A key reason for the growth in socially responsible investing is because the consequences of poor governance have been laid bare.
From BP to Volkswagen, shareholders have felt the impact directly in diminished returns, which has focused their attention.
Equally, with regulation now at the forefront of politicians’ agenda, the risks associated with bad practice are set to rise. Theresa May (UK prime minister), Hillary Clinton (presidential candidate at the time of writing) and eurozone policymakers are all prioritising better corporate governance.
Esmé van Herwijnen, responsible investment analyst at EdenTree Investment Management says: “People are generally more aware of business practices and there is a sense of mistrust in corporate behaviour.
“Frauds in the banking sector and cases like Volkswagen have attracted strong media attention. A wide array of corporate scandals leaving no sector untouched has contributed to increased demand for more responsible investment products.
“The urgency of issues such as climate change also adds to the increased attraction of green bonds or thematic investments.”
Previously, there was also a sense that investors would need to sacrifice performance if they were going to invest ethically.
A number of research papers have largely disproved this: Hermes, for example, suggests that there is a material deterioration in shareholder returns associated with poor corporate governance of around 0.3% per month. This is widely applicable, covering almost all sectors and all types of corporate governance. Companies may be able to withstand poor board composition or a weak remuneration policy, but not a confluence of factors.
This has been seen in the performance of ethical funds.
Over the past three years, the average ethical equity fund (as measured by the FE offshore equity – ethical sector denominated in sterling) has delivered a return of 21.9%, varying between 74.4% for the LGT Sustainable Equity Global fund and 13.5% for the Allianz Global EcoTrends fund. This is higher than the average for the average international equity fund (as measured by the FE offshore – equity international sector), which has delivered 19.2%.
Hendrik Jan Boer, head of Sustainable Investments at NN Investment Partners, believes that increasingly this is because ethical criteria help to identify the stronger companies.
“There is a perspective that sustainability in general should be used as an indicator for management quality. It helps to select quality companies, that are more resilient and transparent, enabling better risk management and improved portfolio resilience.”
Perhaps more importantly, it also helps identify and avoid the weakest companies.
This has been important in the recent investment environment, which has seen weaker companies particularly hard hit. In a low growth world, investors have favoured quality, well-run companies. Increasingly, sustainability criteria are seen as a tool for effective risk management, and this in turn is inseparable from stronger long term performance.
It has also become easier to analyse companies’ ethical behaviour. When ‘green’ investing started to develop momentum in the late 1990s, few tools were available and companies generally did not record their SRI credentials.
Van Herwijnen says there are now more and more tools available.
“Data quantity and quality on sustainability performance continue to improve, making true ESG integration easier than before. More and more investors now calculate the carbon emissions of their investments.”
In terms of database-derived analysis, Morningstar now issues a ‘sustainability rating’ for all funds, which measures how well the underlying companies within a fund are managing their ESG risks in comparison with similar funds. As investors have more tools at their disposal, it becomes increasingly easy to make decisions based on ethical criteria.
However, Jan Boer cautions against believing that increased reporting requirements – as has been the case globally – necessarily helps identify those companies that are likely to do well.
“Some companies provide a lot of transparency and data, but high scores do not necessarily mean that investors are dealing with better companies. Many companies have big departments assigned to dealing with this type of question.”
Jan Boer suggests that while some companies practice what they preach, it is not universal and investors still have to do their own analysis.
He adds that there is a better association between companies that are improving their corporate governance and share price performance, than there is with companies that already have strong ethical practices. Increasingly this is already reflected in the share price. He believes that investors cannot neglect other investment metrics, such as valuation.
The range of ethical investment options is increasing. The old ‘dark green’ investment funds, which focused on exclusion, are increasingly moving towards a new breed of ‘impact’ funds.
“While many ethical strategies focus on excluding companies that are doing harm, impact investing goes one step further, investing only in those companies that are having a positive social or environmental impact,” Jan Boer says.
However, he admits that these strategies can still lack scale, particularly in areas such as microfinance. Equally, thematic funds investing in specific environmental opportunities such as renewables and water continue to grow. The Pictet Water fund is now $4.5bn in size as investors increasingly recognise that there are water challenges around the globe and companies that have solutions to address the problem.
It is now possible to build investments in almost any hue: BNP Paribas Investment Partners, for example, recently expanded its range of SRI equities strategies with the inception of the responsible dividend fund, focusing on criteria such as whether the dividend payout policy compromises a company’s ability to invest.
Emerging markets were once considered a backwater for ethical investment, but funds such as the Stewart Investors Global Emerging Markets Sustainability fund have shown that it is possible to combine ethics and strong performance in emerging markets. There are also companies, such as Hermes, who apply ethical criteria across all their funds, rather than simply isolating it within SRI funds.
Perhaps because of this, the sector is attracting higher inflows across the globe. For example, in Germany, Austria and Switzerland those investments taking environmental and social criteria into account have seen growth of 65%, up to €326bn, and well ahead of their conventional counterparts. According to US SIF (The Forum for Sustainable and Responsible Investment), about one in every six dollars under professional management in the US is now invested with some kind of ethical mandate and momentum is building.
Incorporating SRI criteria is also a means to avoid those companies in danger of obsolescence in a fast-moving world. Jan Boer believes that there are some companies that simply may not exist in five or ten years’ time.
“Some companies will either cease to exist or be taken private. There are still plenty of energy companies that don’t believe in the need to explore new energy. They are still focusing on deep sea oil drilling.”
It is a similar idea driving Pictet’s range of thematic funds – they help identify companies that are futureproof. The question is whether in future there will continue to be a separation between ‘ethical’ funds and everything else – certainly ‘light’ green criteria and corporate governance considerations are increasingly being built into mainstream investment selection. Increasingly, it is only the most obstinate of investment companies that claim to ignore ethical criteria.