A couple months ago I attended a conference on fund management. And there was that one lady there trying to intervene the whole time of the Conference given by a famous hedge fund manager. So the conference was all about performance, staggering returns, leverage, risk… etc. And once he finished his presentation, he gets off the stage, to interact with the attendees and answer their questions so people start asking, some come to him and try to give him their business card saying I’m interested in your funds or maybe we can do business together.
And so I noticed, this same lady who just throw one question, what do you do with SRI? it’s quite funny actually that the hedge fund manager, stopped immediately turned and looked at her and said “interesting concept but I don’t know what to do with that and you don’t make money for your clients with that”.
All this astonished me and made me curious to know what is SRI and why this lady was so excited about it and if it’s an interesting concept is it really profitable?
So today I write this post in which I will share with you what I have grasped from different researches I’ve made about this subject
What is SRI (Sustainable & Responsible Investment)?
We all agree upon the fact that the investor’s main objective is to fructify its wealth but today we see people care more and more about the humanitarian side of finance.
In fact, over the last few years, there’s been a growing interest in sustainable investing. This is a catch-all term that means a lot of different things to a lot of different people.
A first thing to note is that there’s not one single definition of corporate sustainability. The one I’ve chosen to highlight here is taken from the United Nations Global Compact.
The United Nations Global Compact is a United Nations initiative that is concerned with promoting the adoption of socially responsible and sustainable business practices by companies all around the world.
According to the UN Global Compact, “corporate sustainability is about the delivery of long-term value in financial, environmental, social and ethical terms. “So there are two important elements here.
There’s this long-term element to corporate sustainability and this idea of environmental, social and ethical issues.
Another definition for the corporate sustainability is from the S&P Dow Jones Sustainability Index and RobecoSAM. S&P is a company that is known for financial index provision. And Robeco SAM is Zurich-based company specialized in sustainable investing.
Both of these firms maintain the Dow Jones Sustainability Index. The Dow Jones Sustainability Index is a Stock Market Index that is composed of corporate sustainability leaders.
That is to say, it is the stock market index that is composed of firms with exceptional corporate sustainability practices.
So according to S&P Dow Jones Sustainability Indices and RobecoSAM. “Corporate sustainability is a business approach that creates long-term shareholder value, by embracing opportunities and managing risks deriving from economic environmental and social developments.”
So, again you have these two elements the long term and social environmental one hand, and economic developments on the other hand.
So to sum up, corporate sustainability is about two issues. It’s about long-term value creation, and the management of environmental, social and governance risks and opportunities.
The key here is that it’s not the same as giving your money away. Investors are still expecting a rate of return commensurate with the risks of the taking.
Talking about SRI’s Return and risk, are they lower or higher than tradition investing?
To answer this question let’s compare between the two; The first comparison aspect is the diversity of screened assets.
Screening is this idea that you exclude certain assets from your portfolio, which reduces risk-adjusted performance because it restricts you to the extent to which you diversify your portfolio.
In this point, sustainable investing underperforms traditional investing because the last has a larger choice of assets to choose from.
Moreover,sustainable investing underperforms traditional investing once again when it comes to fees. Sustainable investment requires additional research to find adequate assets that full fill the main 3 objectives E, S, G, that stand for Environmental, Social, and Governance.
So because sustainable investors have to gather additional information or data relating to E, S, and G. That will result in higher costs, and therefore higher fees, which would reduce the returns of sustainable investment.
Also, we should not neglect the fact that the size of the sustainable investment firms is rather small. So historically smaller investment firms also tend to charge higher fees.
For all those reasons it’s hard to think of a something that makes SRI profitable, well, in fact, there are many things that make an investor choose SRI One commonly reason relates to mispricing.
The idea here simply is that the market does not price these ESG issues correctly. So to give you a concrete example, think about badly governed companies.
It might be the case that investors do not understand the financial value of governance. Because they don’t understand it, it’s not priced in the short run so the market prices it in the long run, and that would lead to risk-adjusted odd performance.
In addition,sustainable companies and projects lead to new product and process innovation that embrace environmental efficiency, for instance, a company can build up “know-how” that it will be able to apply internally, but also sell to other outside companies.
By developing a cleaner production technology, the company can potentially generate higher cash flows because it offers new products.
On the cost side, the argument is somewhat similar, if you have a company that generates large amounts of waste, or pollution or, you are a company that is characterized by poor working conditions, then that sort of shows a very inefficient use of resources.
Also Neglecting environmental and social issues can lead to catastrophic events. Just think about the BP oil spill in the Mexican Gulf a couple of years ago, or about the emissions scandal at Volkswagen.
So both these instances are related to environmental issues.
But why might investors care about this? Well,investors care about company’s value and most of this value comes from the company’s intangible assets, reputation, management talent, intellectual property, rather than plant machinery or buildings.
In fact, recent estimates suggest the proportion of SMP-500 that’s US equities, value arising from such immaterial assets, is now actually around 80%.
That’s up from just 20% in the mid-1970s. What this means is that a company now must manage its impact on society and environment because that’s becoming ever more increasing in determining the value of its business.
Investors can now draw on databases that collect such measures and these can be integrated with traditional financial variables.
This approach is aimed very much at enhancing investor returns, but it should also have a positive impact of incentivizing good behavior at firms that will surely lead, to a win win win scenario (investor wealth, company’s growth and Humanity)
The bottom line is an investor no longer face a tradeoff between being ethical and ensuring a good return. The two go hand and hand. So she/he can sleep better at night
How to make my investment portfolio SRI?
There are two approaches to making your portfolio responsible and sustainable the first one and Perhaps the most basic form is the exclusion method.
This implies screening out companies involved in activities that the individual investor finds morally questionable. For example, many people came to avoid supporting firms that make the bulk of their money through tobacco, weapons or adult entertainment.
Over the past few years, increasing numbers of investors have also wanted to screen out producers of fossil fuels, notably coal or oil.
It could be even broader, including firms that engage in animal testing, the generation of nuclear energy, or the design of genetically modified crops.
Generally speaking, this approach sets a tolerance threshold. For example, it may stipulate that no more than 5% of revenues comes from a particular activity.
Of course if one makes the rules too rigid, eventually returns will suffer. Still, this exclusionary approach in moderation does not tend to reduce returns.
The second strategy I want to talk about goes beyond the do no harm and actually attempts to have a beneficial effect. Humanity faces various challenges, and new financial products have been devised that reward investors for funding these solutions.
This particular approach is called impact investing. This is usually structured so the financial returns for investors increase if projects achieve the social or ecological goals.
Whether that involves reducing criminal re-offense rates, boosting education achievement in underprivileged areas, or revitalizing run-down neighborhoods.
So to summarize the modern investor should take in consideration other intangible assetsof the company not only its historical returns its future cash flows but also about whether it has a clean production technology.
Whether a company cares about employees over and beyond paying them the wage. And to be interested in the Societal impact of the company on its environment.
Not only because this is beneficial for humanity but also because it’s has a notable influence on the company’s value for the long run.
About the author: KHALI Mohamed Salaheddine: Finance Post Graduate student from the first ranked Business school in Morocco “ENCG” Experienced in Finance and Portfolio Management. Currently work as a Portfolio Manager in Casablanca Stock Exchange as an Intern.