Socially Responsible Investing: Is it the Right Thing to Do?

PART 2: Why SRI akes sense for your pension plan.

By Eugene Ellmen

In the global debate about socially responsible investing (SRI), pension trustees and administrators are often caught in a dilemma. As plan trustees or managers, you want to listen to your plan members who are asking for corporate responsibility and sustainability policies. But you are also acutely aware of your fiduciary responsibilities. What happens if social responsibility policies clash with prudent pension management? How can you resolve this apparent conflict?

Rest easy. There is a growing body of evidence and knowledge to give trustees, managers and administrators comfort in their ability to meet both social responsibility expectations and fiduciary obligations. The body of opinion in pension management is quickly swinging to the notion that responsible investment practices are not just good for the world, but they also make a lot of financial sense.

Nevertheless, there are still a lot of skeptics out there holding on to the notion that social responsibility and fiduciary duty don’t mix. If you are one of these skeptics, read on. Here are four reasons why SRI makes sense for your pension plan.

1. It is legally prudent.
Contrary to some outdated legal opinions that SRI conflicts with good pension practice, the emerging view is that prudent trustees and managers should take environmental, social and governance (ESG) factors into consideration. This view was articulated in a major review of SRI law conducted in 2005 by a British corporate law firm, Freshfields Bruckhaus Deringer, for the Asset Management Working Group of the United Nations Environment Program Finance Initiative.

“The links between ESG factors and financial performance are increasingly being recognised,” states the report, which was based on an extensive review of statute and civil law in 10 jurisdictions around the world. The report comments that it “is clearly permissible and is arguably required in all jurisdictions” to integrate ESG considerations into investment analysis to better predict financial performance. A more recent opinion prepared for an updated version of the report released in July 2009 goes even further. “It is important that it is made absolutely clear to beneficiaries, pension fund trustees and asset managers that ESG is regarded as a mainstream investment consideration,” said the opinion statement, drafted by Quayle Watchman Consulting.

Specifically in regard to common law jurisdictions—which include Canada, Australia, the U.S. and the U.K.—the 2005 report notes that there are no rules prescribing how decision-makers can meet their ESG expectations. The report advises that decision-makers in these jurisdictions should consider and give weight to how ESG factors affect financial performance. “There is a body of credible evidence demonstrating that such considerations often have a role to play in the proper analysis of investment value,” states the report. “As such they cannot be ignored, because doing so may result in investments being given an inappropriate value.”

2. SRI is a means to identify and manage risk.
If there is one lesson that desperately needs to be learned from the current financial crisis, it’s that ESG risk needs to be identified and assessed in investment portfolios. The root cause of the current financial crisis was a lack of awareness of the risk posed by the U.S. sub-prime mortgage market. In essence, the sub-prime mortgage market was laden with social risk through the widespread securitization of mortgages to low-income Americans. The risk of these mortgages, marketed through aggressive and unethical means, was hidden through the opaque nature of the collateralized debt obligations (CDOs) used to bring them to the equity markets. When the risks were ultimately disclosed to the markets, the value of the CDOs collapsed, resulting in extensive damage to investors and credit markets.

A recent Canadian study by the consulting firm CR Strategies analyzed how predatory lending, combined with other social risks such as executive compensation and systemic risk, contributed to the financial crisis. “The crisis does reinforce the critical importance of two tenets of SRI, specifically, the value of long-term investing and the necessity to identify and measure hidden risks and opportunities,” states the report, entitled The Financial Crisis: An Environmental, Social and Governance Perspective. “Considering how central poor governance and transparency were to the crisis, greater attenti on to such issues by the broader investment community might help to avoid or lessen the impact of future crises and has the potential to support long-term performance and sustainability.”

3. SRI can help to generate long-term value.
Mounting evidence shows that long-term investment returns can be enhanced through the incorporation of ESG factors. Numerous socially responsible stock indexes, including the Domini Social Index in the U.S. and the Jantzi Social Index (JSI) in Canada, have matched or outperformed their conventional benchmarks. The performance of these indexes varies from month to month but it looks like there is potential for long-term SRI outperformance. For June 2009, for example, the JSI has recorded annualized performance since inception (January 2000) of 4.72%, compared with 4.64% for its S&P/TSX 60 benchmark and 4.37% for the market as a whole.

Studies have also found that there is no sacrifice for investing in a socially responsible way. In fact, some research has found that attention to climate change and other ESG factors can result in portfolio outperformance. In October 2007, Mercer and the Asset Management Working Group of the United Nations Environment Program Finance Initiative released a major analysis of 20 academic and 10 broker studies on the issue of SRI and financial performance. In the analysis, 10 of the 20 academic studies established a positive relationship between ESG factors and performance. Of the 10 broker studies, three yielded a positive relationship; the rest were neutral.

Clearly, the traditional view that attention to ESG factors will result in negative performance is inaccurate. In fact, there is some evidence to show that such strategies will reduce risk and enhance returns.

4. It’s what your plan members want.
When Canadians are asked whether they would prefer financial products that consider ESG, the majority invariably answers, “Yes!”

Data by GlobeScan, an opinion research firm, on the attitudes of Canadian shareholders show that almost three-quarters of Canadian investors believe that corporate social responsibility (CSR) issues should be an important consideration in their investment portfolios. For example, in 2008, 30% of respondents strongly agreed that CSR reporting is an important factor when making an investment decision. A further 43% somewhat agreed. Sixteen percent somewhat disagreed, and only 8% strongly disagreed.

In a 2009 survey, when asked if it is less risky to invest in socially responsible companies than in “irresponsible” ones, an overwhelming 67% of respondents said they agree, while 27% said they disagree. When asked if they were very interested in learning more about the social and environmental performance of the companies in their investment portfolios, 36% of respondents said they strongly agree, 42% somewhat agreed, 14% somewhat disagreed and only 7% strongly disagreed.

It’s clear that Canadians are intrigued by the idea that they can do good through their portfolios while also earning a decent return—and they expect their pension managers to pay attention to these issues.

Whether it is adopted for reasons of legal prudence, risk management, value creation or plan member preference, SRI is a strategy that needs to be in the tool kit of every pension trustee, manager and administrator. The days of ideological debate are over. It’s time to get on with the job of building social responsibility while prudently managing pension assets.

Eugene Ellmen is executive director of the Social Investment Organization.
ellmen@socialinvestment.ca

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