(July-2002) Taking the devil out of the dollar

Few doubt that socially responsible investment (SRI) has grown into a viable and broadly recognised investment choice in Australia. But super fund uptake of SRI products does not appear to match the hype and explosion of new products on offer.

Rainmaker Information’s director of research Alex Dunnin reckons there are 22 fund managers offering active and passive SRI options across a range of positive, negative and best-of-sector screens. With some 20 super funds actually offering SRI options or using SRI mandates within their portfolio, there is nearly one super fund per fund manager offering an SRI product.

He estimates that both retail and wholesale ethical/SRI funds under management have almost doubled over the year to $1.8 billion, with half this amount sourced from the wholesale market.

Until recently, mainstream fund managers have been reluctant to commit fully to ethical investments because of the unsettled and evolving nature of the sector in Australia, its untested track record (as the funds are so new), inherently subjective basis and scepticism that it is a marketing strategy driven by managers who are unsuccessful in traditional markets.

“Why,” asks executive director at Australian Ethical Investment James Thier, “have all these new products come into play after the tech crash?”

Dunnin argues that the hesitation of trustees is primarily due to size. “Many doubt whether a big fund can get SRIs into a fund’s portfolio,” he says.

Originally, most providers of SRI products were small to medium-sized fund managers. Now larger managers such as Westpac can cope with the potentially sizeable investment mandates of the larger superannuation funds.

Trustees’ concerns about fiduciary duties have also contributed to the lack of wholesale SRI involvement by institutions.

In addition, trustees are finding it difficult to decide whether to put an ethical screen on all of their investments or to offer an ethical investment as an investment option.

Finally, fund managers are wary of implicitly branding their non-screened funds ‘unethical’ or exposing themselves to criticism.

But perhaps the most critical factor behind the reluctance of super funds to back SRIs is the lack of a comprehensive track record. SRI has really only been around for three or four years in Australia.

Research by AMP Henderson Global Investors finds that for the three years to November 30, 2001, the median SRI portfolio yielded the second-highest return (12.3 per cent) at the lowest level of volatility (11.8 per cent) compared to value, growth and small cap indices. It concludes that both a growth and small-cap bias is likely in an SRI portfolio.

A study by John Tippet of Victoria University of Technology shows ethical funds underperformed the market over a seven-year period in the 1990s. He suggests that the small size of the funds meant that the ratio of management fees and expenses to the total income is high, thus lowering returns to investors.

Assessing the merits of SRI products, independent investment firm, Stellar Capital, in its June report published with the University of Melbourne, finds that most had clear investment objectives but definitions of ‘ethical screens’ vary. Says Stellar Capital principal Martin Gold: “Investors can screen their investments for SRI principles without paying a premium management fee. SRI is not new and is here to stay. Increasingly, it is likely to be viewed as a mainstream investment.”

Dunnin says: “The screening mechanisms are the essence of SRI investing. It is what causes the most confusion amongst trustees.”

SRI research specialist Corporate Monitor’s executive director Michael Walsh notes that while the case for SRIs is strong, “good and bad performances will continue”. He adds: “Getting the right fund manager is crucial because SRI funds rely more on stock selection skills from a narrower investment universe.”

While reasons can be found for the slow uptake of SRI, not all are daunted. Westpac Investment Management portfolio manager Erik Mather argues that “hot money pouring into SRIs is not desirable. Slow, steady growth will prevent a dotcom type burnout”.

Westpac’s acquisition of Rothschild Australia Asset Management earlier this year created the third-largest ethical funds manager in Australia, managing over $235 million. It follows leaders Glebe Asset Management and Hunter Hall that manage $336 million and $276 million respectively.

When super funds do decide to invest in SRI, opinion is divided as to whether they should go the active or passive management route. Passive management, argues Kerrie Williams, a consultant at Frontier Investment Consulting, makes it easier to judge whether the SRI is adding or detracting value without the confusing additional risk of active management.

But, warns head of investment research at InTech Dennis Sams, passive investment also relies heavily on the quality of the SRI screen. “If the screen is biased to certain styles or industries, any passive portfolio will be similarly disadvantaged.”

Mark Sainsbury, chief investment officer at Local Government Superannuation Scheme, which went into SRI earlier this year, highlights another vital question facing super funds going into SRI. Does one allow the fund manager to engage with companies in an attempt to improve their sustainability factors? Or does one adopt the standard SRI solution which usually involves only part of the portfolio and requires buying into existing sustainability products?

Sainsbury says: “Fund managers go through an investment process and select stocks that suit their way of constructing portfolios. It was difficult to extend the sustainability screening to a large range of stocks without interfering with managers conducting their business. The solution was an overlay system that uses a long-short portfolio with the advantage of transparency, controllability and flexibility, while not interfering with the matrix of the portfolio.”

Thier expects it to take a few years before the SRI market sees large-scale investment by superannuation funds.

The trend in corporate reporting towards including social and environmental performance results — the so-called triple bottom line — together with more research, SRI providers and funds with developed products is certainly making it easier for super funds to do their homework on SRIs. Added information adds to the ability to select SRIs.

Providing an SRI alternative could become a key differentiating factor between fund managers. “It is part of the trend towards specialisation that consumers and trustees are demanding as they try to take more control within their portfolios, be it through SRI, hedge funds, boutique fund managers or indexing,” Dunnin says.

Second-generation SRI funds have greater portfolio diversification than first-generation funds and have risk-adjusted performance similar to mainstream investments. They are more explicit about selection and screening techniques.

Walsh notes that they are more likely to include positive screens or a best of sector approach, in addition to the conventional ‘sin stock’ avoidance screens.

Finally, legislation is also driving the SRI trend. The Financial Services Reform Act requires superannuation funds to disclose their policy on ethical investments — “the extent, if any, to which labour standards, environmental, social or ethical considerations are taken into account in the selection, retention or realisation of the investment”.

The Australian Securities and Investments Commission (ASIC) is also producing guidelines to assist funds in declaring their ethical position, which should in turn help trustees to apply due diligence, so that investment decisions do not compromise their fiduciary obligations.

But the law is one thing. What happens could be something else. Scott Charaneka, partner at Ebsworth & Ebsworth Lawyers, notes that it “remains to be seen whether these will shed much light on broader issues facing trustees, such as how to gauge members’ support for ethical investments, how to define and select a SRI, and how to set acceptable benchmarks for performance”.

Walsh counters that as long as 30 per cent of the S&P ASX 200 (by market capitalisation) has some involvement in gaming, alcohol, tobacco, weapons, uranium or native forest logging then member’s concerns about these activities should continue to underpin the SRI agenda.