Good Honest Dollar $$

Do firms really need ethical investors?

Today I would like to continue the discussion from the previous post in this series about whether or not attracting investment from socially responsible investors is important to companies.

As noted last Tuesday, in order to understand the consequences for companies of attracting the Socially Responsible Investment (SRI) dollar, we need to understand two fundamental issues:

• the nature of those consequences – why SRI is important; and
• the magnitude of such consequences – how much SRI matters.

The previous post dealt with the former issue. Today, I would like to deal with the latter – the magnitude of the consequences of attracting SRI.

  
The key question
As discussed in the previous post, the ability of the firm to attract the SRI dollar has an impact upon its ability to raise capital in primary markets. It also affects a firm’s share price in secondary markets, which in turn has a range of flow on consequences.

All of these consequences occur via capital markets. Therefore the magnitude of the impact of SRI on from the prospective of corporations will be determined by the magnitude of its impact upon financial markets.

Therefore, the question becomes one of whether or not SRI has a significant impact upon financial markets. Can SRI play hard ball?

 
Small, but material impact
The figures suggest that it can. The magnitude of investment dollars which flow through SRI funds is now sufficient that such funds do have a small but nonetheless material impact upon the markets in which they trade.

In Europe, European Social Investment Forum’s (EUROSIF) estimates SRI funds under management accounted for approximately 10-15% of total funds under management as at December 31 2005. (For reference, download relevant report (PDF file) from here)

In the US, the SRI funds accounted for approximately 11% of funds under management as at December 31 2007, according to the Social Investment Forum’s 2007 Report on Socially Responsible Investment Trends in the United States.

To be sure, the bulk of the trade on global financial markets is still made up of investors who operate outside of SRI funds. The majority of the price-setting power lies with such investors.

Nevertheless, the magnitude investment dollars flowing through SRI funds is now sufficient that such funds exert a material, albeit small, impact upon the markets in which they operate.

 
Caution advised
The above figures should be treated with a degree of caution.

Estimates of the size of SRI market differ greatly according to differences in how an SRI fund is defined and classified.

Moreover, the above figures take into account only funds under management. They take no account of other investors, such as government, sovereign funds, other firms, entrepreneurs, wealthy families or other individual investors.

Nevertheless, it is clear that SRI has a material impact upon financial markets, and that the ability or otherwise of firms to attract SRI investors will have a material impact upon their share prices, their ability to raise capital and their ability to maximize shareholder wealth.

This article is the sixth in a series on Socially Responsible Investing (SRI), otherwise known as ethical investing.

In this post, I would like to discuss the consequences, from a company’s point of view, of being successful or otherwise in attracting ethical investment.

Some commentators argue that attraction of the ethical investment dollar provides an incentive for firms to adopt positive ethical behavior. But is attracting ethical investment really important to a firm? Does attracting SRI really matter?

In order to understand the consequences for a company of attracting socially responsible investment, we first need to examine two issues – the nature of these consequences and the magnitude of such consequences.

In this post, I will examine the nature of the consequences for a firm in attracting ethical investment – the question of why it matters.

The following post will deal with the magnitude of such consequences – the question of how much it matters.

Why SRI matters to a firm
The consequences for a firm in attracting socially responsible investors differs according to whether we are referring to investment in primary markets or  investment in secondary markets.

Accordingly, the two different categories of investment and their differing effects are discussed below.
 

Investment in primary markets
Investment in primary markets occurs where investors provide money directly to a firm, in return receiving either equity or a credit instrument, or a combination of both.

This, in turn, occurs when the company attempts to raise capital.

There are direct (and easy to understand) consequences for companies in attracting (or otherwise) ethical investment in primary markets. By attracting funds from ethical investors, the firm increases the amount of funding it can raise and/or improves the terms upon which it can raise the required capital. The reverse applies to firms which are shunned by ethical investors.

Consequently, ethical investors may have a direct impact upon a company’s ability to raise capital and the terms upon which it is able raise such capital.
 

Indirect investment
Indirect investment occurs when investors do not provide money directly to the firm, but instead purchase a credit or equity instrument on a secondary market. The most common form of indirect investment is the purchase of shares on the stock market.

In such cases, the investor does not transact with the firm itself, but rather with the seller of the credit or equity instrument. Accordingly, the firm does not receive any money directly from the investor, and the consequences for a firm in attracting ethical investors on secondary markets are less obvious.

Nevertheless, such consequences do exist, and they stem from the effect upon the firm’s share price.

The share price of a firm is determined predominately by the level of demand for the shares concerned. By attracting funds from ethical investors, a firm increases the overall level of demand for its shares, and thus, the price at which its shares trade on the market. The reverse effect occurs in cases where firms are shunned by ethical investors.

Accordingly, other things being equal, a firm which attracts ethical investment will attract a higher share price than a firm which does not.

The effect of a lower share price, in turn, does not have an immediate impact on the operations of the firm. However, it does result in a number of flow-on effects.

 
• Failure to maximize shareholder wealth.

In many western countries, the principal objective of the firm is to maximize wealth for its owners. This, in turn, is achieved by maximizing its share price. 

In cases of firms which repel ethical investors, the ability of the firm to achieve the goal of the maximizing shareholder wealth is inhibited.

 
• Becoming a takeover target

Firms which fail to maximize their share price (due to an inability to attract ethical investors) face a greater risk of becoming a takeover target than firms which succeed in that regard.

 Moreover, shareholders of such firms do not receive as much value for their company in the event of a takeover as shareholders of firms which are successful in maximizing their share price.

 
• Adverse effects on employment and remuneration of senior staff.

In cases where an inability to attract ethical investors results in the failure of a firm to maximize its share price, the effect is felt not only by shareholders, but also by directors and senior staff.

Directors and senior staff are accountable to shareholders. In addition, they often hold substantial shareholdings themselves and their remuneration can be substantially influenced by the share price.

Accordingly, failure to maximize the share price may have an adverse impact upon the value of their shares, their remuneration and even their employment at the firm.  

 
So, does SRI matter to companies?
Yes. Success or failure to attract ethical investment has an affect upon a company’s ability to raise capital funds on primary investment markets, and the terms upon which it can do so.

On the secondary market, it does not directly impact the operations of the firm, but the subsequent effect on the share price has flow-on consequences for both owners and senior employees of the firm.

The previous two posts in this series discussed two categories of common objections toward SRI. These were:

• Objections to SRI based on principle; and
• Objections that SRI compromises investment performance.

Another criticism of SRI is that it is simply not an effective mechanism to produce positive social outcomes, a topic that I wish to discuss today.

The viewpoint that SRI is not an effective way to produce positive social outcomes is not one with which I can agree. Nevertheless, the objection raises an interesting question – can we prove that SRI has a positive social impact?

Proof of SRI’s social impact

As noted in earlier posts, SRI can take on a wide variety of forms. Some types of SRI, including Community Investing, Social Venture Capital and Social Entrepreneurialism have a direct social impact. We can point to real world examples to prove the social value of such activities.

Consider Community Investing. When I was in the Philippines earlier this year, one of my favorite experiences was the motorized ‘tricycle taxis,’ which provide an immensely valuable service to rural communities where few families can afford to own a car.

Men who provide this service are usually too poor to obtain credit from banks. But with the help of community loans from Opportunity International, these men are able to purchase the taxi, pay off the loan, and still earn a sufficient amount to feed their family.

Or consider social entrepreneurialism. A new range of clean burning and biomas based cooking stoves which Envirofit International has introduced to rural homes in India provides an example of the social impact of this type of SRI.

According to a post on Think Change India, these stoves reduce toxic emissions by up to eighty per cent, whilst using fifty per cent less fuel.

Examples like these (and there are many more) provide tangible evidence of the social impact of some forms of SRI.

Overall Impact More Difficult to Measure

As stated above, it is possible to prove the social benefits arising from the forms of SRI which have a direct social impact through tangible evidence. However, it is considerably more difficult to quantify the impact of the most common form of SRI – applying ethical screens to an investment portfolio.

The principle reason for this is that the social benefits arising from this strategy are indirect in nature, thereby making it difficult to quantify such benefits in a reliable fashion. It is also difficult to prove beyond reasonable doubt that any social benefits arising as a result of this strategy are substantial.

The social benefits arising from ethical screening are two-fold. Firstly, the strategy directs SRI funds toward socially benevolent companies and industries, helping to stimulate growth in those industries. Secondly, the strategy provides an incentive for companies to improve corporate behavior in order to attract the SRI dollar.

In relation to improved corporate behavior, how can we determine the extent to which responsible corporate behavior is driven directly by SRI as opposed to other factors, such as ethical consumerism or the desire to avoid government regulation?

In addition, how can we determine the extent to which growth in socially benevolent industries is directly attributable to SRI as opposed to other business environment considerations?

We can’t, and as a result, it is very difficult to quantify the overall social impact resulting from the application of ethical screens to investment portfolios.

Given that such an approach represents the most common method of SRI, it is difficult to quantify (and thus prove) the impact of SRI at an overall level.

Any impact positive

Nevertheless, it is almost certain that any impact which SRI does have upon social well-being is a positive impact. In my view, it is difficult to imaging SRI having either no social impact or a negative social impact.

In addition, given the growth in funds in invested in SRI portfolios (now representing 11% of funds under management in America), I would think that the impact funds invested through SRI portfolios is now a material factor in stimulating growth in socially benevolent industries as well as encouraging positive corporate behavior.

Conclusion

I cannot agree with the viewpoint that SRI does not have a material social impact.

Some forms of SRI have a direct, tangible social impact whilst others do not. Nevertheless, there is good reason to believe that all forms of SRI, if applied in a sensible fashion, contribute toward positive social outcomes.

As mentioned in the previous post in this series, critics of Socially Responsible Investing (SRI) generally fall into three broad categories:

• Those who are opposed to the concept of SRI based on principle;
• Those who believe that SRI compromises investment performance; and
• Those who feel that SRI is not an effective mechanism to produce positive social outcomes.

Today’s discussion deals with the second category. The first category was dealt with in last Friday’s discussion and the third category will be discussed next Friday.

(This post is will not discuss empirical evidence relating to investment performance of SRI funds – this will be dealt with in a later post. The discussion in today’s post relates to the nature of the objection as well as that of counter arguments.) 

 
Different approaches, different outcomes

The question of whether or not investing in a socially responsible fashion compromises financial performance is not a clear cut issue, particularly as there are a number of different approaches toward SRI and expected financial outcomes will vary according to the particular approach which is adopted.

Take Social Venture Capitalists, for example. Whilst some social venture capitalists fund only ventures or projects where the anticipated financial return is commensurate with the (considerable) risks involved, others are prepared to accept a lower rate of return, believing that the anticipated social or environmental benefits from such projects makes their funding worthwhile despite the sacrifice in expected financial return.

Or consider Community Investing. Anticipated returns on investments with Community Investment Institituions vary according to the specific institution and type of investment involved. However, generally speaking, investors are given the option of purchasing investment products which are anticipated to earn competititive rates of return compared to other investments within a similar asset class,  or alternatively purchasing instruments where the anticipated financial return is below that of other investments within a similar asset class. The advantage of the latter option over the former is that it allows for more funds to be invested in the relevant community projects and thus has a greater social impact.

My point here is simply that there are different approaches toward SRI, and anticipated financial performance will vary according to the type of investment involved.  

 
The most common approach – a portfolio of ethical investments

The most common approach to ethical investing is to construct a portfolio of investments which meet certain ethical criteria.

Investors who adopt this approach typically either adopt a negative screening approach, whereby certain exclude certain investments from their portfolio on ethical grounds, and/or a process of applying positive screens – purposeful discrimination in favor of a selective range of socially and environmentally benevolent sectors. 

In the case of negative screens, where such screens are applied too strictly, this process places severe limitations on investment options and hinders the ability of investors to generate competitive investment returns. It also severely limits the ability of the investor to construct a well-diversified portfolio and thereby to effectively manage portfolio risk.

However, if investment screens are applied in a sensible fashion, then the screening process should still allow for a wide range of investor choice, as well as ample freedom to construct a well diversified portfolio.   

On the other hand, the process of applying positive screening may or may not adversely affect investment performance from a financial perspective, depending upon how narrowly or broadly the screening process is applied.

The practice of restricting portfolio investment to a singular sector or a narrow range of sectors may well compromise investment performance. Such a strategy places severe limits in terms of investment choice and flexibility, as well as exposing the portfolio to a high degree of risk and volatility.

However, the positive screening process need not compromise anticipated investment performance to a material extent. Rather than restricting investment options to a narrow range of sectors, portfolios can be constructed which include investments across a broad range of sectors, such as health and well-being, education, science and technology, finance, property and construction, alternative energy, infrastructure and other socially or environmentally benevolent industries.

Provided that a sufficiently broad range of industries or sectors are included in the screening process, the practice of applying positive ethical screens to an investment portfolio should not materially restrict investment options or cause undue portfolio risk.

 
Better managed companies

Some proponents of SRI counter that companies which adhere to sound ethical practices are generally better managed companies, and benefit from more productive relationships with a wide variety of stakeholders.

All other things being equal, proponents say, such companies are in the best position to deliver competitive financial returns over the long term.

Whilst it is certainly not the case that every company which behaves in a socially responsible fashion is necessarily a well managed company, I believe that there is considerable merit in this argument.

 
Conclusion

Whether or not investing in a socially responsible manner compromises financial performance or not will depend entirely on the approach taken by individual investors.

Community Investing will generally not produce competitive financial returns, nor will portfolios where ethical criteria are applied in a manner which is too stringent.

On the other hand, sensibly constructed portfolios should allow for a wide range of investor choice, and should result in a significant compromise in anticipated return on investment.

 
Readers please note:

The author is not a qualified financial planner. Information in this post, or otherwise on this blog is intended for general discussion purposes only and is not in any way intended as specific financial advice. Readers are advised to consult a qualified financial planner before making acting on any information or opinions given on this blog.

In last Friday’s post, I outlined the benefits of Socially Responsible Investing (SRI) from the viewpoint of broader society.

If managed effectively, SRI helps produce positive social outcomes by helping to direct financial capital toward companies and industries whose impact on society is positive, and providing an incentive for corporations and industries to adopt positive ethical practices.

Nevertheless, the concept has its share of critics, and whilst I believe that Socially Responsible Investment should be encouraged, objections to the concept are worthy of examination.

Broadly speaking, critics of SRI generally fall into three broad categories:

• Those who are opposed to the concept on principle;
• Those who believe that SRI compromises investment performance;  and
• Those who do not believe that SRI is an effective mechanism to produce positive social outcomes.

In today’s post, I would like to discuss the first category. The second and third categories will be discussed in the following two posts in this series.

 
Arguments against Socially Repsonsible Investment based on principle

Objections to SRI based on principle can be further sub-divided into three additional categories:

• SRI inhibits the effectiveness of financial markets in allocating capital;
• Socially responsible investors are anti-business; and
• SRI represents a form of selling out to capitalism.

Each category is discussed in turn below.

 
Inhibiting the effectiveness of financial markets

The first main objection to SRI on principle is that it inhibits the effectiveness of financial markets in allocating capital in an efficient manner.

According to this argument, capital should be allocated solely on the basis of producing the maximum return on investment (ROI). This, in turn, is determined by consumer and business demand for products and services, as well as the cost of producing such products.

Accordingly, allocation of capital based solely upon maximimum ROI is the most effective mechanism by which capital is allocated toward sectors in which it can be most productively employed. Where ethical considerations interfere with this process, the result may be that capital is redirected towards sectors where it cannot be employed to its maximum effectiveness.

Whilst I cannot dispute the importance of allocating capital toward its most productive use, I cannot agree with this argument.

Firstly, the market allocates capital according to consumer demand and the cost of meeting such demand, but this may not reflect the services which are most needed in terms of broader society. There is considerable demand for products such as weapons manufacturing or pornography, but should capital really be allocated to such areas?

Moreover, the majority of ethical investors seek competitive financial returns as well as ethical considerations. These investors will only allocate capital toward areas where it can be employed productively to produce products and services for which a substantial level of demand exists and where such demand can be satisfied in a cost effective manner.

 
Socially Responsible Investors are anti-business

I have little empathy for this viewpoint, under which socially responsible investors are seen to want to use their investments to push their own social agendas, sometimes with little or no care about the nature of business or the need for the business to earn competitive returns for shareholders.

It may be true that some investors have certain agendas which are not compatible with the business objectives of the investee company. However, this is simply not the case for the majority of investors.

The majority of socially responsible investors seek a competitive rate of return on their investment whilst investing in a socially responsible manner. Those who participate in shareholder activism usually seek to do so in a constructive fashion to achieve workable outcomes.

 
A sell out to capitalism

On the flip side of the coin are those who see SRI as a form of selling out to capitalism, which they see as an unfair and unjust economic system.

Again, I do not have much empathy for this argument. Whilst capitalism is not perfect, it is here to stay in most western countries. For better or for worse, the system will not change anytime soon, and attempting to change the capitalist system, or simply wishing it would change, is not the most effective approach toward achieving social outcomes.

Rather than try to change the capitalist system, it is more effective to work within the system to produce fair and equitable outcomes.

Working within the system is more effective than fighting against it, and in addition to ethical consumerism, SRI represents a mechanism for individuals to work within the capitalist system to encourage ethical and responsible behavior.