sou · GWB3107 · 2008-11-28 00:00:00 — Mercer conducts search for worlds first major emerging markets mandate. (2008). Cleantech investments reach new apex. and private equity placements. Similarly, , Inc. has launched their targeting commodities, energy and water. Infrastructure: Because infrastructure investments are often so large and involve multi-year if not multi-generational contracts, the potential for public scrutiny can be a material consideration. An interesting example from 2007 was the purchase of power company . by Kohlberg Kravis and TPG Capital. Facing concerns about regulatory approval and openly expressed opposition from environmental groups, the consortium agreed to reduce the number of coal-fired plants it would build and to invest instead in energy efficiency and renewable energy. 5.6Responsible Investment and Performance Academic research on responsible investment, socially-responsible investment, and ethical investing continues apace. Mercer monitors academic literature, focusing where possible on highly-cited peer- reviewed publications. In conjunction with the of the Initiative (FI), Mercer researched and wrote a report, , released in October 2007.32 The report examined 20 academic studies and ten broker studies that studied responsible investment using various research methods and concentrating on diverse regions and approaches. 32 The report can be found online at /ri under Publications or form the website: The overall findings from the majority of the research include: It is a misconception to assume that responsible investment leads to financial underperformance Various factors such as manager skill, investment style and time period are integral Evidence suggests that there appears to be no performance penalty from taking ESG factors into account in the investment management process (10 studies are positive, 7 neutral and 3 negative) As a financial discipline, responsible investment can be successfully implemented in virtually any investment style Genuine ESG analysis needs to be distinguished from simple automatic exclusions Systematic translation of ESG factors into quantitative inputs and financial ratios still needs to be developed in broker research Other articles of interest from 2007 and early 2008 include the following research on corporate governance issues: Pornsit Jiraporn and demonstrate a link between shareholder rights and capital structure. Firms covered by the study showed higher levels of leverage where rights were more restricted than other firms.33 Jiraporn and Yixin study the impact of staggered board elections on leverage. Again, firms with a staggered board show lower levels of leverage than firms in which all directors are elected at the same meeting. The same results were found in regulated as well as industrial firms. The difference between the two board structures, with regards to leverage, seems to disappear after the passage of Sarbanes-Oxley. The authors posit this relationship exists, at least in part, because staggered boards tend to protect inefficient management.34 33Capital structure, shareholder rights, and corporate governance, , Volume 30, Number 1. 34Capital structure, staggered boards, and firm value, , Vol. 64, No. and find that higher executive compensation levels, vis-à-vis the firms peers, does not lead to better performance than the rest of the peer group.35 recently completed a study, Governance and Performance in Corporate (February 2008), which found that companies with the best corporate governance records have produced returns higher than those with poor governance records. This was based on a survey of 654 UK FTSE-listed companies from 2003 to 2007. Causality was also tested and the Association reports that governance drives performance, rather than the reverse.36 Other articles of interest, addressing social, environmental, and related issues, include: , based in the UK, published a report on SRI and ethical funds that argues that these funds have positive impact on the struggle to confront climate change. In fact, many of them have significant positions in corporations that are considered, by many environmentalists, to be obstacles to climate change reforms. By contrast, there are an increasing number of targeted funds that invest in nothing but clean technologies.37 argues that there is positive relationship between employee satisfaction and long-run stock performance. Using backtesting, Edmans created a portfolio based solely on magazines, to Work for in . The portfolio was rebalanced annually. The results from 1998 to 2005 showed a return double that of the market and outperformance against industry- and characteristic-matched benchmarks.38 In a major nod to industry trends, published a long survey of corporate CSR practices in its January 19th 2008 edition. The survey presented a positive view of the relationship 35Executive compensation: Much ado about nothing? 63, No. 37From firm website: 38Does the Stock Market Fully Value Intangibles? Employee Satisfaction and Equity Prices by of Wharton, 2007 Winner, see: between CSR and corporate results – although recognizing many of the problems involved in assessing and implementing CSR. The magazine also noted and rejected its earlier editorial criticism of CSR noting, in addition to financial results, peer pressure is such that few corporations can afford to ignore how they are perceived by social critics.39 A survey article by on the development of the fair- trade industry focuses on how the industry has changed over time and the role of mass-marketing in this transition. The phases identified respond to changing approaches to consumer demand and include the solidarity era, niche-market era, and mass market era, followed by the institutionalisation era. This typography provides an interesting parallel with responsible investment as it has evolved to meet customer (i.e. Investor) needs starting with a values-driven era, moving through niche products towards value-added and finally incorporation into institutional risk management processes.40 In recent years, we have seen increased interest in responsible investment and growing integration of ESG-analysis into the investment process of many asset owners and investment managers. importantly, however, there is increasing evidence that responsible investment strategies are being integrated into mainstream dialogue within the financial services industry. We have come to a point where few asset owners and investment managers deny the role an enhanced risk-return framework should play in modern investment management. However, despite an overall growth in RI, ESG integration remains quite rare. Looking at the full spectrum of approaches to RI amongst global pension funds, very few position themselves as leaders in this area. We define the leaders as those funds that fully integrate ESG factors in decision making processes from a risk and return perspective. Examples include for Health, Mental and Social Interests (PGGM), the UK Environment 39Economist, January 19, 2008. 40The eras and participants of fair trade: an industry structure/stakeholder perspective on the growth of the fair trade industry, Corporate Governance, Volume 7, Number 4, 2007. Agency, Pension Scheme (BTPS) and Dutch Stichting Pensioenfonds ABP. These funds integrate RI considerations into requests for proposals, investment mandates and investment manager agreements, and have developed a proactive approach to ownership. Furthermore, the leaders assess the ESG capacity of current or prospective investment managers and tend to analyse existing portfolios for exposure to ESG risks. To various degrees, these funds have also conducted RI manager search and selection for alternative strategies. At the other end of this spectrum are the ethical or socially responsible investors, who address ESG factors on ethical grounds, and are not necessarily concerned about any affect that these factors may have on the performance of underlying investments. These funds are considered laggards according to this definition as their ethical considerations are taken independently from the investment management function. Also asset owners who have reverted to simplistic exclusions and /or superficial engagement policies would fall in this category. In the mid-category on this spectrum, we find developing funds that have started to move towards integration. They have generally developed an RI action plan in the context of their overall plan philosophy and beliefs. This often includes a component of peer benchmarking. To various degrees, they have also started to move away from simplistic exclusions and to integrate RI considerations into their own portfolio construction, requests for proposals, investment mandates and investment manager agreements. 6 Next steps for the AP funds The Swedish AP funds vary considerably in their integration and can be found in both the developing and lagging category. Few have communicated clear rationales for their adopted positions on RI, and are not among the global pension funds that actively consider risks and opportunities that arising from ESG issues in their investment processes. Looking forward, the AP funds can further enhance their aptitude in the RI space by moving towards full integration of ESG issues in investment decisions. The asset owners that are leading in the RI field have often addressed a number action items that are described below. Many of the following have relevance for the AP funds as well. Example of Actions Taken Beliefs and Policy Development Review beliefs and attitudes towards RI Review of RI policy, strategy and philosophy Integration of RI into Investment Policy and Review of Mandates and Managers Ensure ESG integration of all relevant policies, mandates, and activities Review all existing managers and consultants for ESG suitability Report on the carbon footprint of the companys entire portfolio Incorporate ESG as an essential factor in manager and other supplier selection processes Investment Manager , Mandate and RFP review Manager /ESG review ESG portfolio monitoring Manager search and selection Review of ESG integration and research providers Review of ownership policy Review of ownership policy Develop criteria for engagement Develop internal engagement capacity or appoint external engagement overlay manager Proxy voting and engagement services review Search and selection process for a Leadership and Collaborative Initiatives Become a leader in incorporating responsible investing Participate in collaborative initiatives Inclusion of fund performance against RI targets in Annual Report Educate and inform clients and the public on RI Communicate new developments to beneficiaries and the wider public regularly Encourage research and demand standardised reporting Seek advice and recommendations on collaborative initiatives Seek advice on PRI implementation Determination of strategy for communicating policies, practices, outcomes with respect to RI/ESG integration among beneficiaries and the wider public Doing Well While Doing Good? A survey of the socially responsible investments literature1 and Jenke Ter Horst3 1This survey is written by order of the Commission on ESG-issues for the . 2Corresponding author; , , , 5000 LE Tilburg, the , and CEPR, email: , phone: 3048. 3Department of Finance, , , 5000 LE Tilburg, the , email: . During the last decade, one of the impressive new developments in the financial community has been the rise of social and ethical investments. Although the origins of ethical investing date back many hundreds of years, the modern roots of social investing can be traced to the political climate of the late 1950s and early 1960s. Issues such as the environment, civil rights, and nuclear energy increased the social awareness of investors. Accordingly, mutual funds were set up that specifically met the demand for incor- porating ethical criteria into the investment process. This develop- ment led to a dramatic increase in ethically managed mutual fund assets, an industry that now represents several hundred billion dollars in the . If all U.S. private and ethically screened portfolios are included, now, at the end of 2008 this number tops the three trillion dollar mark. At the moment, approximately of all money under professional management in the is part of a socially responsible portfolio. Because of the size and importance of this movement, both academics and practitioners have investigated the financial consequences of ethically or socially responsible investing (SRI). The fact that MISTRA, environmental research, is funding a research program, is an excellent example of the relevancy of this topic. In this survey we will discuss a number of projects from the research program amongst others. One of their questions is, does it cost to be socially responsible? There are many authors who have investigated the financial consequences of these investments and evaluated how SRI factors such as environmental, social, and governance factors (the ESG factors) affect the portfolios' financial outcomes. For the U.S. and the UK, there is evidence that the financial performance of the SRI industry is different from that of the conventional investment industry (see, e.g., Statman, 2000; and , Koedijk, and , 2005). How- ever, for and the Asia-Pacific region, there is evidence of underperformance (see, e.g., Renneboog, Ter , and , 2008a). In the SRI industry it is common for investment professionals to pursue both financial goals and non-financial objectives. SRI funds usually employ all kinds of SRI screens that restrict their investment opportunity set. Excluding companies based on screens that reflect social, environmental, or corporate governance issues reduces the diversification opportunities, and therefore may nega- tively affect the financial performance of those funds compared to the performance of conventional mutual funds. Moreover, the exclusion of companies may negatively affect the stock prices of those companies, and raise the expected returns. This exclusion effect probably explains why the so-called sin stocks in the U.S. have significantly outperformed the stock market in the last decade (and Kacperczyk, 2008). However, one can also argue that the screens are used as filters to identify companies that can expect superior future performance. The identification effect would imply that the screening process generates value-relevant information that would otherwise not be apparent to investors. This implies that screening would later result in superior fund performance. Both the outperformance and the underperformance hypotheses can both be motivated by theoretical arguments. For example, if financial markets underestimate costs that may emerge during corporate social crises or environmental disasters, then portfolios that use screens based on these criteria may show outperformance. For example, Derwall, Gunster, , and Koedijk (2005a) show that a portfolio of firms with high environmental scores outper- forms a portfolio of firms with low scores. One of the key assumptions in this part of the SRI literature is that stock markets misprice information on ESG in the short run. In this survey, we examine the most important and recent papers that provide the theoretical arguments and empirical findings related to financial under- or outperformance. It has to be stated that the empirical literature on SRI fund per- formance mainly focuses on mutual funds. Pension funds that invest with SRI constraints got attention, probably due to data availability. Besides data availability, it is also difficult to compare social responsible pension funds with usually much smaller social responsible mutual funds. Nevertheless, the question whether and how pension funds should incorporate ESG issues in their investment decisions is a topic that receives considerable attention (see, De gearriveerde toekomst, 2007). Recent studies by Eurosif (2006) and (2006) show that engagement and integration strategies are becoming mainstream for pension funds nowadays. The potential power of pension funds in terms of voting practices or in the form of direct dialogues between the funds and the companies are instruments to encourage companies to incorporate ESG issues in business practices. Furthermore, the integration of values-based investing in the traditional asset allocation and risk management process is a trend that becomes truly visible. The historical development of the SRI industry also shows some interesting patterns. The first-generation SRI funds used mostly negative or exclusion screens. This negative screening implies that the funds excluded certain parts of the initial asset pool. In contrast, the second-generation SRI funds primarily used positive or selection screens. Doing so enabled them to select companies with a best in class approach. The more recent third and fourth generation of SRI funds combines the selection and exclusion screens together with shareholder activism. In a sequence of papers, Renneboog, Ter , and (2006, 2008a, 2008b), using a sample of SRI funds from throughout the world, discuss the effects of the use of different investment screens on the performance of SRI funds, the money flows into and out of SRI funds, and the flow volatility of the SRI funds. In this survey, we discuss their findings and relate them to the issue of whether there are systematic differences between SRI investors who work on an engagement basis and those who use a divestment strategy. For pension funds that already incorporate ESG issues in their investment policy an interesting question is whether they should restructure investment strategies from negative screening towards positive screening. Positive screening will probably narrow down the investment opportunity set of the pension fund much stronger than negative screening does. Furthermore, it has to be noted that the use of engagement power of pension funds can only be effective when the funds have an ownership stake in a company. Therefore, switching from negative towards positive screening may have undesirable ESG implications for society in general. Alter- natively, empirical evidence shows that positive screening can generate value. the period 1992-2007, a best-in-class approach would have outperformed a conventional portfolio strategy for the U.S. A recent SRI literature stream focuses on what socially respons- ible investors want, and what distinguishes them from conventional investors. The integration of personal values in the traditional risk- return trade off framework of portfolio optimization is an important cornerstone of this part of the SRI literature. As stated by Statman (2007), Like conventional investors, socially respons- ible investors want high returns and low risk, but socially respons- ible investors also want their portfolios to conform to their values, whether promotion of worker rights, opposition to war, or protection of the environment. Renneboog, Ter and (2006) find that socially responsible investors care about social or ethical issues in their investment decision. Money flows into and out of SRI funds that mainly employ sin/ethical SRI screens are much less sensitive for past fund returns than conventional fund flows. Alternative investments such as private equity and hedge funds are important asset . Thus, it is interesting and relevant for us to examine whether and to what extent these asset incorporate social responsibility into their investment decision process. Although, as far as we know, there are any acade- mic papers on the subject, we nevertheless observe that sustainable or socially responsible private equity is gaining momentum. For example, a recent study by Cumming and (2008) shows that Dutch institutional investors invest in sustainable private equity. However, it appears that both the organizational structure and the global diversification opportunities affect the size of the sustainable investment program. Today, the SRI industry represents a significant part of all investment funds. Therefore, we wish to examine whether ESG affects corporate behavior. In this survey we present a number of different papers that investigate this issue. For example, Barnea, Heinkel, and Krause (2005) examine the effects of negative pollu- tion screening on the investment decisions of polluting firms. The main finding in this study is that negative screening reduces polluting firms' incentives to invest, which would lower the firms' total investment in the economy. The remainder of this paper is organized as follows. In Section 2 we review theoretical arguments and the empirical findings related to financial under- or outperformance of SRI funds. Section 3 discuss differences in behavior between socially responsible investors and conventional investors. In Section 4 we discuss financial performance and SRI Factors. In Section 5 we review the studies on systematic differences between SRI investors who work on an engagement basis and those who use a divestment stra- tegy. In Section 6 we review the few papers on alternative assets such as private equity, hedge funds, and real estate in relation to social responsible investment. In Section 7 we discuss the literature related to the question of whether ESG affects corporate behavior. In Section 8 we conclude. We briefly indicate the scholarly frontier and topics for future research in the development of SRI. The performance of SRI mutual funds compared to conventional funds is the most extensively studied topic in the SRI literature. From a theoretical point of view, imposing SRI constraints in the investment process reduces the diversification opportunities. According to Markowitz's portfolio theory, these constraints move the mean-variance frontier to the right, and result in less attractive risk-return tradeoffs relative to those in conventional mutual funds. Alternatively, SRI screening may generate value-relevant information. Socially responsible portfolio selection based on environmental, social, or governance criteria may lead to outperformance. For the period 1981 1990, , , and Statman (1993) examine the performance of 32 SRI funds and 320 non-SRI funds in the U.S. They find that SRI funds established before 1985 outperform, on a risk-adjusted basis, their conventional counter- parts by almost per year. The more recently initiated SRI funds underperform their counterparts by almost per year. Although economically significant, the differences in performance are not statistically different from zero. Statman (2000) finds a similar result. Statman examines the performance of 31 SRI funds and 62 non-SRI funds over the period 1990 1998 and reports a risk-adjusted outperformance of about on an annual basis. For both studies, it holds that both SRI and non-SRI funds underperform the benchmark. One of the first international SRI fund performance studies is by , Koedijk, and (2005). These authors use the Fama- French Carhart (FFC) model to measure the performance of SRI funds in , the UK, and the U.S. over the period 1990- 2001. For the UK, they find that domestic and internationally investing SRI funds significantly outperform their conventional counterparts. Domestic ethical SRI funds in the U.S. significantly underperform, but the difference for internationally investing funds is not significant. For , they find nonsignificant differences between ethical and conventional funds. , Koedijk, and (2005) report that German and U.S. ethical funds experienced a learning phase. Initially, the funds under- performed, but during the period 1998 2001 the funds matched the performance of conventional funds. Geczy, Stambaugh, and (2005) use a different approach. Using a Bayesian framework, these authors examine whether investors in socially responsible equity mutual funds pay a price, via their investments, for their willingness to do well.