socially responsible investing on a global basis
TRANSCRIPT
SOCIALLY RESPONSIBLE INVESTING ON A GLOBAL BASIS: MIXING MONEY AND MORALITY OUTSIDE THE U,. S. FRANK J. TRAVERS is director of investment manager research at Oppenheimer G. Co., Inc., in New York City, where he is responsible for the monitoring and evaluation of investment managers across all asset classes. H e has held equity research and analysis positions at Evaluation Associates, Morgan Stanley, and R C B International. H e earned a B.S. at St. John’s University and an M . B . A . at Fordham University.
M any investors who have gone to the trouble to allocate assets in interna- tional socially responsible investments . (ISRI) are probably more than wiUlng
to give up some return to invest according to their beliefs. In reality, they don’t have to. While ISRI today represents a s m a l l piece of the non-U.S. equity investment pie, it is a growing, vibrant, and effective means of achieving the advantages of unrestricted non-U.S. investment. These benefits include: dwersi- fication, an expanded opportunity set, globalization of the marketplace, and the abhty to take advantage of less efficient markets.
The main objection to SRI is that the restric- tions placed on portfolios are perceived to have a negative impact on returns. After all, the main goal of investing is to maximize return within a defined set of risk parameters. Many naysayers point out that in the U.S. most ethical portfolios have not kept pace with the S&P 500 index. I don’t believe t h s is a fair comparison - most unrestricted domestic equity portfolios have also underperformed the S&P 500.
Exhibit 1 represents the Evaluation Associates, Inc., large-capitalization equity universe, which consists of over 250 unrestricted products, displayed over several time periods. The S&P 500 has placed in the first quartde in the year-to-date, one-year, and three-year distributions. Over the longer time periods, the index has performed above or close to the median.
In other words, the S&P 500 has performed quite well over the last ten years and has beaten most: domestic equity managers, both restricted and unrestricted.
But what about international equity and SRI? Once again, the belief is that ISRI portfblios have underperformed and wiU continue to underperform the benchmark. As a result, this asset class has received virtually no attention. Most investsors would be surprised to discover, however, that a number of prominent investment management firms offer prod- ucts that focus on SRI outside the U.S.
EXHIBIT 1
As OF JUNE 30, 1997 U.S. LARGE-CAP EQUITY UNIVERSE
40
35 .-
I 101 u 5 1 1 YTD 1 Year JYearr 5Yearr 7 Y e m 10Yean
I *S&P 5W Index I
WINTER 1997 50 SOCIALLY RESPONSIBIZ INVESTING ON A GLOBAL BASIS: MIXING MONEY AND MORALITY OUTSIDE THE U.S.
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Since the definition of what constitutes SRI is different for everyone, I will spend some time discussing some of the underlying restrictions in broad terms.
DEFINING SRI
SRI has become a catchall phrase that captures just about any restriction that may be construed as ethical or socially responsive. There are actually three ways that an investor can go about investing in a socially responsible manner: 1) through investment only in companies that pass restrictive screens, 2) through shareholder activism designed to change the way in which a company does business, and 3) through direct investment in the community. Exhibit 2 displays the three levels of ethical investing and measures the degree of difficulty associated with each.
The focus of this article is on the bottom part of the triangle: screened equity investments, such as mutual funds, institutional commingled accounts, and institutional separate accounts. This is the easiest form of SRI, because it requires only that you write a check to an investment manager who you feel will do the best job. Shareholder activists play a much more direct role in trying to impact the way compa- nies do business. Investment in the community, such as housing for the poor, requires an even greater investment of time and effort.
The main problem with defining SRI is that the parameters or restrictions that apply are indwid- ual measures. There is no common threshold that applies evenly across all asset classes. Certain organi- zations allow companies that manufacture weapons in their portfolios; others do not. Religious organi- zations have certain restrictions, while endowments and foundations have a series of others.
For example, under strict Islamic guidelines, money managers are restricted fiom buying the stock
EXHIBIT 2 MEANS OF SOCIALLY RESPONSIBLE INVESTMENT
Investment
Shareholder Activism
Screened Equity Investments
of companies that receive more than 15% of their revenue fiom interest; as a result, banks and hance companies are basically excluded &om this investable universe. Many Christian organizations restrict the purchase of companies that engage in one or more of the following lines of business: tobacco, alcohol, weapons, and contraceptive devices. Taft-Hartley accounts often have special restrictions on labor and employee relations.
The restrictions most often considered by SRI investors may be broken into two categories: 1) negative, which involves the search for companies that violate one or more of the restrictions, and 2) positive, which involves the search for companies that contribute in some way to society. The negative restrictions are designed to eliminate companies fiom the investable universe, whde positive restrictions are designed to add companies to the universe.
Negative Restrictions
Alcohol, tobacco, and gambling, traditionally labeled “sin” stocks, represent the most common types of restrictions. It is important to note that the restriction is not only on the manufacturers of these products, but also on hstributors, wholesalers, and retailers. Restrictions relating to reproductive rights also consider such practices as the manufacturing or distribution of birth control devices and drugs and products used in abortions.
Restrictions concerned with weapons and military contracts are also quite common. Once again, it is important to understand that producers of component parts must be considered. The same applies to nuclear power plants and the companies that provide parts or services vital to their operation.
Environmental restrictions can be very cW- cult to research because they refer to dozens of possi- ble abuses such as surface mining, waste disposal, deforestation, and manufacture and use of pesticides. The CERES principles promulgated by the Coah- tion for Environmentally Responsible Economies provide one means of assessing a company’s behavior with respect to a number of environmental issues. These restrictions can extend to companies that produce paper products or lumber. Manufacturing companies that operate plants that emit toxins into the air or water can also be included.
These types of violations are not only ditticult and time-consuming to research overseas, but what may be considered dlegal or immoral in the United States may also be perfectly acceptable conduct in other countries. This is where culture and politics
W i m R 1997 THE JOURNAL OF INVESTING 51
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come into play. Another difficult restriction concerns unfair
labor practices, such as child labor and sweatshops, and equal rights and representation for women and minorities within an organization. As in the case of many other restrictions, what is regarded as “unfair” to one person may be fine with another. These restrictions usually have the greatest impact on companies that manufacture mass goods, such as textdes companies.
Another restriction focuses on employment discrimination on the basis of religion. The MacBride Principles spell out a series of concerns related to tensions in Northern Ireland between Protestants and Catholics, but can easily be applied to any other situation around the world (see Kinder, Lydenberg, and Domini [1993, p. 2431).
Positive Restrictions
The guidelines for a socially restricted portfo- lio can also include companies that go out of their way to help the community. Although this is not the norm, some of these conditions may include good labor relations, a favorable environmental record, a record of contributing to charity or to the local community, or an outstanding effort to eliminate discrimination in the workplace.
the firm’s total revenues from the product or service that is in violation is below some preset percentage. Percentage of total firm sales can be used as another hurdle level.
Investment in companies that currently violate one or more of the underlylng client restric- tions but show signs of improvement is the most difficult (and subjective) of the three. What consti- tutes improvement? Taking the paper company as an example, let’s suppose that 25% of the firm’s revenues now come from paper sales to tobacco companies. If the amount represented 50% a few years ago, should we consider this an improvement?
The answer requires additional research. If the firm’s management has made a concerted effort to reduce sales to tobacco companies, then the answer might be yes. If the reduction is just the result of losing clients to the competition, this “improve- ment” is purely incidental and actually unintentional.
Both the investor and the investment manag- er need to have a clear understandmg of tlhese issues before any transactions are made. This will ensure that the clients get what they are paying fcir and that managers meet their fiduciary responsibhties.
OBJECTIONS TO INTERNATIONAL SRI
Poor Performance SHADES OF GREY
Few of these restrictions are as straightforward as they may seem. How do you classify a paper company that supplies cigarette paper to tobacco companies? What about an aluminum company that sells cans to a beer company? Another difficult type of company to classitjr is one that provides “inciden- tal” products or services. A good example of this is a computer chip maker that sells its product to a wholesaler, who then sells the chips to a company that produces guidance missiles. The chip maker is not selling the product directly to the weapons maker, but without the chips the missiles wouldn’t work.
There are three ways to handle these types of situations: 1) zero tolerance; 2) well-defined levels of tolerance; or 3) investment in companies that are in violation but are striving to improve. The first option is straightforward, but the second and third allow for some flexibdity.
Setting defined levels of tolerance allows the investment manager to invest in companies that violate any of the restrictions if the contribution to
The most prominent argument against ISRI is that the restrictions imposed on portfolios hurt relative performance. Exhibit 3 graphs the cumula- tive performance for the Morgan Stanley Capital
EXHIBIT 3 HISTORICAL CUMULATIVE PERFORMANCE FIVE YEARS TO JUNE 30, 1997
1201 Int’l Podolio
7 : : : : : ; ; ; I : 8 9 10 11 12 13 14 15 16 TTKTTZI 21
52 SOCIALLY RESPONSIBLE INVESTING ON A GLOBAL BASIS: MIXING MONI :Y AND MORALITY OUTSIDE THE U.S. WINTER 1997
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EXHIBIT 4 CORRELATIONS
AVERAGE AVERAGE NON-SRI SRI
EAFE MANAGER MANAGER
EAFE 1 .oo Average Non-SRI
Manager 0.72 1 .oo Average SRI
Manager 0.71 wl l.oo
International Europe, Australasia, and the Far East (EAFE) Index, the average unrestricted international equity manager in our data base, and the average international equity SRI manager in our data base. The graph clearly makes three points:
1.
2.
3.
Actively managed portfolios, both restricted and unrestricted, have consistently beaten the EAFE Index over the period. The total return for the restricted and unre- stricted managers for the period is very s idar . (On an annualized basis, the average SRI manager gained 15.6%, and the average unre- stricted manager 14.4%.) The trachng error between the average restrict- ed and unrestricted managers is very low. The two lines move in lockstep with each other throughout the entire period. Exhibit 4 strengthens this argument.
As the non-SRI manager number boxed in Exhibit 4 indicates, the correlation between the average restricted portfolio and the average unre- stricted portfolio is very high. Also note that both the restricted and unrestricted portfolios are virtually identically correlated with the EAFE Index.
Despite the fact that the average ISRI manag- er outperformed the average unrestricted manager by 120 basis points on an annualized basis for the peri- od, it should not be assumed that ethical investing provides hgher returns. For more on t h s issue, look at Exhibit 5. Ths bar chart allows a comparison of the restricted and unrestricted international equity products managed by the same portfolio manager (the third and fourth bars).
Using only the managers who have an ISRI product, I calculate the average return for their unre- stricted portfolios for comparison against their
restricted ones. On an annualized basis, the ISRI portfolios outperform their unrestricted counterparts by 50 basis points per year (15.6% versus 15.1%). Given the short period (five years) and the smaller- than-average size of the ISRI universe, these numbers are not unhkely.
Higher Fees and Fewer Product Options
Fees are often an issue in ISRI. Although some managers do, in fact, charge higher fees for this service, it should be noted that under 10% of the managers in our data base of SRI managers do so.
Another objection raised is the view that the ISRI universe is prohibitively small. There is no doubt that there are fewer SRI products available than unrestricted products, but we currently track over forty different firms that manage ISRI money and another thirty that are considering offering an SRI option.
Short History
Another potential problem with international SRI centers around the problem of analyzing a port- folio with a very short history. Our universe of international SRI managers indicates that the average product has just over twelve quarters of history. This is definitely short, but most of these managers also offer unrestricted portfolios with longer histories. If the restricted and unrestricted portfolios are both managed in the same manner, the unrestricted port-
EXHIBIT 5
FIVE YEARS ENDED JUNE 30, 1997 HISTORICAL A”UAL1ZED PERFORMANCE
18 15.6 15.1
Manager Manager’s
Ponfolio
Unresmcted Manager Unrestricted
WINTER 1997 THE JOURNAL OF INVESTING 53
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folios can be used as a proxy to evaluate the overall process, philosophy, and style. The shorter histories do, however, impact the overall statistical significance of the long-term performance numbers.
Due Diligence on Foreign Stocks is More DifEcult
In the U.S., all publicly traded companies are required to file quarterly and annual reports on a timely basis. This is not the case overseas. While most developed countries have some form of report- ing requirements, they are generally not as compre- hensive as they are here. Emerging markets pose an even greater problem - reporting requirements are poor in some countries and non-existent in several others. In addition, accounting dfferences in coun- tries make relative comparisons more difficult.
These issues can be broken into two basic questions: 1) can investment managers effectively evaluate non-U.S. stocks? and 2) can they gather enough dormation to determine which companies violate the restrictions imposed on the portfolios?
For the first question, look at Exhibit 6, which graphs how the respective indexes have performed against a variety of international equity universes. The boxes within each bar represent the quartde distribution for each respective universe; the top box is the best and the bottom the worst. The numbers displayed in the bars indicate the underly- ing benchmark return for each time period.
In the unrestricted international equity universe, it is clear that most active managers beat the EAFE index, as EAFE places in the fourth quar- tile over the one-, three-, seven-, and ten-year annu- alized periods. At its best (which is the five-year period), EAFE is able to place only in the third quartile. Although the effect i s slightly less pronounced, the same is true in each of the other asset classes as well. The bottom line is that active management works in the international markets due primarily to two factors: 1) the EAFE Index is poor- ly constructed, and 2) many overseas markets are inefficient (or at least less efficient than the U.S. market).
The answer to the second question depends on the capabilities of the individual investment manager. Some managers conduct painstaking research; others do not. All the evidence you should need is in Exhibit 3, which shows that the perfor- mance of the average ISRI manager is almost identi- cal to that of the unrestricted manager.
Process Bias: Top-Down or Bottom-Up?
Unquestionably, ISRI portfolios are research- intensive. For the proper level of due diligence, it is necessary to find out anything and everything about a company that might relate to any of the particular restrictions. This leads to a distinctively bottom-up bias in our international SRI universe. Most of the managers are either completely bottom-up or more
EXHLBIT 6 INDEX RANKING IN SELECTED E N UNIVERSES - -ODs ENDINGJUNE 30,1997
UNIVERSE
1ST QUART-
2ND QUART-
3RD QUARTKLE
4TH QUART-
BENCHMARK
NoN-U.S. EMG MKTS
MSCI MSCI EAFE EMF
INTL ASIA SMALL-CAP JAPANESE EUROPEAN EX.-JAPAN L 1, 3, 5
SALOMON MSCI EM1 JAPAN
3 3, 5, 7
MSCI hJ1SCI EUROPE PAC EX-JAPAN
Note: The numbers represent the annualized return for each respective period (ex:3 = three-year annualized return).
54 SOCIALLY RESPONSIBIE INVESTING O N A GLOBAL BASIS: MIXING MONEY AND MORALITY OUTSIDE THE U.S. WINTER 1997
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heavily weighted toward bottom-up than top-down. It should be noted that a number of top-
down managers offer international SRI products that screen according to the most basic restrictions (alco- hol, tobacco, weapons). These screens, however, are usually run in terms of the industry codes and classi- fications in their data bases. Because these data bases are normally updated using public information put out by the company, these types of screens tend to be more effective in the U.S. than outside the U.S. Remember, the level of disclosure by foreign companies ranges flom very good in places like the U.K. to almost non-existent in some of the emerg- ing markets.
No Benchmark
There is currently no international SRI benchmark available for comparative purposes, so most investors compare returns to the MSCI EAFE Index. As there are so many different definitions of what constitutes SRI, constructing a benchmark that satisfies everyone is virtually impossible.
One solution to the benchmark problem for domestic SRI is a product developed by Kinder, Lydenberg, Domini & Co. KLD created the Domini 400 Social Index in 1990. The makers started with the S&P 500 and applied a series of exclusionary screens (designed to eliminate weapons, alcohol, tobacco, gambling, and nuclear power) and quahta- tive social screens (which evaluate companies on diversity, employee relations, and the environment). These screens reduced the number of companies to approximately 250 names. To that list are added about 100 companies that are not part of the S&P
500, but that maintain the S&P’s large-cap focus and industry representation. The h a l 50 companies are some with exceptional social characteristics.
The MSCI EAFE Index is the most popular international equity benchmark, but it is by no means a perfect one. Some of the concerns about the index are: 1) its large-cap focus; 2) its hgh exposure to Japan (33% currently allocated to Japan, while the average international equity manager holds about 20%); and 3) lack of exposure to any of the emerging markets (the average active international equity manager holds 8% of his or her assets in emerging markets).
INTERNATIONAL SRI UNIVERSE
So how can we evaluate the performance of an ISRI manager or product? One of the best ways is to measure performance against the peer universe. Since the EAFE benchmark does not accurately represent what most managers hold in their portfo- lios, it seems more than reasonable to compare performance to other active portfolios with similar mandates.
There are so many restrictions normally considered to be part of SRI, though, that develop- ing a universe is almost as tricky as creating a bench- mark. At first blush, it might appear that the best way to go about developing a universe would be to create a separate universe for each restriction sepa- rately (that is, one that is tobacco-free, one that is alcohol-flee, and so on) and to combine them in a manner that matches each client’s specific set of restrictions. Many of the problems we have Ascussed, such as fewer products and shorter perfor-
EXHIBIT 7 QUARTILE DISTRIBUTION - RESTRICTED VERSUS UNRESTRICTED UNIVERSES - A S OFJUNE 30, 1997
35 7 ! 25 30i
0-
1 Year I 3 Years 5 Years
i Restncted Umverse I/ Unresmcted Umverse I WINTER 1997 THE JOURNAL OF INVESTING 55
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EXHIBIT 8 PRODUCTS IN ISM UNIVERSE BY TIME PERIOD
NUMBER OF QUALIFYING TIME PERIOD SRI PRODUCTS
YTD 1 Year 3 Years 5 Years
23 21 12 7
mance history, &e it impossible to do this in any meaningful manner. Furthermore, if you consider the “shades of grey” problem, it becomes impossible to construct a universe of products with precisely the same restrictions and degree of tolerance.
Given these difficulties, the international SRI universe was created using these (less than perfect) criteria:
1.
2.
Only non-U.S. portfolios are used (no global, regional, or emerging markets products). Each product must minimally screen out the “sin” stocks (tobacco, alcohol, and gambling). Products with additional screens are also included. Representative accounts are used in most instances, since very few companies construct composites for their SRI portfolios.
3.
While there are over forty ISRI products in our data base, only twenty-three made it to the final universe using these criteria.
Exhibit 7 displays the performance results of
the SRI universe over several time periods and compares it to the unrestricted international equity managers’ universe; the shaded boxes represent the SRI universe. Interestingly, the quartile distributions are very similar. The year-to-date and one--year peri- ods track each other closely, and the three- and five- year periods look a bit less like one another.
Ths effect occurs because of the number of products available for inclusion over each ;time peri- od. The number of products included in the ISRI universe broken out by time period is shown in Exhibit 8.
The shorter time periods have distributions that are very similar, because there are more products in the universe in the YTD and one-year periods. We can therefore draw more statistically :significant results for the shorter time periods. Moreover, the level of crossover between managers’ restricted and unrestricted portfolios has historically been very high. A comparison of each manager’s restricted and unrestricted portfolios indicates that they are almost the same. O n average, the restricted portfolios include 89% of the holdings in the unrestricted port- folios, so the fact that they move together shouldn’t surprise anyone.
The ISRI universe supports the main message: ISRI portfolios offer competitive returns. These returns have exceeded those of the EAFE Index over time, while keeping pace with the universe of unrestricted international equity portfo- lios as well.
REFERENCE
Kinder, P., S. Lydenberg, and A. Domini. Investingfor Good. New York HarperCollins Publishers, 1993.
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