The international SRI option

SRI: Is action in international equities the answer?

In deciding how to take account of social, environmental and ethical issues, pension funds are considering variety of approaches. Many are looking at some form of engagement, but this does not offer any performance potential, cannot cover address certain issues, and can create conflicts of interest. Others have considered investing a small portion of the fund in a more active SRI fund, but this creates concern about diversification and risk.

What pension funds require is an approach which

avoids major drawbacks

is clearly legal

enables them explore the potential of SRI in a prudent way

allows them to show they are taking a positive approach to SRI.

The solution may be to allocate a portion of the international equities part of the portfolio to an active, socially responsible mandate.

Before going further, it should be emphasis that such a mandate should not be an old fashioned, negatively screened mandate. Instead it clearly should be performance orientated – i.e. a mandate that recognises the potential for social and environmental issues to have an impact on shareholder value, and where the fund manager bases its investment strategy on these links. Typically, the fund manager should have a robust theoretical framework, perhaps built around a model such as sustainable development. In many cases the mandate would operate on a best in class basis – i.e. seeking select from among the best companies in each sector, but to invest across the complete investment spectrum.

Increasingly, evidence suggests that such an approach is indeed possible. A very pertinent example is the long term performance of the Domini 400 index, a broadly based socially responsible index in the US intended to provide an alternative to the S&P500. The Domini 400 has outperformed the S&P substantial and consistently. Over 10 years, the Domini 400 has produced a $ total return of 20.83% p.a. compared with 18.79% for the S&P500. $1000 dollars invested in the Domini ten years ago would now be worth £1070 more than a similar investment in the S&P.

Apart from the performance implications there are considerable practical advantages to such an approach.

Engagement across the board is not a realistic option with many international equities. This is because of both the corporate governance framework and the investment arithmetic. There can be significant obstacles in many countries to exercising one’s vote and influencing management. Comprehensive reporting, regular ordinary votes such as the re-election of directors, the ability to use proxy votes and even adequate notice and information of AGMs may be absent. Practical issues of language and distance add to the complications, and not least, the sheer number of companies makes widespread engagement impossible. Furthermore, even large UK funds, which are likely to have fairly significant shareholdings in UK companies and thus significant influence with their management, are likely to have far smaller shareholdings in overseas companies and thus will have far less influence.

Diversification and risk against the benchmark are far less of an issue. In the UK, the potential to operate an active SRI strategy is limited by concerns about diversification. This is particularly an issue with the large companies that dominate the index in the UK. In an international context there is more than sufficient choice to be reasonably selective with the investment universe and still have a highly balanced portfolio. For instance, with some 2000 companies in the FT-A World Index ex UK, focusing investment on the top 30% of companies on social and environmental grounds would still leave an investment universe of over 600 stocks, more than enough to construct a diverse and balanced portfolio. Importantly, relative risk against the benchmark can be kept low. Research by the Storebrand Principle Funds shows that they can construct a "tracker" portfolio of some 100-150 companies, all of which are regarded as being as in the top 30% of their sector, and yet have a tracking error of under 50bp. Thus it is possible to invest only in good companies and have only modest risk.

Furthermore the importance of relative risk is far lower than with the UK portfolio. With the UK portfolio, the risk against the All-Share is important because the All-Share is used in calculating the Minimum Funding Requirements. In contrast, international equities are inevitably mismatched against the MFR. This makes risk relative to the international benchmark of secondary importance (e.g. for monitoring fund managers), and instead the absolute level of risk (against cash) is in fact rather more important (or to be precise the risk against the mismatched assets). On these measures, there is unlikely to be an increase in risk from pursuing an active SRI strategy in international equities.

A best in class policy can be operated more effectively internationally. With many sectors, representation in the UK is limited. Furthermore, in many industries (e.g. pharmaceuticals, oil etc) the major competitors are international. Thus constructing a balanced best in class portfolio can be most easily done in an international framework, where the full range of competitors can be analysed. This ability to make the broadest comparisons also increases the prospects of enhancing performance.

Finally, as international equities are usually under 20% of the overall portfolio of most UK pension funds, the impact on total risk and return within the pension fund will be moderated by the other portions of the portfolio.

Given these points it seems reasonable that a socially responsible mandate could cover a substantial proportion of the international equities portfolio (say one third to one half). This would make the mandate sizeable and administratively worthwhile (both for the investment manager and for the pension fund) yet it would only represent a reasonably modest proportion of the overall fund (5-10%). While the mandate should ideally cover all international equities, a mandate just for the American or European portions would be a possible alternative (the choice is still wide enough), if this suited the particular investment strategy.

There are a number of investment managers who would appear be able to operate such a fund and have a track record or otherwise interesting products. The Storebrand Principle Global fund has been operating for four years and has demonstrated low risk and improved returns over its benchmark. The Dow Jones Sustainability Indices, announced last year and operated in conjunction with Sustainable Asset Management of Switzerland, are an interesting alternative for those who prefer more passive approach. In the UK, the Henderson Investors Global Care team provides good international SRI coverage, and has generally a good track record. On the research side Innovest Strategic Value Advisors of the US has a well researched, performance orientated product which could be used by investment managers. Others are also developing products in this area and more competitors are likely to emerge in due course.

In conclusion an active SRI mandate in international equities avoids the drawbacks of most other SRI options. It is legally safe. It would enable pension funds to understand how SRI operates in practice, to learn how social and environmental issues can interact with shareholder value, and to show to members and to outsiders than they are taking the socially responsible investment seriously and positively. It is well worth discussing with your investment advisors.

This briefing note is prepared for background information purposes only – it is not intended as investment advice nor is an offer to buy or sell securities or investment services. Any investment decision should always take account of the individual circumstance of the investor. Always consult professional advisers.

June 2000

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