Study Reveals Why Socially Responsible Investment Lags in Mainstream Finance

Study Reveals Why Socially Responsible Investment Lags in Mainstream Finance

A company that profits while doing harm to the community is likely to suffer in the long run. Yet the mainstream financial community has so far placed little emphasis on social, environmental, and ethical issues in its investment decisions. This can be changed, as the new report released by the World Economic Forum’s Global Corporate Citizenship Initiative(GCCI) and the London-based think tank, AccountAbility, reveals. The report entitled “Mainstreaming Responsible Investment” identifies the key impediments to broader consideration of non-financial factors by the mainstream investment community, and explores changes in policies and practices that could “tip” systemic change in the investment community in this direction.

Mainstreaming Responsible Investment is the outcome of a series of three expert roundtables during 2003 and 2004. As Simon Zadek, chief executive of AccountAbility, observed: “The Report is based on two years of deep discussions on the topic involving practitioners themselves. Its findings and recommendations draw directly from the perspectives of pension fund trustees and executives, portfolio managers of mainstream asset management firms, as well as buy-side and sell-side analysts.”

“We found that the issue is decidedly not the personal values of these market participants but rather the framework of industry customs, structure and regulation in which they operate. It is the combination of available information, participant competencies and, most of all, institutionalized incentives that drive behavior, ” said Richard Samans, managing director of the World Economic Forum’s Global Institute for Partnership and Governance.

Highlighting the systemic nature of the problem, fund managers point to the role of their clients in driving their focus on short-term performance. As one fund manager argued, “As long as client [e.g., pension fund trustee] mandates require us to deliver performance benchmarked against short-term market tracker indexes, we will of course remain short term in our outlook.” Analysts, similarly, argued that they could rarely advance social and environmental performance issues as long as their clients, fund managers, are only concerned with drivers of short-term performance and market valuations. One analyst summarized his experience thus: “Strategic research on future social and environmental risks and opportunities got me my five minutes of fame. But there were no buyers for the work, and this is what counts at the end of the day. Given the choice again, if I want to stay in business, I would not do such research.”

Mainstreaming Responsible Investment includes a series of recommendations for the reform of industry practices and public policy. These draw upon chapters contributed by three distinguished expert practitioners from different segments of the investment value chain: Mehdi Mahmud, executive vice-president of Jennison Associates (asset management); Francis Condon, until recently head of European Steel Research, ABN AMRO Equities (investment analysis); and Stephen Davis, president of Davis Global Advisors (pension fund trustee advisers), respectively.

The report paints a picture of rising pressure for change in the financial community, driven largely by the changing composition of corporate share ownership due to population aging and the related growth in private retirement savings. Investors in pension funds, mutual funds and insurance policies now collectively own the majority of shares in key markets. Their investment horizons are inherently long term, as their savings are intended mainly to support retirement, the education of their children or other long-term family needs. Yet the pension funds, mutual funds and insurance companies investing money on their behalf typically do so in a very short-term manner, with results and asset management contracts evaluated almost exclusively on the basis of short-term indicators that do not incorporate social, ethical and environmental aspects of corporate performance that generally become material to financial performance only over time.

“A particular problem,” said Samans, “is that most pension funds fail to meet the bedrock governance standards they increasingly demand of companies, and trustees are often poorly equipped for their duties.”

“The real owners of capital in today’s markets are you and me, the intended beneficiaries of the pension funds, mutual funds and insurance companies. The responsibility of institutional investors must be to meet our intrinsic interests, which go far beyond near-term returns since we have long-term needs and depend on the long-term vitality and health of our societies’ economies, communities and the natural environment. Our interests must be that trustees and fund managers acting on our behalf take into account material social and environmental aspects of corporate performance,” said Zadek.

To this end, the report outlines an agenda of reforms to realign incentives within the institutional investment community and strengthen its ability to produce and understand non-financial information that may be relevant to financial performance. Among the recommendations are:
  • Create an international set of good governance principles for pension funds akin to a corporate governance code

  • Increase the duration of asset manager mandates

  • Increase the disclosure of asset manager compensation structures

  • Develop new business models for research on non-financial issues by analysts

  • Re-evaluate the relationship and relative organizational standing of portfolio managers and buy-side analysts

  • Pay, train and empower pension fund trustees more like corporate directors

  • Create a specific professional competency for non-financial analysis

  • Increase the emphasis on non-financial aspects of corporate performance in graduate business schools

  • Widen the dialogue between analysts and corporate investor relations officers on non-financial information
Mainstreaming Responsible Investment is based on discussions held in three roundtables. The first roundtable, hosted by Deutsche Bank, broadly explored investment community perceptions of the relevance and treatment of social and environmental aspects of corporate performance. The second roundtable, hosted by Swiss Re, explored key relationships in the “investment value-chain,” notably between institutions representing the intended beneficiaries and ultimate owners of capital, and those mandated to invest funds on their behalf. A particular focus was on embedded incentives that determine to a great degree the outcome of these relationships. The third roundtable, hosted by the U.K. Department of Trade and Industry, brought together analysts, fund managers and corporate investor relations officers to explore how analysts’ information, competencies and incentives impact on valuations and decision-making, specifically how analysts, ratings organizations and investor relations officers make decisions as to whether to incorporate specific non-financial aspects of performance.

The report can be downloaded in PDF format online.