this new reality, investors can anticipate that their traditional investments will attract the increased scrutiny of an ‘SRI-lens,’potentially leading to a greater number of more broadly applied SRI-managed options.

The Evolution Of SRI
SRI has developed substantially since its inception whereby mission-driven investors (often religious, social, or environmental organizations) avoided securities which conflicted with their ideals. These approaches often applied screening techniques which avoided investment in ‘sin’ stocks such as alcohol, tobacco, gambling, or armaments. This process, typically known as ’ethical screening,’ had a number of obvious barriers to mainstream adoption. For the institutional fiduciary, reducing the eligible number of securities in the investable universe was (and still is) viewed as not providing for a theoretically optimal solution. Universally, the appeal of an ethical (or ‘values-based’ approach) is, of course, dependent upon one’s values – whether that be an individual or an organization (which arguably would present a much greater challenge for definition).

Despite the roadblocks of fiduciary duty and criticisms of sub-par performance, the SRI movement continued to evolve. A second approach developed with the aim of recognizing firms contributing positively to ESG issues, rather than excluding those that violate specific values-based principles. This approach is seen as more advantageous than ethical screening as it does not rule out specific firms or sectors. Rather, security weights are adjusted to reflect a relative ‘best-in-class’ approach – as an overlay to the security selection decisions resulting from traditional financial analysis. As such, these portfolios typically provide broader diversification across all sectors and display risk/return characteristics similar to those of traditional portfolios.

Still unconvinced of the potential merits, the majority of mainstream investment management firms have not been compelled to build capabilities to analyze ESG risk factors.

Socially Responsible Investing – A Potential Source Of Alpha?
Risk mitigation, sustainability, and long-term shareholder value are the new mantras for socially responsible investing – a lexicon familiar to investment managers. The assessment of ESG issues is being positioned as a supplement to the rigours of traditional financial analysis – and even a potential source of alpha. For example, a firm with a known reputation for excellent labour relations practices should be able to attract and retain a higher quality workforce which could very well provide a competitive advantage manifesting in improved productivity and profitability.

A number of key drivers are advancing this philosophy into the mainstream investment community – not the least of which is a growing body of literature suggesting that ESG performance can impact a firm’s sustainability and, hence, valuation. The attention being given to ESG analysis is not going unnoticed by corporate America. In a recent study published by SIRAN (Social Investment Research Analysts Network), 39 of the S&P100 companies now issue annual corporate social responsibility (CSR) reports, much like they do on their financial performance. Furthermore, 58 of the top 100 firms have special sections of their websites dedicated to sharing information about their social and environmental policies and performance.

Only a few years ago, it would have been unfathomable to envisage that longterm market outperformance might be achieved through adopting an ‘SRI’ approach. Today, as witnessed through the progressive and collective efforts of the New York State pension plans, this is not the case. Given the infancy and complexity in assessing ESG risk factors, it can be theorized that security prices are not being discounted efficiently for the level of risk embedded in a firm’s socially responsible behaviour. If so, the implication follows that investors capable of developing competencies to analyze ESG issues will be better positioned to benefit from any information asymmetry that exists in the marketplace.

While it may take some time yet for the investment community to get behind the ‘alpha-potential’ theory, there are examples of the impact of ESG risk factors that are playing out daily. In the wake of a number of factors such as high profile corporate scandals, an ever-increasing focus on climate change (a recent focus of the G8), and the responding regulations of governments (such as Sarbanes-Oxley), it is increasingly believed thatthe large institutional investors that dominate the global capital markets have a role to play.

As market participants respond to the growing interest of clients in SRIrelated capabilities, we expect to witness an increase in SRI-labelled products in the short-to-medium-term horizon. The consulting profession is developing capabilities to help investors understand and navigate through the broader options which are being availed to them. Longer term, as the risk/reward benefits of engaging in ESG research become more clear, perhaps the ultimate success and value of this additional analysis will manifest itself in the loss of the SRI/ESG label altogether – if it becomes as common a staple in securities analysis and portfolio management as traditional financial parameters and metrics.

Jane Ambachtsheer is a principal of Mercer Investment Consulting, based in Toronto, and Mercer’s global head of socially responsible investing. Brian Dayes is a senior consultant in the Toronto office of Mercer Investment Consulting.

1. Social Investment Organization, “Canadian Social Investment Review 2004”, April 2005.
2. From SIO website, News & Archives, quoting from a review published by SHARE, accessed 2 June 2005 - 305-ShareholderProposals.htm.
3. From the CPPIB’s social investing policy, 4. 2005 Fearless Forecast. ©2005 Mercer Human Resource Consulting LLC and Mercer Investment Consulting, Inc.

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