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Socially Responsible Investment
Introduction
The topic of Socially Responsible Investment (SRI) has become a significant consideration for the trustees of many occupational pension schemes when setting their investment strategy. This may be due to a deliberate policy pursued by the company or the trustees; for example, a hospital trust may not allow their pension scheme to invest in the tobacco industry. Alternatively, members of a scheme may collectively prefer its assets to be invested ethically. Since 2000, trustees of occupational pension schemes have had a responsibility to set out their attitude to social, environmental and ethical investment issues in their Statement of Investment Principles.
Some investment managers have seen this as a potential marketing opportunity, with the result that a number of investment funds which explicitly take account of SRI are now available. The vast majority of these relate to equity investment rather than corporate bonds. This note examines how a SRI fund works, what the FTSE4Good indices are and what issues trustees need to consider when implementing a SRI policy.
How do SRI funds work?
Some SRI fund managers have developed their own criteria to decide which companies the fund will invest in. For example, the fund may only invest in companies that satisfy some or all of the following criteria:
- Work towards environmental sustainability
- Develop positive relationships with stakeholders (e.g. employees, customers, local government)
- Uphold and support human rights
As well as (or instead of) such "positive criteria" that companies may have to satisfy, there may also be "negative criteria" that will cause a company to be excluded. For example, a SRI policy may prohibit investment in companies which manufacture certain products or are involved in certain industries (e.g. tobacco, pornography, gambling, nuclear weapons, links to oppressive regimes).
SRI funds vary in the criteria that they employ with the result that, while some are fairly relaxed, others screen out a large percentage of the available investment options (for example, one UK SRI fund's criteria means that it can currently invest in only around 25-30% of the firms in the FTSE All-Share Index). As a result, the stricter funds tend to have a bias towards investing in smaller companies, which can make them more volatile than non-SRI funds.
Other SRI funds do not set their own criteria; instead, they follow the criteria set by an independent body. In some cases, managers of segregated funds allow the client to select which SRI criteria are to be used.
Associated with the introduction of SRI is the concept of "engagement". Some fund managers will put pressure on companies to improve their ethical performance so that they meet certain SRI criteria. It is in the interests of the fund manager to have as wide a universe of investible companies as possible to enable them to maximise fund performance. The companies can also benefit; inclusion in SRI funds may improve their share price as well as their reputation.
Case law (in particular the "Scargill Case") has established that trustees should be confident that the membership would support certain ethical criteria being applied - otherwise it would be wrong to restrict the available investment universe. This is because restrictions may impact on performance and the trustees have a duty to pursue the most beneficial investment strategy. In the Scargill Case it was considered inappropriate for the Mineworkers Pension Scheme to refuse to invest in electricity company shares simply because they were in business competition.
FTSE4Good Indices
In July 2001, the FTSE4Good index series was created to provide a market benchmark for socially responsible investment. These indices are similar to the various other FTSE indices but with the requirement that included companies must, in the opinion of the FTSE4Good Advisory Committee, satisfy the FTSE4Good ethical criteria. Every six months, this committee reviews their entry criteria and produces a list of those companies who have entered the index as well as those who have dropped out.
The FTSE4Good UK Equity Index is the socially responsible equivalent of the FTSE All-Share Index. As the FTSE4Good ethical criteria are not particularly strict, approximately 83% of the All-Share Index (weighted by market value) is in the FTSE4Good UK Equity Index. This percentage has increased by 7% since July 2001 - perhaps demonstrating the perceived advantage for companies to be seen as "socially responsible". The following graph compares the performance of these two indices over the past five years, rebased to a value of 100 in 1999 (the FTSE4Good index has been backdated to 1999 for this purpose). Over the period, the FTSE4Good index has under-performed the All-Share Index by about 5.5%.
Source: FTSE
In terms of global equity investment, the FTSE4Good Global Index is the FTSE4Good equivalent of the FTSE All-World Developed Index. Currently, around 57% of the All-World Developed Index (by market value) is included in the FTSE4Good Global Index. As is the case with the UK equity market, the FTSE4Good Index has underperformed its non-SRI equivalent over the last five years; in this case, by about 4.8%.
Source: FTSE
The degree to which the adoption of a SRI policy affects the performance of a pension scheme's assets will vary depending on how strict the chosen SRI criteria are. Stricter criteria will cause greater concentration of the portfolio which leads to higher volatility compared to the market as a whole. This volatility could mean out-performance or under-performance (with the effect over the last 5 years being under-performance as illustrated).
Considerations for the trustees
There are several potential advantages and disadvantages to adopting a SRI policy for a pension scheme. First, the advantages:
- Some SRI fund managers argue that they have a better insight than standard fund managers into the companies they invest in due to the extra research into ethical considerations that must be carried out. Evidence suggests that there may be some truth in this: some SRI funds have actually performed better in the last few years than the same manager's non-SRI counterpart.
- Adopting an ethical policy may enhance the image of the company and the pension scheme with the result that new employees are encouraged to join. For example, trustees of money purchase schemes may wish to offer a SRI fund as an investment option to its members as an alternative to other standard funds. This would allow members with ethical concerns to join without affecting the scheme's other members.
- Peace of mind that comes by taking the "ethical" option!
However, there are also disadvantages:
- There are considerably fewer SRI funds currently in the UK market than standard funds. This is also true of index-tracking funds. As a result, the choice of ethical criteria is limited and fewer managers means the risk of selecting a manager who then returns poor service or performance may be increased.
- The performance of the FTSE4Good indices does illustrate that a SRI policy may under-perform a non-SRI strategy. Therefore, members and sponsors of final salary pension schemes may be opposed to SRI if they are more concerned about overall returns than ethical considerations. Members of money purchase schemes may also have the same concern if a SRI fund is their only available option.
- The time and cost of selecting a SRI fund may be greater than if a standard fund is chosen because of the further research into ethical considerations that has to be undertaken.
Even if the disadvantages of a SRI policy out-weigh the advantages, some trustees may still decide that they want to know more about their own manager's "engagement" policy. This may mean asking the manager to report on "ethical" performance as well as investment performance, including the development of social responsibility within the companies in which they invest.
Conclusion
For trustees considering adopting a socially responsible investment approach, there are a number of factors to weigh up. The main question for trustees is whether the ethical benefits for their scheme of SRI outweigh the associated risks.
For specific advice on pension investment issues please speak to your usual Barnett Waddingham contact.
Barnett Waddingham, April 2004.