Investing with a conscience has the potential for long-term rewards

THE need for responsible investment has never been more relevant in the wake of the BP Deepwater disaster in the Gulf of Mexico and multinational oil companies' controversial activities in the Canadian tar sands.

Responsible investment has traditionally been seen as a domain for militant activists and students whereby stocks that do not meet certain environmental, social and governance (ESG) criteria – for example, tobacco producers and arms makers – are excluded. But the investment industry now talks about fiduciary responsibility rather than ethical exclusion and it is becoming more mainstream.

More than 800 institutional fund managers – managing around $20 trillion of assets – have signed up to the United Nations’ Principles for Responsible Investment since they were launched in 2006.

Danyelle Guyatt, global head of research for responsible investment at Mercer, says that she has seen an increase in interest in responsible investing from institutions. However, the recognition by pension funds of the need to incorporate ESG issues into their investment processes is not uniform across all countries. Colin Melvin, head of Hermes' Equity Ownership Scheme (EOS), says: “There is a clear regional bias towards the big UK, Dutch, Nordic, Australian and Canadian pension funds wanting an engagement service whereas the Americans and Japanese have to date shown less interest.” In the UK there is a strong fiduciary backdrop, expressed most recently in the development of the Stewardship Code, which is now seen as a blueprint for a global initiative.

There are a number of ways in which funds are improving their ESG capabilities. Mercer's Guyatt says: “The growth areas where we are advising pension funds on how to capture new opportunities include thematic funds, integration of ESG factors into investment decisions and exercising their right as shareholders to vote.”

But why are pension funds shifting towards ESG investment? David Russell, co-head of responsible investment at the Universities Superannuation Scheme (USS), says: “Partially because of the nature of its membership, the fund was under pressure to look at these issues quite early on.” Depending on the profile of its members, a pension fund may be keen to engage on certain issues. For example, the key issue for a medical pension fund is public health. While some pension funds, such as USS, may do this in-house, other smaller institutions may outsource the ESG assessment to the likes of F&C or Hermes’ EOS. “We are seeing increasing concern from pension funds on ESG risks including public health, climate change and corporate governance and these are some of the areas where we are engaging actively with companies,” says Sandra Carlisle, director for governance and sustainable investment at F&C, which was the first asset manager to establish an ethical fund, known as the Stewardship Fund, in the UK in 1984.

Since pension funds are concerned about liability matching, performance is a key factor. While screening out stocks based on ESG factors affects the breadth of the investments, ESG issues can impact the value of the stocks – note the vertiginous drop in BP’s share price over recent months.

Mike Taylor, chief executive of the London Pension Fund Authority, says: “If we invest responsibly (in the ESG sense) then we will get better returns over the longer-term. It is difficult to prove the returns on environmental and the social side, but it is this belief that underpins the way we implement our investment strategy.”

Hermes’ Colin Melvin agrees: “It seems clear to us that companies with active shareholders tend to do better than those that don’t. Calling the directors of a company to account improves their performance.”

Consequently, engagement with companies is the primary way in which pension funds try to ensure that they fulfil their fiduciary responsibilities and enhance the value of the company. David Russell at the USS says: “Engagement does a number of different things, including reducing risks, helping identify problems before they happen and encouraging change. It is where we believe we can demonstrate value-added.”

But while equities are key for pension funds, fixed income has become an increasingly important asset class in recent years. ESG evaluation for fixed income is still relatively new, but it is growing. Steve Waygood, head of SRI at Aviva Investors, says: “There have been more (ESG) mandates for fixed income in the past two years than I had seen in the previous eight.”

For corporate debt, Waygood says that they use the same methodology as they would for the firm’s equity. For sovereign debt, they bring a variety of indicators including Gini coefficients, adherence to the Kyoto Protocol and human rights into an overall assessment of a country's ESG success.

Pension funds are realising that responsible investing can lead to better long-term performance, so whether it is through investing directly in ethical funds or adopting an ESG overlay decision-making strategy, they are stepping up their capabilities. It has certainly been a good start, but everybody involved recognises that much more still needs to be done.

IN FOCUS | RESPONSIBLE INVESTING

The UN Principles for Responsible Investment (PRI) were launched in 2006 and now have around 850 signatories, managing over $20 trillion of assets. Signatories to the UN PRI commit themselves to incorporating environmental, social and governance (ESG) issues into their investment analysis, develop their engagement capabilities, and seek appropriate disclosure on ESG issues from the entities in which they invest. The number of sustainable funds in the UK now stands at 54 with £5.6bn of assets under management at the end of 2009, an annual increase of 26 per cent, according to the Investment Management Association (IMA).