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MarketWatch July 2017

SRI: It Pays to Be a Responsible Investor

Keith Williamson_author.jpg Keith Williamson
Investment Analyst

Socially Responsible Investing (SRI) is not a new phenomenon. As far back as 1758, the Religious Society of Friends (Quakers) outlawed its members from investing in the slave trade. Various investors have been applying similar investment principles ever since.

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What is SRI?

Ethical investing gained significant traction throughout the latter part of the 20th century. It was largely driven by the demands of large university endowments and faith-based institutions not to invest in companies with exposure to controversial industries – the so called ‘sin stocks’.

This would usually preclude investment in alcohol, tobacco, weapons or gambling related businesses.
 

Figure 1: Typical exclusion criteria of an ethical fund


Source: Davy Asset Management

In 2005 the establishment of the United Nation’s (UN) Principles for Responsible Investing (PRI) focused on environmental, social and governance (ESG) issues such as climate change and human rights. Today, investors are increasingly evaluating companies’ positive contributions under these three headings, in addition to considering the traditional negative exclusion criteria. To this end, the terms SRI and ESG investing are often used interchangeably, and investing responsibly is no longer solely the preserve of charitable bodies or religiously focused foundations.

 

SRI has gained in traction in recent years

The growing allure of responsible investing has seen the volume of assets invested in SRI strategies trend upwards. The most recent figures estimate the total value of investments managed responsibly to be in the region of $23 trillion.

In the last two years global SRI assets have grown by over 25%. Europe has been at the forefront of this trend and accounts for over 50% of the world’s SRI, while the US comes in second with a 38% share. In Europe and Australia/New Zealand more assets are now managed in SRI strategies than non-SRI.

 

Table 1: Growth of SRI assets by region 2014-2016


Source: Global Sustainable Investment Alliance
Asia ex Japan 2014 assets are represented in US dollars based on the exchange rates at year-end 2013. All other 2014 assets, as well as all 2016 assets, are converted to US dollars based on exchange rates at year-end 2015.


As investors are taking such a vested interest in ESG matters, more and more companies are re-assessing their corporate values. Many have shaken up their board compositions and introduced better corporate governance measures as a result of this shifting paradigm. Many large companies, including Apple, now have policies for the fair treatment of their workers. This affects the supply chain too, and the reverberations of each company’s positive actions can be felt far from the source. The cumulative effect of this should not be underestimated, and as more large firms adopt ESG practices in their operations, even more will be forced to follow suit.
 

Recent examples of company malfeasance

Two recent examples will illustrate where a responsible approach can add value: BP’s Deepwater Horizon (Macondo) oil spill in April 2010 and Volkswagen’s (VW) vehicle emission scandal in September 2015.

In the two months after the Macondo oil leak BP’s share price fell by over 45%, while VW’s shares lost over 35% in just two weeks following news of the firm’s Clean Air Act violations. Both companies were widely held across global equity portfolios, but were excluded by fund managers who give sufficient regard to ESG factors. Neither BP nor VW was a constituent of the benchmark MSCI World SRI Index at the time of their respective crises.
 

Figure 2: MSCI World SRI Index since inception versus MSCI World Index

Source: Bloomberg
 

Ethical investing can beat the broader market

One of the most common concerns around investing in sustainably managed funds is that performance may be hindered by the selective screens applied. It seems intuitive that a portfolio selected from a broader base should outperform one chosen from a limited subset of that universe. However, historical returns tell a different story.

In Figure 2 we compare the MSCI World SRI Index with the unscreened MSCI World Index. The SRI index has outperformed its parent index by almost 15% since its inception in 2007, or 1.4% annualised, and has shown less volatility too. An SRI approach appears to perform best in emerging markets where the SRI index has outperformed its parent by over 2.4% annualised since inception.

The rationale for this outperformance is threefold:

  • Businesses that actively engage on ESG issues tend to have better corporate governance and  risk management procedures. This enables managers to run the company and allocate capital with investors’ interests at heart which leads to a more sustainable return on invested capital (ROIC) and subsequently higher shareholder returns.
  • As investors continue to place increasing importance on ESG factors when evaluating stocks, the flow of capital into the better companies has grown and the stock price has appreciated accordingly.
  • Empirical studies have found that stocks with socially responsible attributes exhibit higher expected returns because investors are not able to correctly value the positive effects of these ESG characteristics. Companies with strong ESG credentials are simply undervalued by the market.


SRI for the long-term investor

The growth in socially responsible investing over the last two decades shows no signs of abating. There is plenty of room left for growth in many of the world’s key markets. Indeed further development in this type of investment philosophy should serve only to widen the performance differential between SRI and traditional investments.

If the benefit to the world of investing responsibly is not enough to warrant an allocation in an investor’s portfolio, surely this argument alone – that investing responsibly does not impair the expected returns – should be the deciding factor. Until all companies are equally well governed and investors are able to value this important quality we believe that the case for SRI will remain.
 

WARNING: Past performance is not a reliable guide to future performance. The value of investments may go down as well as up. Returns on investments may increase or decrease as a result of currency fluctuations.


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