Grassroots revolution

Even the least fashion-conscious financial services professionals will have realised by now that green is the new black.

Although sustainable and responsible investing (SRI) has existed in Australia since the early 1990s, it has gained extraordinary momentum in recent years.

There are now more than 80 SRI funds representing more than $4 billion in funds under management. These funds have traditionally performed on a relatively equal par with their mainstream counterparts but delivered superior returns for the 2006-07 financial year.

Research by ratings firm Morningstar found SRI funds posted average total returns of 29 per cent, compared with mainstream funds’ 26 per cent.

SRI funds’ increased popularity and improved financial performance undoubtedly has much to do with the growing awareness, on individual, business and government levels, of environmental concerns, particularly climate change.

Former US vice-presdient Al Gore’s groundbreaking documentary An Inconvenient Truth, released in May last year, opened eyes, hearts and minds to the devastation climate change is wreaking on our planet.

The Stern Review, released just a few months later by renowned economist Sir Nicholas Stern, warned the global economy could shrink by between 5 and 20 per cent each year if we don’t act now. The message was clear: it will cost far more to ignore climate change than it will to address it immediately.

The financial services industry has been quick to demonstrate its support for tackling climate change, as well as other major environmental and social concerns (including, for example, poverty and widespread health problems such as HIV/AIDs, diabetes and obesity).

ColonialFirstState’s general manager, alliances, Graham Hand summed up the sentiments of many industry members.

“The way the world is changing will create new opportunities for companies and there will be significant benefits for those which harness them. Planners and analysts need to recognise these changes because their consequences will increasingly affect the value of companies,” he said.

In 1999, the Ethical Investment Association of Australasia (EIA) was set up to represent the region’s burgeoning SRI movement. In 2003, it created a charter that set minimum standards for members and, two years later, developed the world’s first SRI certification process.

The United Nations has also released a set of principles for responsible investment, which several Australian institutional investors — led by Melbourne-based Portfolio Partners — have signed.

The six principles set out a framework for incorporating environmental, social and corporate governance (ESG) issues into traditional investment analysis. To date, more than 200 institutional investors worldwide have signed them, representing in excess of US$9 trillion in assets under management.

So, what is SRI exactly?

There is a great deal of confusion in the marketplace about what SRI actually is.

There are ethical, socially-responsible, sustainable and green investment options to name but a few. However, these terms stand for substantially different things, and are not merely linguistic variations on the same theme.

It is interesting to note the EIA is set to change its name to the Responsible Investment Association next month. Communications manager Megan Lewis said the name change reflects the SRI movement’s evolution.

While SRI has traditionally been regarded as an alternative strategy for those wanting to invest with their values, a growing number of fund managers believe companies that meet ESG criteria not only help combat environmental and social problems but also generate the best long-term returns.

Lewis said investors shouldn’t rely on a fund’s label, but rather research the companies it invests in and why.

Australian SRI funds are legally required to include in their product disclosure statements (PDSs) an explanation of how they select, retain and sell investments, however, wading through these can be time-consuming and confusing.

A simpler way of comparing SRI funds is to use the EIA’s SRI certification program.

Launched in 2005 after two years of industry consultation, the program is designed to make it easier for investors to find the SRI investment(s) best suited to their values and desires.

“Fund managers are required to articulate their approach to SRI and explain, clearly and concisely, why they select the stocks they do,” Lewis explained.

“Their applications are then assessed by [accountancy firm] Grant Thornton and, if they meet the necessary criteria, awarded SRI certification.”

Investors are able to choose from investments that employ one or more of the following strategies:

Negative screening

SRI fund managers who employ negative screening exclude companies they believe have a detrimental impact on the environment and/or society.

So-called ‘sin’ industries can include armaments, tobacco, alcohol, gambling, deforestation and/or uranium mining. This approach clearly appeals to investors who have strong views on certain issues, but critics argue shrinking the pool of potential investments based on moral judgments penalises performance.

As Mark Mills, managing director of global sustainable investment management company Generation Investment Management, points out: “Many people believe this negative screening process forces an unacceptable trade-off between ethical criteria and investment performance.”

Positive screening

Positive screening involves investing in companies that positively address environmental and/or social challenges. These include companies that purvey renewable energy sources, sustainable waste management systems and agriculture as well as those that offer solutions to widespread health problems (pandemics).

AMP Capital Investors’ Sustainable Share Fund, for example, includes investments in what senior investment specialist Angus Dennis describes as “industries of the future”.

“These industries offer a strong growth profile as they’re leveraged to key sustainability trends influencing consumer priorities and government policy. Increased awareness of climate change, for example, is leading to mandatory renewable energy targets for businesses worldwide, carbon trading and a focus on water conservation.”

Best of sector

This approach involves investing in companies deemed to be industry leaders in terms of their management of ESG issues. These funds, often termed ‘sustainable’, are based on the premise that ESG criteria are performance criteria and are growing in both number and popularity.

It should be noted these funds can include companies involved in so-called sin industries. Many fund managers justify this on the basis that these industries contribute to a limited proportion of a company’s total profits. Others argue that investing in the best companies, in terms of their management of ESG issues, in all sectors encourages everyone to lift their game.

Lewis said the often wildly differing methodologies fund managers employ to evaluate companies and their management of ESG issues make it imperative to do your research and not simply rely on a product’s label or promotional spiel.

Both Challenger’s Socially Responsive Share Fund and Sustainable Asset Management incorporate the best-of-sector approach into their investment analyses, for example, but their portfolios look very different.

The Challenger Fund has a zero tolerance policy to companies involved in harvesting native forests, uranium mining, cruel or inhumane animal testing, alcohol, tobacco and armaments production and gambling.

However, Sustainable Asset Management doesn’t rule out any industry, provided it has listed companies on the stock market and at least one of these is moving towards a more sustainable future.

Other funds with a sustainable focus will not invest in industries they don’t believe have good long-term prospects.

Passing fad or here to stay?

There is considerable evidence to suggest SRI has made a permanent impression on the investment landscape.

In addition to growing international concern for ESG issues, particularly climate change, more and more fund managers are incorporating them into their analyses in the belief they significantly influence a company’s chances of success.

As Portfolio Partners managing director Craig Bingham said: “Companies and economies do not operate independently of the world around them, nor are they immune to the limitations placed on them by their environment and the communities in which they operate… Investors who have a systematic process for assessing and understanding sustainability issues and how businesses manage them are equipped with a better understanding of business in general.”

AMP’s Angus Dennis said intangible factors, such as a company’s ability to attract and retain staff and clients is likely to become increasingly dependent on its management of ESG issues.

“The sensitivity [of a company] to environmental and social issues is expected to increase into the future, associated with changing generational priorities. Studies have shown 72 per cent of Generation Y members won’t apply to a company if they don’t believe in what it stands for. Compare that with just 25 per cent of Generation Xers and baby boomers.”

EIA’s Lewis said she would go so far as to say SRI has the potential to revolutionise the international investment arena.

“The growing awareness of issues such as climate change is transforming the way people go about their daily lives, do business and, increasingly, invest their money. It’s hard to argue with why you wouldn’t put your money into an ethical fund if they’re managing to match or outperform less ethical products.”