Socially Responsible Investing: From Fringe To Mainstream

Includes: BAC, GE, KLD, QCLN
by: Contributor Markets Financial

In the past, the concept of "socially responsible investing" often elicited visions of the left-leaning portfolio manager sitting at his desk wearing Birkenstocks and a tie-dyed T-shirt. In reality, this couldn't be further from the truth. Over the last decade or so, socially responsible investing (SRI) has evolved from its humble beginnings as a fringe form of investing to one of the fastest-growing areas of the investable spectrum.

According to the Social Investment Forum, SRI-more commonly referred to by the investing community as the environmental, social, and corporate governance (ESG) space-surged from $639 billion in 1995 to $3.07 trillion at the start of 2010. During the same period, the number of investable vehicles incorporating ESG factors increased from 55 to nearly 500. One reason for this growth may stem from the fact that investors are paying more attention to such terms as corporate governance, social responsibility, sustainability, and environmental impact, and these factors are having an increasingly greater influence on where they decide to invest their money. As a result, the ESG space, which has long been considered an underperformer, is showing strong growth potential - and turning business and industry leaders' heads.

The Performance Hurdle: It's More Than Just "Green"

One primary area of contention within the ESG space has been performance. The prevailing assumption in the investing community-and a topic that many studies have addressed - is that ESG managers typically lag the overall market. A joint study by Harvard University and London Business School has found the opposite to be true. Researchers found that, over an 18-year period ending December 2010, $1.00 invested in a value-weighted portfolio consisting of high sustainability organizations that had adopted a number of environmental and social policies grew to $22.60, whereas a similar low sustainability portfolio grew to only $15.40.

Another reason for this perceived underperformance may have to do with investors' earlier tendency to focus only on the environmental aspect of ESG, which is often equated with "green" investing. Arguably, the corporate governance and social portions, which more investors now seem to be considering, have a greater effect on long-term performance.

Many analysts, including CFA charterholders, are trained to focus on corporate governance in their security evaluations, and they often attribute long-term stock price appreciation to strong corporate governance practices, such as independent board membership, the use of independent audit committees, and maintenance of a culture focused on the basic principles of integrity, trust, and honesty. According to GMI, a global leader in corporate governance ratings and research, companies with the highest corporate governance ratings outperformed the Russell 1000 Index by an annualized 275 basis points from 2002 to 2010.

In addition to good corporate governance, evaluating a company based on whether it has strong social practices and no history of discrimination can lead investors to promising investment options. According to a study on employee satisfaction and long-run performance by Alex Edmans, a professor at the Wharton School, a "value-weighted portfolio of the '100 Best Companies to Work for in America' earned an annual four-factor alpha of 3.5 [percent] from 1984 to 2009, and 2.1 [percent] above industry benchmarks."

Performance in practice. For a practical validation of performance, you can scroll through the Morningstar® SRI screen and find a number of four- and five-star funds that have outperformed their broader peer groups on a consistent basis.

Although past performance doesn't guarantee future results, it does back up recent studies suggesting that ESG can outperform. And, given these findings, I don't believe it is a stretch to assume that the fundamental concepts of ESG could lead to positive price appreciation over time, especially when you factor in the mounting interest in the space and the increasing number of assets seeking ESG-like investments.

Moving To The Mainstream

I would argue that it is highly likely that underperformance in the ESG space has had more to do with a lack of resources and manager experience than the actual ESG overlay. Traditional money managers typically have a large number of analysts at their disposal. This has allowed them to cast a larger net - by attending trade shows, meeting with company management, and the like - to gather more information. Now that more assets are flowing into the ESG space, taking it from the fringe to the mainstream, this resource imbalance appears to be changing.

As mentioned above, ESG assets grew from $639 billion to $3.07 trillion between 1995 and 2010, outpacing the growth of overall market assets by 120 percent. A more recent example of this growth disparity between ESG and traditional assets can be seen by looking at AUM growth of PIMCO Total Return III and PIMCO Total Return, both of which are run by one of the most noteworthy traditional bond managers in recent times. The ESG fund's AUM grew 7 percent in 2011, while assets in the traditional fund grew by just 1 percent - an indication that investors are placing greater emphasis on what a fund invests in.

More conventional ETF providers, including iShares and First Trust, are beginning to offer socially responsible options as well - e.g., iShares MSCI USA ESG Select Index (NYSEARCA:KLD), First Trust NASDAQ Cln Edge Green En Idx (NASDAQ:QCLN). If this trend continues and investor awareness expands even more, I think it is safe to assume that more resources and better talent will undoubtedly follow the asset flows, and any performance disparity that may have existed historically will narrow further in the years to come.

Businesses' Interest In ESG

Certain businesses and industries have been taking note of the increasing interest in ESG factors over the last few years as well, and it seems to further validate the long-term growth trend we're seeing in this space. Lobbying dollars to Washington have increased by more than 100 percent in the last decade in an attempt to influence legislators regarding oil industry policy. Of course, a lot of money has been spent trying to overturn certain EPA standards that are viewed as negatives for the oil and gas industry. At the same time, this activity signifies how much environmental factors have been influencing policy decisions.

Further, many companies have been dedicating advertising dollars to clean up their corporate images. One of the strongest efforts has come from oil companies, such as Shell, which have spent large sums of money trying to "green" their corporate image by touting green technology aimed at reducing CO2 emissions and improving efficiency. In addition, major corporations, including Bank of America (NYSE:BAC) and General Electric (NYSE:GE), have fought hard to improve perceptions of their workplace culture, social practices, and executive compensation, factors that were of much less concern to investors in the 1980s and 1990s.

Finally, in a sign that the global investing community has also embraced ESG investing, many public employee pension plans and some private company and union pension plans have added ESG language to their investment policy statements. According to the CFA Institute, the United Kingdom introduced legislation concerning ESG criteria, which has contributed significantly to the growth of socially responsible investing in pension plans throughout the region. If similar measures are implemented domestically, one could assume that a similar growth would result.

ESG Is Here To Stay

In a world where individual investor insight into the asset management process is becoming more commonplace, the practice of evaluating companies based on strong corporate governance standards, first-rate social practices, and clean environmental track records is becoming more mainstream. And as more and more investors become aware of such issues, we can only expect the ESG space to continue to grow - and potentially provide investors with attractive investment returns.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.