sou · GWB3107 · 2008-11-28 00:00:00 — We are interested to note that the role as shareholder is much more common in the U.S. SRI industry than in or the Asia-Pacific region. Finally, Renneboog, Ter , and (2008a) report that of the SRI funds base their SRI screening activities on in-house research. Furthermore, Renneboog, Ter , and (2008a) examine whether the screening structure affects the risk-adjusted performance of the SRI funds, an issue that has not previously been explored. They find that on average, SRI funds underperform a sample of matched conventional funds by about 60 basis points per month. However, screening activities have a significant impact on the risk-adjusted performance. Funds that focus on community involvement can expect an additional return of 30 basis points per month, while an in-house research team can increase risk-adjusted performance by ten basis points per month. Apparently, the screening process can generate value-relevant information. Screen- ing intensity, as measured by the number of screens applied, increases the underperformance. Finally, following an activism policy does not significantly affect performance. and Gjolberg (2008) study the potential ethical impli- cations of screening of the Norwegian Government Pension Fund- Global (GPFG). The study shows some interesting conclusions that do not necessarily hold for the usually much smaller SRI funds. In the recent public debate, it has been proposed that the GPFG should restructure its investment strategy from negative screening towards positive screening. However, as stated by the authors, for a large pension fund such as GPFG, this restructuring can significantly narrow the investment opportunity set of the fund. In the extreme case, positive selection can imply that the fund only holds clean companies in the portfolio. But that implies that you cannot directly use your engagement power to change ESG standards in the right direction in companies that failed to be included in the portfolio. Furthermore, according to GPFGs mandate, the fund is not allowed to hold an ownership stake that exceeds . This constraint implies that the funds investment universe is already restricted to larger companies. Positive selection strategies in combination with the size of pension funds and the often existing maximum ownership stake, will reduce diversification possibilities. This reduction will lead to higher risk exposure of the fund itself, and may have undesirable ESG implications for society in general due to less influence of the fund in companies. Major institutional investors increasingly recognize that social, environmental, and ethical issues may have an impact on According to Sparkes and Cowton (2004), the maturation of the SRI concept has important implications for the relation with corporate social responsibility. SRI has shifted from to mainstream, and these days, due to shareholder pressure by institutional investors, companies are more or less obliged to address CSR issues. The direct engagement strategy and shareholder advocacy can both involve writing letters to the management, filing shareholder resolutions, engaging upper-level executives in a direct dialogue, or initiating lawsuits. According to SIF (2005), the number of shareholders' resolutions in the U.S. on ESG issues increased by , from 299 proposals in 2003 to 348 in 2005. It is interesting to note that companies seem to respond in a cooperative way rather than fighting shareholder resolutions. Shareholders increasingly withdraw their proposals after the management agrees to address the shareholders' concerns. In Europe, the Broad SRI market, i.e., plus engage- ment and integration, has grown by about to more than 1 trillion assets under management as of (Eurosif, 2006). The engagement strategy, dominated by the UK, has gained a lot of momentum, and has grown by . Eurosif observes an increase in shareholder involvement at general meetings, in particular at those involving corporate governance issues. But the question is whether institutional activism creates value for shareholders. Barber (2006) evaluates the activism of the largest pension fund in the world, CalPERS (). Barber (2006) distinguishes two types of activism: shareholder activism and social activism. Shareholder activism relates to the conflict of interest between corporate mana- gers and shareholders. Increased monitoring by institutions may reduce the agency costs involved and raise the value of stocks for all investors. Social activism covers the conflict of interest between portfolio managers and investors. Managers may abuse their voting power to benefit their own objectives, rather than those of their investors. Although social activism may lead to important social benefits, such as reduction of pollution, it may damage potential returns to shareholders. However, investors in SRI mutual funds may care more about ESG issues in their investment decisions and pay less attention to fund performance. CalPERS is considered a leader in institutional activism, taking on issues such as greenhouse gas emissions, labor negotiations, and investments in tobacco firms. Barber (2006) reports that during the period 1992–2005, CalPERS activism led to a small positive market reaction of about 23 basis points the moment that CalPERS pub- licly announced its focus-list firms. This result indicates that activism creates shareholder value at the short run. the long term, the performance of the focus-list firms is even more impressive. The average focus-list firm appears to outperform the market by almost annually. A portfolio strategy of investing in the focus-list firms as soon as the firm is placed on the list leads to an economically but statistically nonsignificant abnormal perfor- mance of about annually over a holding period of five years. In the late 1990s, CalPERS became the leader in the divestment of tobacco industry stocks. Barber (2006) reports according to press accounts of this decision, the CalPERS board did not consider political nor moral values of CalPERS investors when arriving at their decision. We note that and Kacperczyk (2008) report that sin stocks, such as tobacco stocks, outperform comparable stocks by about at an annual basis. This result indicates that CalPERS' decision to divest stocks from this industry did not benefit CalPERS investors. However, although social activism probably does not maximize shareholder value, it can nevertheless be in accordance with the preferences of the investors. A Dutch report on sustainable investing for pension funds shows that pension funds increasingly pay attention to environ- mental, social or corporate governance issues in their investment decisions during the period 2003 2007 (De gearriveerde toekomst; 2007). Interestingly, only of the Dutch pension funds con- sider financial performance as a reason to incorporate ESG issues, indicating that pension funds take the personal or societal values of their participants into account in the investment decision process. For the pension funds the question remains on how to incorporate ESG in their investment policy? Corresponding to the figures of Eurosif (2006), besides engagement the integration of values in the traditional risk-return trade off framework seems to be preferred above pure negative or positive screening. The reason is that e.g. in a pure best-in-class approach, companies will be compared on ESG issues only, while financial performance is not taken into account. In the integrated values process both issues play a role. To summarize, the answer to the question whether institutional activism creates value for shareholders is still an open issue. As shown by Statman and Glushkov (2008) divesting from so-called shun stocks did result in a return disadvantage. However, this return disadvantage can be compensated by investing in companies with high ESG scores, indicating that activism related to ESG issues can potentially lead to shareholder value. 6 SRI and alternative asset . Alternative investments such as private equity, real estate, and hedge funds are important asset nowadays. Given the increase in the size of the investments in these alternative asset , it is relevant to examine whether they also incorporate social responsibility in the investment decision process. The aim of a hedge fund is to generate a positive return inde- pendent of the market movement. While managers of traditional mutual funds charge a management fee, hedge fund managers impose both a management fee and an incentive fee. The incentive fee encourages managers to achieve high returns, while high-water- mark levels try to avoid excessive risk taking by the managers. A high-water mark implies that previous losses must be recovered before the manager receives an incentive fee. Moreover, hedge funds are very flexible in the type of securities they hold and the positions they take. Investors in hedge funds are often confronted with lock-up periods of sometimes more than three years. These restrictions on withdrawals allow fund managers to set up long- term or illiquid positions. The nonstandard features and the low correlation of hedge funds with traditional asset make them an interesting investment alternative that reduces risk exposure by diversification. This is one of the main reasons why institutional investors such as pension funds allocate capital to hedge funds. According to , there are only a very few socially responsible (green) equity hedge funds in the market. As far as we know, there is no academic research on the performance of those green hedge funds. The magazine Investment Advisor reports that in October 2006, AIG global investment group was managing about million in assets that had been invested under SRI constraints. The head of the hedge fund strategies of AIG states that the returns on the restricted accounts are very similar to those of the non-restricted funds, indicating that SRI constraints do not necessarily have a negative effect on the aim of hedge funds to generate positive returns independent of market movements. Some other green hedge funds in the market are the , which has about million under management and which focuses on environmental factors; and , which has four market-neutral funds and about million under management. These funds are managed using environmental and social factors as criteria. Furthermore, there is a small number of hedge funds that are based on religious grounds, such as the Shariah funds that invest according to Islamic law. So, we can state that hedge funds with an SRI agenda are only a recent phenomenon, and it is hard to predict how such funds will develop in near future. Another important asset class is real estate. Researchers report that account for approximately of the consumption of raw materials and energy. In addition of the wood that is not used for fuel production is consumed in construction. Overall, and the associated materials produced for construction account for at least of world greenhouse gas emissions. Once a is constructed, the energy consumption associated with it continues. Recent estimates indicate that energy represents of operating expenses. These magnitudes suggest that real estate can play an important role in making societies more energy efficient and sustainable. Typically, awareness of this possibility is growing. A recent example is the increasing emphasis on green ratings for both new and existing construction. In general, these ratings assess the energy footprint of and provide the owners and occu- pants with a yardstick of the energy efficiency and sustainability of properties. However, the use of these ratings has been limited. Moreover, both real estate developers and institutional investors are generally uncertain about how far they should go in imple- menting environmental investments. Thus, sustainable real estate investment vehicles is still in its infancy. But research in the area is picking up. In a recent paper , Quigley, and Eichholtz (2008) investigate the impact of sustainable practices and analyse a large sample of U.S. For some 8,000 subject and office , the authors relate market rents and asset values to a set of objective hedonic characteristics of , holding the location characters of properties. In addition to determining the average rental premium, their method also makes it possible for them to estimate the rental increment for each green relative to the control in its immediate geo- graphic neighbourhood. Another asset class with attractive diversification opportunities for institutional investors is private equity. Most private equity funds are organized as limited partnerships, with institutional investors acting as capital providers and limited partners. The limited partners usually make a commitment to provide funds when needed for new investments. A typical fund has a lifetime of about ten years. The general partners make investment in compa- nies during the first five years, and exit from the companies during the second half of the company's lifetime. The funds usually charge an annual management fee on committed capital during the lifetime of the fund (see, Metrick and Yasuda, 2007). Sustainable or socially responsible private equity is gaining momentum in the private equity industry. According to a case study by Robeco (2007), there are about 200 dedicated sustainable private equity funds, and more than 50 of them can be considered as being of institutional quality, given the amount of money raised. The funds focus on new forms of energy, agriculture, and new ways of utilising resources such as, water. Since it is expected that the demand for water will increase in near future, the potential for sustainable private equity investments is very large. A recent study by Cumming and (2008) examines the intersection between socially responsible investing and private equity. Using survey data from Dutch institutional investors, the authors report that the internal organizational structure of the institution and global diversification opportunities significantly affect an institution's decision to invest in sustainable private equity. Institutions in which the investment decisions are centra- lized through a Officer are more likely to have socially responsible investment policies than are institutions with less centralized decision structures. Furthermore, it is more likely that the funds invest in socially responsible private equity programs in Europe and the U.S. than that invest in domestic or Asian programs. This result may indicate that there are relatively few sustainable investment opportunities in Asian countries. Finally, Cumming and (2008) report that larger institutional investors are more likely to be involved in socially responsible private equity. So, although academic research in the direction of alternative investments is still in its infancy, we nevertheless observe that socially responsible private equity and sustainable real estate starts to incorporate social responsibility in their investment process. Academic research will probably catch up in near future. 7 The Effects of SRI on Corporate Behavior In both Europe and the U.S., of the total assets under professional management is invested according to SRI policies. Given the huge growth of the SRI fund industry over the past decade, it is interesting to examine whether the increased attention to environmental, social, and corporate governance issues affects corporate behavior. One of the important trends that researchers observe is the growth in activities related to corporate social responsibility. Corporate social responsibility can be defined as actions taken by firms with respect to stakeholders and environment that go beyond what is legally required. As stated by Porter and (2006): CSR has emerged as an inescapable priority for business leaders in very country. Today, most major companies devote a large section of their annual report to CSR. One of the reasons companies may take ESG or CSR issues into account in their business policies may be due to increased pressure of society in general. Nongovernmental organizations, such as human rights organizations, community groups and anti-apartheid activists, have strong networks and force public pension funds to divest companies that do not take CSR issues into account (Guay, Doh, and , 2004). to reduced risk-sharing oppor- tunities, divesting those firms that do not adhere to ESG standards can lead to an increased cost of capital for these firms. Later, it can be more difficult for those firms to find investment projects that increase the total value of the firm. Alternatively, reporting that your company takes ESG issues into account may also be used as an information signal to financial or labor markets regarding the firm's quality or reputation. (2007) develops a micro-economic model of firm CSR behavior in order to explain the often observed over- compliance of companies with respect to social and environmental responsibilities. In the model, investing in CSR is considered as investing in goodwill capital. The model shows that when con- sumers reward CSR the costs of CSR may be offset by the benefits in terms of higher profitability. and Semenova (2008) provide empirical evidence in this direction. Firms are motivated to invest in CSR to obtain a higher ESG ranking, and are rewarded with relatively higher stock prices. Heinkel, , and Zechner (2001) examine the effect of exclusionary ethical investing on corporate behaviour. Basically, these authors examine whether the presence of green investors influences or persuades the company to change from using a polluting technology to a clean one. The theoretical model assumes that there are two types of risk-averse investors, green and neutral. The latter ignore ethical considerations in their investment decisions, while green investors refuse to invest in firms that do not meet their ethical criteria. Furthermore, the model assumes that each company can choose between a polluting and a clean technology, and that the green investors will not invest in the firms that use the polluting technology. From the model, it follows that negative screening criteria by investors leads to fewer polluting firms in investment portfolios. This result implies that the stock price of those companies will fall and that the cost of capital will increase due to lower risk-sharing opportunities. A result implying a higher cost of capital that is empirically confirmed by and Kacperczyk (2008), who report that sin stocks outperform the stock market Heinkel, , and Zechner (2001) show that the proportion of green investors in the economy eventually decides whether a company will convert from a polluting technology to a clean one. Thus, as soon as the increased cost of capital of the polluting firms exceeds the cost of capital of firms that use a clean technology, the polluting firms will decide to turn to the more environmentally friendly technology. A calibration of their model with empirically reasonable parameters indicates that a proportion of about green investors in the economy is necessary to persuade a company to change to a clean production technology. This result implies that the previously mentioned of the total assets under professional management that is invested according to SRI guidelines is not sufficient to encourage firms to use a clean technology in their model. Nevertheless, it increases the cost of capital of those firms. Barnea, Heinkel, and (2005) extend the previous model by explicitly modelling investments by firms. They report that negative screening reduces the incentives for polluting firms to invest for various levels of reforming costs. This result implies that the total level of investment in the economy as a whole decreases. In both models that predict an increase of the cost of capital for companies that do not take ESG issues into account, a necessary condition is that there are not sufficient arbitrageurs in the market who are buying the shares of the polluting firms if they are underpriced. Barnea and (2006) examine the drivers behind firms' increase in CSR expenditures. They argue that when CSR expendi- tures are low, that fact contributes positively to firm value due to, e.g., lower pollution related costs. However, since there is no limit in the amount that firms can transfer to its stakeholders, Barnea and (2006) state that at some point, CSR expenditure must decrease shareholder wealth. This reduction of firm value is in line with the theoretical objections against the stakeholder model, as shown by (2001) and Tirole (2001). Using a data set in which they classify firms as either social responsible or irrespons- ible, these authors find that insider ownership is significantly and negatively related to CSR ratings. Insiders are usually defined as all officers and directors of the company, and beneficial owners as those who own more than of the companys stock. These insiders may gain private benefits, such as reputation effects, from having a high CSR rating. However, the costs of obtaining a high rating may reduce total firm value due to overinvesting in CSR. Therefore, when insiders bear of the cost of overinvesting in CSR, CSR expenditures may create a conflict between different shareholders in a company. Barnea and 's (2006) findings show that apparently, insider interests are more aligned with firm value maximization rather than with bearing the costs of being involved in CSR. Furthermore, Barnea and (2006) report that on average, leverage is negatively related to CSR ratings, indicating that high debt levels make overinvesting in CSR more difficult because creditors take a more monitoring role in the firm. Finally, the authors find that institutional ownership appears to be positively correlated with CSR ratings. Apparently, possibly driven by pressure from society, public institutions care more about social issues than about financial performance. In this survey we present an overview of the literature on the financial consequences of socially responsible investing. The performance of socially responsible investment (SRI) funds is the topic that is most extensively studied in the empirical SRI litera- ture. In this literature, the question of interest is whether imposing SRI constraints affects the performance of SRI mutual funds compared to conventional funds. We can conclude that the majority of studies show that the risk-adjusted performance diffe- rence is not statistically different from zero between socially responsible investment mutual funds and their conventional counterparts. A more recent SRI literature stream considers the performance of SRI funds as granted, and explicitly examines the behavior of socially responsible investors. From this part of the literature it becomes clear that socially responsible investors care about other issues than financial performance only. Personal and societal values also play an important role in their investment decision process. For pension funds engagement and the integration of values into the investment decision process becomes mainstream. Apparently, the values of their participants are taken into account. Closely related is the question of whether the introduction of environmental, social, and corporate governance targets affects financial performance. Major institutional investors, such as pension funds, increasingly recognize that ESG issues may have an impact on shareholder value. Direct engagement or shareholder advocacy has gained a lot of momentum. Although the answer depends critically on whether these non-financial targets are priced by the market, it appears that social responsible investors can do well and do good. the period 1992-2007, for U.S. companies, a portfolio strategy that followed a best-in-class approach would have outperformed a conventional portfolio strategy.