Buying your place in heaven

By Edward Smith

Sunday 1st December 2002

When 19th-century Quakers refused to invest in alcohol or gambling, and 1960s anti-apartheid protestors boycotted companies with South African interests, they didn't realise they were founding a movement: socially responsible investment (SRI). Now, after 100 years on the fringe, it seems SRI is going mainstream.

In the US, according to the Social Investment Forum, one in eight dollars under professional management is invested in a socially responsible fund - of which there are 192. In Britain, investments in ethical funds rose a staggering 1750% between 1989 and 2000. Australian SRI funds' assets stood at $A1.3 billion in July 2002, according to the Ethical Investment Association - up 86% between 2000 and 2001 (compared to 7% for all managed funds). Worldwide, an estimated $NZ3 trillion is invested in SRI funds. And top markets now have SRI indices such as the FTSE4Good and the Dow-Jones Sustainability Index.

But so far New Zealand is lagging behind. There are no funds screening New Zealand companies alone, although large fund managers such as Tower, AMP Henderson and Saggita (formerly Rothschild) have recently launched SRI products onto the New Zealand market. And with Finance Minister Michael Cullen saying the New Zealand Superannuation Fund will be "a fund which explicitly adopts socially responsible investment guidelines and practices", perhaps SRI's profile will soon be raised in this country.

So should you embrace SRI? Ask yourself these questions:

What do I care about?

The Quakers and the anti-apartheid protesters took a single-issue, negative-screening approach. Today, SRI encompasses a cornucopia of concerns, from animal testing and global warming to child labour and deforestation and, more recently, chief executive bonuses and employee relations. Work out what matters to you before getting out your chequebook.

For some investors, this isn't hard. Muslims, for example, follow the principles of halal investing, which excludes investments in interest-based businesses (such as banks) as well as alcohol, gambling and pornography. But for the secular investor, the choices are less clear. Do you avoid whole industry sectors, the countries that support them or specific companies? What about investing in governments that give to AIDS research while buying armaments? How do you judge a corporation with a laudable track record in employee rights and a terrible one in community relations?

Guidance is available from specialist financial advisers or you could invest directly in a fund that makes the choices for you. But fund and index screening processes can vary, so check them out. One of the best-known indices is the Domini Social 400 Index. The DS400 screens for alcohol, tobacco, defence, gambling and nuclear power as well as employee relations, environmental impact, product safety and diversity, then adds other companies it considers strong models of corporate behaviour. The Calvert Social Index screens for a wide range of social and environmental issues, including employee rights. On the other hand, the Brideway Social Responsibility Fund excludes only tobacco and armaments sectors. Calls to action differ, too. Some funds and indices blacklist a company as soon as it reportedly commits an indiscretion. Others only exclude it if the company is found guilty in court. The Carlisle Index still screens out one of America's most widely held stocks, General Electric Company (GEC), on the basis of the company's controversial discharge of toxic substances into the Hudson River many years ago, even though the US Environmental Protection Agency subsequently judged the river safe for recreation and fishing.

How much time do I have?

Tracking your own ethical portfolio is even more time-consuming than keeping an eye on other investments; the areas of corporate behaviour targeted by SRI are particularly vulnerable to change. Dwindling market share, mergers and acquisitions or a new chief executive can all mean a major policy shift. This year the Domini Social Index jettisoned Compaq over worries about its merger with Hewlett-Packard, and US clothing company Lands' End after it was acquired by retail giant Sears.

There is information available. For Kiwi investors, www.goodreturns.co.nz and www.sharechat.co.nz are helpful. For Australian companies, try www.ethical.shares.green.net.au, www.connect4.com.au, the Australian Stock Exchange (www.asx.com.au) or www.industrysearch.com.au. Other independent international sites are Investor Responsibility Research (www.irrc.org), the Domini Social Index website (www.dsi.com) and www.goodmoney.com.

Despite the screeds of available information, it is debatable whether it is possible to really get behind the public face of a company, industry or government - even ethical funds invested in Worldcom, after all.

Can I afford it?

SRI funds are expensive. Some fund managers charge higher management fees because they see SRI as a specialist segment. They also have to spend more on screening and monitoring their SRI investments. And transaction costs are often higher because an active SRI fund may dump shares (if the company's behaviour changes for the worse) more often than other funds.

According to fund-rating agency Morningstar, a typical SRI fund charges 15% more than its traditional equivalent. This means if the fees and expenses of a typical international share fund are around 2%, an equivalent SRI fund would be 2.3%. This might not seem like a lot. An investment of $100,000 that would grow to $110,000 in a standard fund would grow to $109,700 in the equivalent SRI fund after fees and expenses.

What can really hurt is tax. Many investors who do not regularly buy and sell shares avoid being taxed on their capital gains because the IRD classifies them as passive investors. Some managed funds offer a similar tax advantage but none of the New Zealand funds that follow SRI indices are tax-favoured, meaning investors will pay capital gains tax. Suppose a tax-effective international share fund earns a net return of 10%. An equivalent taxable fund would only return around 7.1%, and an equivalent taxable SRI fund would return 6.9% thanks to higher fees and expenses. So the choice is between a fund that grows from $100,000 to $110,000 and one that grows to only $107,000.

What returns do I want?

There is mixed evidence about whether socially responsible investing gives you better returns. The Mistra Report, one of the most up-to-date on the topic, concludes that while existing research is limited, "at worst, stock selection using social screens has no negative impact on financial performance and at best has a measurable positive impact". Then again, a study last year by John Tippet of Victoria University of Technology showed that over a seven-year period, the performance of ethical funds was worse than that of the general market, mainly because the high management fees lowered investor returns. And a 2002 Australian study from Stellar Capital says socially responsible investors are up to 0.7% worse off than traditional investors.

A key factor is that SRI portfolios generally contain a higher proportion of growth shares (shares with a relatively high price-to-earning ratio). Typically, these are in newer industries such as telecommunications and biotechnology. When growth shares are doing better than average (as seen in the dot-com bubble), SRI indices will outperform broader indices. When growth shares slump, so will SRI indices. So-called "vice" shares are often represented by well-established industries - tobacco, armaments, mining - and tend to do relatively better in a market downturn.

This bias towards growth shares in SRI indices might explain why academic studies find it hard to reach a consensus on relative performance: the results are highly sensitive to the period of the study. There are other problems. SRI has too short a history to analyse long-term performance. And the sector is changing fast. SRI screening methodologies are getting more sophisticated, and companies are coming and going at a rapid rate. All this means he composition and performance of the SRI market today will not necessarily be the same next year as this year or last year.

Can I afford the risk?

Research by investment services firm Frank Russell Company shows that in the 10 years to 2002, total volatility for the Domini Social Index was 15.9%. For the Standard and Poor's 500 Index, it was 15.1%. The higher the percentage, the more risky the investment.

The issue here is diversification. One of the golden rules of successful investing is to spread risk by diversifying into as many areas of the investment universe as possible. By screening out individual companies, entire industries and even countries, socially responsible investors and funds run the risk of creating a lopsided portfolio that is more vulnerable to market upswings and downturns.

Does SRI work?

One of the obvious questions to ask about SRI is: does it make a difference? After all, it is almost impossible to prove a link between investor activity and corporate reform.

One of the most widely quoted examples of SRI success is the boycott of companies with investments in South Africa during the 1980s. Yet a study into the effect of socially activist investment policies on South Africa at that time showed that neither the financial markets' valuation of the targeted companies nor the South African financial markets were affected by the investment boycott. What did work was the publicity that surrounded it. It raised broad public awareness of the apartheid issue and forced companies with business interests in South Africa to reconsider their involvement in the light of negative public relations.

Now that the engagement model (see "Judging the judges") is becoming more popular, it is possible SRI may begin to play a more active role in the business community. A well-established UK SRI fund, Friends Provident, is leading the way by switching from portfolio screening to leveraging its investment power as a large shareholder to promote more responsible corporate behaviour. More funds have promised to follow suit. And shareholder activism is increasing. The Social Investment Forum, an organisation made up of socially responsible investors and companies, is pressuring the US government to hold executives even more accountable for their companies' social and environmental reporting and disclosure than recent legislation demands.

Combine these trends with tighter corporate reporting standards (for example, triple-bottom-line reporting that covers environmental, social and economic results) and it seems likely that investor power will begin to have more influence.

Judging the judges

Common SRI methodologies

Negative screening: avoids certain investments. For example, companies that violate equal employment laws, produce cigarettes or test products on animals.

Positive screening: invests only in certain companies such as those with waste reduction programmes or good records in community involvement.

Engagement: uses voter rights, shareholder resolutions and ongoing dialogue to encourage companies to reduce their negative impacts on the environment, society and other stakeholders.

Cause-based: supports a particular cause or activity by financing it.

Best in sector: invests in the companies in each sector (including traditional SRI "baddies" such as mining) with the best track record in key ethical areas.

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