The market for socially responsible investing is changing, and institutional investors should pay attention to its growing influence and visibility, a new study says.
A recent report estimated that at the end of 2012, the responsible investing market had $3.74 million in assets under management, or 11.2 percent of the $33.3 trillion in total assets under management in the U.S., says the study by Commonfund Institute.
While responsible investing has grown and “is more than a passing trend,” its purpose has moved from a “practice of negative screening and exclusion of certain types of investment to one seeking or encouraging certain characteristics in portfolio companies,” says the study, From SRI to ESG: Changing the World of Responsible Investment.
In the face that evolution, it says, investment professionals continue to debate “whether a portfolio’s long-term performance can be enhanced by including environmental, social and governance (ESG) considerations in the security selection process.”
While responsible investing dates from the colonial era, when some religious groups refused to invest their endowment funds in the slave trade, the study says, socially responsible investing first took shape as an investment philosophy in the 20th century.
In 1921, Pioneer Group became the first mutual fund to screen out tobacco, alcohol and gambling investments, the study says, and social responsible investing, or SRI, was adopted in the 1960s by civil rights, environmental, social and antiwar protest movements.
As environmental awareness grew in the 1970s, the first funds were introduced that looked at issues beyond traditional “sin” investment screens, the study says, and the movement against apartheid in South Africa led to creation of the first funds that screened out companies doing business in a specific country.
The number of SRI mutual funds grew to nearly 60 by the mid-90s, and SRI assets under management totaled about $640 billion, the study says, with climate change, corporate scandals and humanitarian crises emerging as new concerns in the 21st century.
Models for responsible investing also have changed, the study says.
Socially responsible investing, the traditional model, build portfolios that aim to avoid investments in specific stocks or industries through negative screening, it says, while “impact investing” aims to invest in projects or companies with the express goal of bringing about mission-related social or environmental change.
What now has emerged, the study says, is known as “environmental, social and governance investing,” or ESG, which integrates ESG factors into “fundamental investment analysis to the extent that they are material to investment performance,” the study says.
Beyond negative screening
While the negative screening used in SRI “can be a useful tool for institutions desiring to express ethical, religious or moral values through their investment portfolio, the study says, it may prove too restrictive for many because it “limits the range of securities available for investment.”
ESG analysis, it says, takes a “broader view” by examining whether environmental, social and governance issues “may be material to a company’s performance, and therefore to the investment performance of a long-term portfolio.”
Preliminary studies suggest that while “integrating ESG issues into fundamental investment analysis procedures can improve investment performance, it still is too early to draw comprehensive conclusions,” the study says.
ESG data reported by companies is of “varying quality,” it says, and the “lack of consistent standards or reporting methods makes it difficult for investors to compare investments with confidence.”
Users of ESG data continue to call for “more standardized reporting mechanisms to improve the quality of data that is at the heart of any analysis of risk and materiality,” it says.
Determining long-term impact
“ESG risk factors affect company performance over the long-term,” it says. “Managers and investors hoping to gain a competitive advantage by adding sustainability practices to an organization’s strategy appear unlikely to obtain short-term outperformance.”
And different analysts have different perspectives “on how long it takes to confirm an impact from ESG risk factors,” it says.
It also says that while ESG investing practices traditionally have applied most broadly to publicly traded equities, the broad category of alternative investments “pose challenges to traditional ESG analytical methods because of the relatively opaque nature of their investment processes.”
Extent of ESG use
The 2012 NACUBO-Commonfund Study of Endowments reported that among institutions of higher education, 18 percent of the 831 responding institutions used at least one of the ESG criteria in managing their portfolios, the study says.
And the 2012 Commonfund Benchmarks Study of Foundations found the use of ESC criteria more limited, it says, with only nine percent of responding institutions saying they use ESG in their investing process.
Boards of institutions considering using ESG might create a working group, in the form of a subcommittee of the board or investment committee, to study the issues and the possible application of ESG processes and principles to the institution’s investment portfolio, the study says.
Institutions also might retain an adviser with expertise in ESG to conduct an initial analysis of the portfolio to determine a “baseline of exposure to defined ESG issues,” it says.
Institutions also may want to put in place procedures for measuring and monitoring their exposure to ESG factors on an ongoing basis, it says.
“Whether or not a particular institution decides to add ESG practices to its investment toolkit,” the study says, “fiduciaries will need to bear in mind its presence and, potentially, its increasing influence and visibility.”
— Todd Cohen