Socially Responsible Investing and Hedge Funds

Avoiding the sin stocks doesn't mean missing out on returns

ERIK EIDOLF, MANAGING DIRECTOR, HARCOURT INVESTMENT CONSULTING

SRI dates back several centuries as norm-oriented investors incorporated their values in their investment decisions. In the United States, the Christian Methodist Church started to invest in the stock market in the early 20th century when they consciously avoided ‘sin stocks’, such as gambling and alcohol, and companies benefiting from the slave trade. During the 1960s, SRI as we recognise it today started to develop in the aftermath of the social and environmental movements that took place at that time. Religious considerations became thus of lesser importance in the context of SRI investing, moving beyond ‘sin stocks’ towards ethical beliefs and social responsibility.

In recent years, environmental disasters and increasing awareness of global warming, combined with social concerns such as labour rights, equal opportunities and human rights in third world countries, have been recurring themes for SRI investors.

Another increasingly important driver for the strong growth in SRI, especially in Europe, has been legislative developments. In the early 2000’s, several countries imposed disclosure requirements on their public pension funds. In 2001, the European Commission published a working paper (“Promoting a European Framework for Corporate Social Responsibility”), mandating that EU member governments should put “the proper regulatory or legislative framework in place in order to define a level playing field on the basis of which socially responsible practices can be developed”. Since then, countries like Austria, Belgium, France, Germany, Norway, Italy, Spain, Sweden and even Australia have imposed policies and/or laws on SRI affecting public pension funds.

What is SRI

SRI is often used as a ‘catch-all’, umbrella term that encompasses a wide variety of strategies. These range from integrating extra-financial information into the analysis and investment decision-making process, investing only in those companies that score best in ethical and sustainable development, to employing screening tools that avoid companies or sectors that are deemed unsustainable. In the recent past, in the wake of corporate scandals such as Enron and WorldCom, there has also been an increased focus on corporate governance issues. The factors usually considered by SRI investors are social, ethical, environmental and corporate governance.

Implementing SRI

There are many ways and means to achieve SRI. Even though strategies and investors’ concerns differ both between continents and investor groups, SRI generally takes two forms: screening and engagement.

Screening is the oldest and most common strategy. Basically, it is a decision that is made before an investment takes place. There are two different kinds of screening: negative and positive.

  • Negative screening is sometimes referred to as ‘exclusion’. It consists of barring investments in certain companies, sectors or countries based on social and environmental criteria.
  • Positive screening is the process of actively investing in companies with a commitment to responsible and sustainable business practices irrespective of their underlying sector or industry. The most popular form of positive screening is the so called ‘best in class’ strategy, where leading companies with regards to social, environmental or ethical criteria in each sector/industry are identified and included in the portfolio.

Engagement is a post-investment tool. It is the collective term for a number of actions that can be taken to influence companies as an active owner. Traditionally, ownership engagement has been mostly used in corporate governance matters. Nowadays, more responsible investors are engaging in corporate dialogue to influence behaviour across social, environmental and ethical topics.

SRI demographics

In the wake of the increased awareness for sustainable investing, the global SRI-market has experienced substantial growth in the past decade. Since exact figures are not compiled on a global basis, one has to rely on the estimates of regional SRI industry associations.

In the United States, according to the Social Investment Forum, total SRI assets grew by more than 250%, to US$2.29 trillion, from 1995 to 2005. In Europe, we see a similar pattern, where the SRI-market (according to Eurosif, the European Sustainable and Responsible Investment Forum) is estimated to be managing approx. €1.14 trillion (and growing above the rate of the overall European equity markets). As a whole, SRI funds are estimated to account for as high as 10-15% of all European assets under management and nearly 10% for assets under management in the US. In short, money managed in an SRI context surpasses the money managed by the entire hedge fund industry.

In terms of the investor participation, the SRI market has primarily been driven by institutional investors who today account for an estimated 90-95% of all SRI investments globally.

Hedge funds have enjoyed rapid and well publicised growth in the past 10 years. Today, they are seen as being at the forefront of financial innovation and cater to an ever increasing range of institutional investors globally. Conversely, SRI is barely present within the hedge fund space. There are only a small number of hedge funds that manage assets based on predefined SRI policies. A comparatively small number of hedge funds focus on renewable energy and carbon trading strategies, also called ‘green’ hedge funds.

Hedge funds can’t say no to SRI

However, we believe that SRI will enter the hedge fund space very shortly, and in meaningful ways. The institutional investor base, from which hedge funds primarily derive their growth, is increasingly aware of SRI issues and asks for appropriate solutions. This increases demand from existing investors. Equally, significant amounts of capital are managed by institutions who insist on investing exclusively in SRI compliant products. This group has so far not invested in hedge funds because of the lack of compliant solutions. As demand continues to build, a new market for hedge funds will emerge.

Estimates are that the world’s population is set to grow from 6 billion to 9 billion by 2050. This dramatic redrawing of the demographic landscape will occur in conjunction with increased globalisation, accelerated industrialisation, and resource consumption at a rate far surpassing long term capacity. This exploration of resources (be it human, natural, or economic) will not only have far reaching consequences on our environment and society but also on the capital markets and the services provided by the financial management industry.

In 2007, together with two institutional SRI investors, the Swedish insurance group Folksam and the Norwegian insurance group Storebrand, Harcourt launched an institutional SRI compliant fund of hedge funds; Belair (LUX) Sustainable Alternatives Fund.

Both Folksam and Storebrand are actively engaged in globally developing and promoting corporate responsibility and serve as founding members of United Nation’s Principle of Responsible Investments (“UN PRI”) initiative. The UN PRI is a set of aspirational guidelines for investors that are designed to assist in the incorporation of environmental, social and corporate governance issues into mainstream investment processes and ownership practices. The 277 institutional members of UN PRI now represent in excess of US$11 trillion in assets.

In our commitment to SRI, Harcourt was in July proud to sign the UN PRI as the first hedge fund firm in the world. The cause is good and long overdue.