Have SRIs promised high but . . . delivered low?

Australia’s SRI fund managers made two general claims in their 2001-02 investment prospectuses and marketing material.

Firstly, SRI funds claimed to be able to change corporate practices by affecting corporations’ access to capital funding. This argument can be called the cost of capital argument. Economic analysis and the market share of SRI funds in Australia, Europe and the US shows this claim is unlikely to eventuate.

The second claim was that the financial returns of SRI funds are no different from those of other investments and may even result in superior financial returns. This argument can be called the outperformance argument. SRI funds cannot claim success for the second claim to date, despite being a feature of the market for over 15 years.

The managed fund option has attracted some attention in the media and academic circles during the past decade. Investors wanting to hold an SRI portfolio can purchase units in a trust fund that follows SRI guidelines.

The number of SRI funds began to grow in the early 1970s in the US and from the mid-80s in the UK and Australia. The market widened somewhat in the 1990s, and in 2002, a total of 74 SRI managed fund options were identified in Australia. By 2003, over $2 billion was invested in retail and wholesale Australian SRI funds.

The portfolios of the vast majority of SRI funds in Australia are comprised of equity investments listed on actively traded stock exchanges. SRI funds make their portfolio selections on the basis of financial and investment risk assessments, much as any other active fund manager.

Where SRI funds differ from other funds is in their use of environmental, social and ethical criteria to construct portfolios. Common social and environmental investment criteria include corporate governance and employment policies, the extent of involvement in specific industries — such as mining, armaments manufacture or gambling — or on the positive side, in ‘alternative’ energy production such as wind farming.

The cost of capital argument

Under the cost of capital argument, it is claimed SRI funds can reduce the cost of capital for ‘good’ companies relative to ‘bad’ ones. By selecting a ‘good’ company for investment, a SRI fund will purportedly increase that company’s supply of capital, reducing its cost of capital, which allows a company to pursue more capital projects.

Conversely, choosing to divest from a ‘bad’ company will decrease a company’s capital supply, in turn increasing the cost of its capital funding and, according to the rhetoric, will lead to the company abandoning its projects. To avoid this, the company will change its practices.

This argument is unlikely to eventuate in practice. Any lasting effects of capital restriction or expansion would only eventuate in the absence of alternative capital providers; that is, in conditions of relatively inelastic capital supply.

These conditions are not those of liquid capital markets, where arbitrage opportunities are taken as they arise. For example, if a fund’s divestment from a company actually resulted in a direct downwards movement in share price, other investors would treat the price as representing a discount to its ‘true’ value and buy into the stock, so returning it to its ‘equilibrium’ share price.

It is plausible that the market may notice the buy/sell behaviour of SRI funds as signalling previously unknown profitable opportunities or significant contingent liabilities. SRI funds may be looked upon as experts in identifying unrecognised liabilities, for example, potential environmental disasters. The argument for an indirect effect, however, is just as weak.

Social criteria are not included in the ‘fundamentals’ of a company by investment analysts. Consequently, the direction of any signalling effects, should they exist, are not guaranteed.

Other factors that suggest the cost of capital argument is unlikely to be borne out are:

* the proliferation of SRI funds in the last decade, which would dissipate any potential effect of investments in and divestments from companies, as relative holdings of SRI funds in individual companies become smaller; and

* the tiny holdings SRI funds have in large companies are not significant enough of themselves to materially affect the share prices of those companies. The average size of an SRI fund is approximately $30 million, which in a total market of over $700 billion of funds under management (FUM) cannot be expected to materially impact a company’s share price.

Market share of SRI funds

The validity of the cost of capital argument depends on whether the relative size of SRI funds create real economic effects. Although SRI is often said to be the fastest growing sector of the investment market, SRI funds only comprise a tiny fraction of FUM in Australia, the United States and Europe.

In Australia, SRI funds represented less than 0.3 per cent of total FUM between September 2000 and September 2002. The proportion is echoed in international markets. SRI retail managed funds in Europe accounted for just over 0.42 per cent of total FUM in June 2001. The figures were even lower for retail and wholesale SRI mutual equity funds in the US, where the SRI market share hovered around 0.2 per cent for the two years to September 2002.

The graph opposite shows that SRI funds at current levels cannot be expected to make much difference to corporate operations. The market share of retail and wholesale SRI funds for the United States and Australia is shown over the period from September 2000 to September 2002.

The table below shows FUM in SRI funds in Australia, the United States and Europe. FUM relates to retail and wholesale equity managed funds, except for Europe, where retail funds only are shown. European data relates to the United Kingdom, Austria, Belgium, Finland, France, Germany, Italy, Norway, Poland, Spain, Switzerland and The Netherlands.

The outperformance argument

Claims of ‘enlightened self-interest’ have long emanated from international SRI managers. The claims continue with Australian SRI fund managers.

The 2001-02 prospectus ofVanguard Investments Australiastates: “Companies taking a lead in [sustainable] development will gain a competitive edge and outperform their industry peers.”

By investing in these types of companies, retail investors in this SRI fund would be provided “opportunities to profit from the growth potential of sustainability-driven products”.

Similar claims are contained in the 2001-02 Challenger International prospectus: “Relative outperformance comes from investing in quality companies [that] will be re-rated to their true valuation at a later date.”

The outperformance argument relies on the identification and subsequent pricing of ‘externalities’, that is, the side-effects, either desirable or undesirable, of corporate operations.

Using the theory of public sector economics, when governments price those externalities, superior market performance of companies is expected to follow.

A win/win/win situation is expected to result, with improvements to the natural environment and society, increases to the profits and share price of the company concerned, and the company’s investors reaping the benefits of capital growth and an improved dividend stream.

Researchers have long sought to determine whether the argument could be valid. At the moment, it can only be said that the research is inconclusive regarding systematic SRI outperformance. On the basis of the research performed to date, SRI funds would not be able to claim systematic outperformance relative to other actively managed funds or to general market indexes.

Research does suggest, however, that actively managed SRI funds do not underperform conventional active funds. This is not so surprising, as the distinction between SRI funds and conventional managed funds, at any rate, may largely be in name. Two features of SRI funds would support such a conclusion:

* the portfolios of SRI funds appear remarkably similar to those of conventional managed funds. The November 2002 Corporate Monitor tables revealed the 16 largest Australian SRI funds held 171 of the top 200 companies in the Australian Stock Exchange; and

* research shows the performance of SRI funds is correlated more with the performance of conventional market indexes than with SRI market indexes.

Conventional modern finance theory shows SRI funds are unlikely to affect companies’ capital investment programs and are unlikely to outperform broader market indexes.

This analysis breaks little new ground. If investors and fund managers know that many of the claims of SRI funds are unlikely to be realised, what are their motivations for investing in and offering SRI funds?

Perhaps SRI funds ‘legitimise’ other investments held in conventional investment vehicles. Mackenzie and Lewis (1999) suggested that SRI allows investors to ‘assuage their consciences’. Using an experiment, they found that some investors chose to direct only a small portion of their investment monies into SRI funds, the majority of their wealth spread among conventional financial investments.

Financial markets can also use the concept of social responsibility as a legitimating device to buttress themselves against pressures for external regulation.

This could be important for the major financial institutions in Australia that, since 2000, have all offered SRI funds within their families of financial products. By offering SRI funds, major financial institutions can claim they are exercising adequate accountability.

At any rate, the regulators may be interested to learn that many of the claims made in the prospectuses of SRI funds are unlikely to be realised. Agencies such as theAustralian Prudential Regulation Authority, theAustralian Securities and Investments Commissionand the Australian Competition and Consumer Commission should take note.

Matthew Haigh is an academic in the Department of Accounting and Finance, Division of Economic and Financial Studies, Macquarie University.