INTRODUCTION
As the world is changing, so is the way people invest. Over the past decade, we have seen the emergence of sustainability as a financial mega-trend that has not only changed how corporations across the world operate but increasingly how investors seek a return.
More and better non-financial information is becoming available, and it is fuelling the drive of socially responsible investing (SRI) into the mainstream. Evidence is growing that there is strong value in these new sources of non-financial information to improve risk-adjusted returns, and investors are taking note.
But what are the origins of SRI, or as it has been more traditionally known, ethical investing?
In this article, we explore the history and the building blocks of conventional ethical investing. A better understanding of ethical investing is important for Islamic finance participants as it is common knowledge that Islamic investing was first developed based on the strategies adopted by the conventional ethical investment industry and there are strong parallels between the two.
In this article, we look at the historical development of ethical investing up to the present time and introduce a few common approaches to portfolio construction which incorporate Environmental, Social and Governance (ESG) issues. We look at the universal values upon which the industry is based and examine each ESG factor addressed in these values and the United Nations-sponsored initiative which links together investors who have publicly declared their support for the incorporation of ESG principles in their investment strategy.
We conclude by touching upon a couple of academic reports linking good ESG practices and stock market performance and consider evidence of live funds which have successfully utilised non-financial information to improve shareholder value. In time it is hoped that the Islamic investment industry achieves similar significant developments as its conventional ethical investing counterpart.
WHAT IS ‘ETHICAL’ INVESTING?
Ethical investing is commonly referred to as ‘sustainable’ or ‘responsible’ investing. Although these terms are often used interchangeably with reference to a particular style of investing, the difference in terminology reflects the evolution of ethical investing over time.
According to Fung et al, there are five common strategies used to create socially responsible or SRI portfolios; negative screening, best-in-class, engagement, shareholder advocacy and integrated. This article will look at these aspects of responsible investing from the perspective of time and portfolio construction.
The early proponents and adopters of ethical investing were the 18th-century Methodist church and the 19th-century Quakers who held strong objections to the commercial slave trade. Initially, these objections were founded on theological lines but have evolved over time, to be based on moral norms. This particular evolution can be seen in relation to advocates of ethical investing who in the late 1960’s objected to investment in companies that manufactured weapons during the Vietnam War. It was this which led to the establishment of the first global ethical mutual fund; the Pax World Fund in 1971.
At the same time, global protests against apartheid in South Africa began to gain ground. In the UK, there were vociferous calls for Barclays Bank and other British companies to pull out of South Africa during the 1970s and 1980s. The term ‘negative screening’, which is the process of excluding companies from investment portfolios or in some cases, ‘divestment’ – referring to the selling-off investments in certain companies – is synonymous with this era of ethical investing.
In the 1990’s, ethical investing became increasingly linked to the promotion of environmentally sustainable development, with a growing group of investors viewing the negative effects of climate change as a cause of serious business and investment risk.
Increasingly investors were coming to the realisation that the short-term ‘stock performance’ investment approach was no longer sustainable and that alternative investment guidelines were needed for capital allocation. The term ‘sustainable’ is now more commonly used to better reflect the belief or aim behind this style of investing which is to invest in a manner that is sustainable for the environment, society and the world at large.
More specifically, this ‘sustainable’ investment approach has evolved on the basis of preserving the environment and our natural resources for the long term, building and nurturing a healthy society and essentially acting in a responsible manner towards all stakeholders including future generations.
As a result, companies which nowadays are now considered morally reprehensible as an investment choice range from those which produce and manufacture weapons of war to those which pollute and degrade the environment.
Tied to developments in ethical investment over recent years is the rise of Shareholder Engagement. That is, strategies used to open channels of communication between a shareholder and a company to improve its ESG performance. Proponents of the movement have demonstrated that simple capital allocation has its limitations and that a more comprehensive approach – enabling investors to influence boards and senior management – has greater prospects of bringing about positive change and at a faster speed. Having recognised the need to influence decision-making at managerial level in order to bring about long-term structural changes, institutional investors now take the additional step of incorporating ‘stewardship’ in portfolio management such as through the exercise of voting rights. This change is reflected in modern parlance, through the term ‘sustainable and responsible’ investing.
PORTFOLIO CONSTRUCTION
An overview of ethical investing warrants a brief description of the typical approach to portfolio construction. Selecting stocks based on ethical considerations was initially centred around the screening and removal of companies operating in unethical industries such as weapons manufacturing. Funds managed on this basis were popularly known as ‘dark green’ funds. Over time, however, stock selection became more sophisticated and positive screening or the ‘best-in-class’ approach became increasingly popular. This approach allowed investment managers to select companies which were best amongst their peers when ranked according to ethical guidelines or which had the best ESG practices.
The ability to rank companies according to their ESG practices enabled new stock selection approaches to be developed. One such approach of forensic analysis, for example, Accounting and Governance Risk (AGR) ratings, questions whether the financial reports published by companies could be potentially inaccurate and excludes companies that are ‘anomalous relative to their peers.
GUIDELINES: UNITED NATIONS GLOBAL COMPACT
The core ESG issues which are relevant for investors to consider are addressed in the ten principles of the United Nations Global Compact (‘UN Global Compact’). The seeds for the UN Global Compact were first sown in 1999 in Davos, by the then Secretary General of the United Nations Kofi Annan, who called on world business leaders to join with the United Nations, labour associations and civil society in promoting universal values on social welfare and the environment. The universal values which form the foundations of the UN Global Compact are the Universal Declaration of Human Rights, the International Labour Organization’s Declaration on Fundamental Principles and Rights at Work, the Rio Declaration on Environment and Development and the United Nations Convention Against Corruption. Considering these sources, the ten principles enjoy universal consensus as the standards upon which all relevant issues relating to human rights, labour, environment and anti-corruption issues are comprehensively addressed. These ten UN Global Compact principles are set out below according to their overarching values.
Human Rights
- Principle 1 states that businesses should support and respect the protection of internationally proclaimed human rights
- Principle 2 states that businesses should make sure that they are not complicit in human rights abuses
Labour
- Principle 3 states that businesses should uphold the freedom of association and the effective recognition of the right to collective bargaining
- Principle 4 states that businesses should eliminate all forms of forced and compulsory labour
- Principle 5 states that businesses should abolish child labour
- Principle 6 states that discrimination in respect of employment and occupation should be eliminated
Environment
- Principle 7 states that businesses should support a precautionary approach to environmental challenges
- Principle 8 states that businesses should undertake initiatives to promote greater environmental responsibility
- Principle 9 encourages the development and diffusion of environmentally friendly technologies
Anti-corruption
Principle 10 which states that businesses should work against corruption in all its forms, including extortion and bribery.
The UN Global Compact asks businesses to embrace, support and enact, within their sphere of influence, these aforementioned principles within their strategies, policies and operations and businesses which choose to do so are considered as ‘participating’ in the initiative and are referred to as ‘participants’.
DECLARATION OF SUPPORT
Institutional investors that support the incorporation of ESG principles in their investment strategy are encouraged to publicly declare their support by signing up to the United Nations-supported Principles for Responsible Investment Initiative (‘PRI’). The PRI is a set of six principles which reflect the importance of ESG matters in investment practice and was launched in 2006, with 1,325 signatories to date. By signing up to the PRI, investors commit to do the following:
- Incorporate ESG issues into investment analysis and decision-making processes
- Be active owners and incorporate ESG issues into their ownership policies and practices
- Seek appropriate disclosure on ESG issues by the businesses in which they invest
- Promote acceptance and implementation of the six principles within the
- Investment industry
- Work with the PRI Secretariat and other signatories to enhance their effectiveness in implementing the six principles
- Report on their activities and progress towards implementing the six principles
Arguably the first and second PRI principles are the ones which are of most concern to the ethical investor. The first principle requires the incorporation of ESG issues into the investment decision-making process, which could be through the strategies mentioned earlier, whilst the second PRI principle requires signatories to be active owners and carry out stewardship activities such as by exercising voting rights in a particular manner. Enshrining active ownership within the PRI principles reflects the industry’s recognition that stewardship activities may be able to directly influence policymakers to improve their performance in the areas of Environment, Social welfare and Governance.
GOOD ESG PRACTICES AND PERFORMANCE
Simple logic and anecdotal evidence suggest that ethical investing naturally protects shareholder value, for example by avoiding companies which are badly governed.
However, there are now numerous studies which make the link between poor ESG scores and the negative financial consequences that subsequently arise. It is also common knowledge that poor corporate governance has led to some of the biggest fines and bankruptcies in history. One infamous example is the misreporting which brought down Enron and one of big five accountancy firms, Arthur Andersen, in 2002. Indeed, research shows that the ten largest fines and settlements in corporate history are all related to the failure of businesses to take into account sustainability and ESG issues. As of March 2015, these fines amount to a hefty USD$45.5 billion.
There is various research (such as the ‘From the Stockholder to the Stakeholder’ report referred to above) which conclude that integration of ESG factors can lead to a competitive advantage by reducing risk, improving performance through process or product innovation or by improving the reputation of the firm. These studies make the link between ethical investing and the enhancement of financial returns and improvement in stock performance. Furthermore, a 2011 study on the “100 Best Companies to Work For in America” found that employee satisfaction is positively correlated with shareholder returns (See ‘Does the stock market fully value intangibles? Employee satisfaction and equity prices’ in the Journal of Financial Economics). This finding supports the popular theory that good employment practices lead to happier and more satisfied staff, which in turn leads to better company performance and returns. It also implies that human capital is ironically becoming increasingly, not less, important in the modern corporation. These theories are significant within the field of ethical investing because, generally speaking, equity markets still fail to take into account ‘employee satisfaction’ when pricing stocks. The study does not examine the causal link between employee satisfaction and tangible values such as positive earnings announcements but numerous urban myths exist around the idea of employee satisfaction. Amongst the more popular belief is that employee satisfaction is determined not by financial compensation alone but by emotional satisfaction which is determined by factors such as fair and equitable treatment amongst colleagues and the ability to work sociable hours. It could be argued that brands which understand this have achieved global dominance and do so not merely on the quality of their product but by the ability to ensure consistent employee satisfaction in each branch of the business, regardless of where the business is located globally.
In September 2014, Arabesque Partners and the University of Oxford published one of the most comprehensive meta-studies on the financial impact of sustainability to date, analysing over 190 academic papers, industry reports and books on the topic of good ESG practice. The authors of the report ‘From the Stockholder to the Stakeholder’ found a strong business case for corporate responsibility, concluding that sustainability topics can have a material effect on a company’s risk profile, performance potential and reputation – leading to financial impact on a firm’s performance.
The report’s authors cite research demonstrating that sustainable product innovation can have a substantial impact on a company’s revenues, and that medium to longer-term competitive advantages can be achieved through a broader orientation towards stakeholders and shareholders.
Furthermore, they argue by embedding sustainability into an organisation’s culture and values, the firm can build a competitive advantage and benefit from its sustainability programme over the medium to longer term.
The report also examines a company’s cost of debt and cost of equity and concludes that good corporate governance pays off in terms of reducing borrowing costs (credit spreads) and decreasing a firm’s cost of debt.
In addition to the effect of good governance measures, sound environmental and sustainability policies also lower the cost of debt and the report cites examples of firms in the pulp and paper industry which release more toxic chemicals having significantly higher bond yields. It also cites studies which show superior sustainability performance (including employee well-being) leading to better credit ratings and lowering credit spreads.
The report also finds that good corporate governance translates into lower risk, that better disclosure reduces information asymmetries, which contribute towards reducing the cost of equity. It finds that good environmental sustainability reduces a firm’s beta, good employee relations and product safety all lead to a lower cost of equity and that ninety per cent of studies on the cost of capital, show that sound sustainability standards lower the cost of capital.
The report examines research on a firm’s profitability from an accounting perspective and concludes that poorly governed firms have lower operating performance levels (lower Tobin’s Q and return on assets). It examines empirical research which demonstrate that good corporate environmental practices such as reduction of pollution levels and the implementation of waste prevention measures, translate into a competitive advantage and better corporate performance.
It also refers to studies which find that good corporate relations with employees, customers and the community significantly improve operational performance and finds that eighty-eight per cent of research show that solid ESG practices result in better operational performance of firms. The report focused on particular features of governance structures and concludes that superior governance quality is valued positively by the financial market.
Not surprisingly the report also finds that positive environmental news triggers positive stock price movements whilst environmental disasters adversely affect stock price. It also finds empirical evidence on the positive relationship between employee satisfaction and stock returns. Statistically, the report finds that eighty per cent of studies show that stock price performance of companies is positively influenced by good sustainability practices. The report concludes that the future of sustainable investing is likely to be active ownership by multiple stakeholder groups including investors and consumers and that it is in the long-term self-interest of the general public, as beneficiaries of institutional investors, to influence companies to produce goods and services in a responsible way and that by doing so, the public is not only generating better returns for their savings and pensions but also contributing to preserving the world they live in for themselves and for future generations.
THE FUTURE
With greater disclosure and reporting, non-financial information is becoming standardised and more accessible and this type of information is being used by the investment world to improve portfolio returns. At Arabesque, non-financial information together with state-of-the-art technology is already contributing to out-performance in live funds. With increasing evidence of the link between non-financial information and stock market performance surely it is time asset owners and managers including those in the Islamic investing space to integrate such information for the immediate benefit of shareholders and to build a more socially and environmentally responsible model.
