Why is SRI not rooted in mainstream fiscal society?
OF SOUTH Africa’s R4 trillion asset management industry, investment mandates for socially responsible investments (SRI) are a mere 1 percent. This is a sobering statistic if SRI is seen as a proxy for responsible investing and given the need for sustainable growth in our economy. We all know the challenges by now which range from energy security and infrastructure development to health, housing and education.
Why has SRI failed to entrench itself in the mainstream financial community? A UK study has shown that the marginality is echoed even in the language; ESG (environmental, social and governance) factors are often labelled “non-financial” or “extra-financial” issues.
And a study concluded by the European Centre for Corporate Engagement revealed that two-thirds of sell-side research analysts do not include ESG factors in their valuation and analyses of companies; and that the mainstreaming of SRI encounters an added layer of resistance if it is considered to be outside the convention of mainstream traditional investment analysis.
The issue is not helped by an abundance of overlapping terminology: responsible investing, ethical investing, ESG, SRI and more recently impact investing. Yet strip away the jargon, focus on sustainability, and you are left with a simple imperative: how to invest with a long-term sustainable view that seeks not only to deliver a good financial return but to address societal issues.
The theme is universal and gaining attention around the world as the public mindset shifts to preserving scarce resources. In South Africa, the Bertha Centre for Social Innovation and Entrepreneurship at the UCT Graduate School of Business is conducting research into social impact bonds.
I have long wondered why only a few boards of trustees of pension funds look seriously at SRI mandates. There seems little point in focusing solely on financial returns if members will retire into a society whose fabric is crumbling around them. Furthermore, long-duration investments such as those funded by investment grade debt, are ideally suited to pension funds that are aiming to match long-dated pension liabilities as they provide an amortising repayment profile and a natural inflation hedge.
In a proposal for my ever-postponed PhD thesis I examined three main barriers to sustainable investing as follows: A reinterpretation of fiduciary duty. A lack of evaluation tools for sustainable investments.
The accountability gap between
It is a natural reaction for clients to think they will need to give up some financial return if they are to take ESG issues seriously.
corporate stakeholders.
According to the Pension Funds Act, fiduciary duty prescribes that trustees, fund managers and investment consultants act “in the best interest” of their beneficiaries. Globally, in line with modern portfolio theory, this has been interpreted as the maximisation of risk-adjusted returns.
Since the turn of the century, however, a new take has entered the fray on the debate on fiduciary duty, led by academics and economists in the US. The gist is that institutional shareholders represent a proxy for the entire economy and that it is precisely because of fiduciary duty that ESG factors must be considered when there is a longterm potential for financial gain from them.
James Hawley (St Mary’s College) and Andrew Williams (St Mary’s College of California) argue that in the global investment industry, a handful of institutional shareholders exist, that hold such large and diversified portfolios that their shares represent a proxy for the entire economy. These institutions, examples of which are the Universities Superannuation Scheme in the UK, CalPERS in the US, and the Public Investment Corporation in South Africa, aptly termed “universal owners”, have their financial performance tied to the macroeconomic performance of the countries they reside in and thus they should be involved in the “universal monitoring” of their portfolio companies and the market impact of negative or positives impact on the environment, society and economy as a whole.
Steve Lydenberg, the Domini Social Investment chief investment officer, builds on this concept, except that he uses the term “universal investors” (UIs) to describe these entities. He argues that to the extent that UIs are pension funds, they have a longterm investment horizon and should theoretically pursue investments that yield returns that are SRI in nature and have a greater impact on society and the economy as whole.
Their fiduciary duty should take ESG issues into account. However, Lydenberg contends that in practice this is not the case. UIs tend to pursue market returns like other investors, combining stock indexing to reduce management fees with active management to add alpha (performance above benchmark), across a diverse set of asset classes. They do so for two reasons:
Their performance is almost always measured against market-related benchmarks, and the performance of their peers, rather than against their ability to provide a higher quality of life for their beneficiaries on retirement. Second, their ability to measure and quantify social responsibility investments is much less developed than for traditional investments.
The lack of a unitary framework for the financial assessment of investment value and return in the SRI space is another impediment. Where ratios such as price earnings ratio and return on equity are common in the traditional investment industry, no equivalent metrics exist for SRI.
From the early 2000s, Jed Emerson, a Californian academic, developed the notion of “social return on investment” (SROI) and proposed a framework and tools to track performance of what he calls the “blended value proposition”, the intersection that combines social and financial return.
It has its detractors. The Roberts Enterprise Development Foundation (REDF), a philanthropic organisation, asks: “Can SROI analysis ever generate a single figure by which two competing philanthropic investment opportunities may be compared?” “How do you compare and calculate the SROI for an educational-based programme as opposed to an environmental-based programme. What beta is used given that projects do not inherently carry the same risk?” In response, REDF encourages that research should attempt to standardise the question of beta and discounting rates for socially responsible investments.
A third impediment to shifting SRI from the margins to the mainstream lies in the “accountability gap” between corporate executives, shareholders, and the broader stakeholders. As the actual drivers of operational decisions, executives are motivated by short-term profitability numbers which determine their compensation. As a result, decisions that reflect SRI thinking are not always at the forefront of their actions. SRI initiatives are often long-term in nature and thus direct and immediate recognition in monetary terms might not occur within their term of office.
Robert Monks, a corporate government activist, and Allen Sykes, a former managing director of consolidated Gold Fields, refer to two limitations to the governance of capitalist corporations that may work against long-term social interests:
Corporate executives are not effectively accountable to their individual or institutional investors.
Investors are not ultimately accountable to their ultimate beneficiaries – members of pension funds.
Due to the increased power being wielded by executives in the modern corporation, academic debate has spawned a fresh debate that revolves around two evolving perspectives: the shareholder view and the stakeholder view. The shareholder view states that corporations should serve the shareholders’ interest; the stakeholder view argues that corporations and institutional investors have urgent social responsibilities to other stakeholders such as customers, suppliers and communities, who may lack knowledge and information to directly influence corporate conduct. The latter view is increasingly finding resonance with the academic and stakeholder communities.
An important requirement for the success of sustainable investing in South Africa is that investment managers must demonstrate to end investors that SRI funds can outperform their benchmarks and traditional investment funds. It is a natural reaction for clients to think they will need to give up some financial return if they are to take ESG issues seriously. Fortunately, the evidence seems to indicate that this is not necessarily the case.
A 2012 report by Deutsche Bank Climate Change Advisors surveyed more than 100 academic studies of sustainable investing from around the world. It concludes that ESG factors are correlated with superior risk-adjusted returns and that 100 percent of the studies showed that companies with high ratings for ESG factors have a lower cost of capital. Furthermore, 89 percent of the studies examined showed that firms with high ratings for ESG factors exhibit share price outperformance.
Contrary assumption, this is strong evidence that trustees should be favouring ESG-focused funds as these are exposed to factors that will help them generate superior performance over the longer term.
While sustainable investing is young and much work needs to be done, there is strong argument from a financial and ethical perspective for trustees to consider allocating a portion of their investments to products that explicitly target ESG considerations.