September 21, 2017

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Evaluating Performance: Is Best-in-Class Best for SRI?

"Disclosing how you're destroying the world doesn't stop it. It doesn't go far enough."

Jeffrey-macdonald2

By G. Jeffrey MacDonald

For three decades, investors keen to build a better world have grudgingly held stocks in less-than-perfect industries. Owning shares, they’ve hoped, would afford them two good things: solid performance via diversification and an insider voice to encourage best practices at firms that just might listen.

But activists say too little has come of the so-called “best-in-class” approach, which supports the least bad actors in a wide range of industries from oil and gas to mining. And new portfolio research suggests the strategy might be overrated.

“There is more of a challenge being applied to best-in-class as a strategy, ” says Ominder Dhillon, head of distribution for Impax Asset Management, a London-based firm. “In a low-growth world, are all sectors going to generate growth in similar amounts? I don’t think so. So we have to focus our efforts on those areas that have the best prospects.”

Diversification vs. Divestment

As best-in-class faces fresh scrutiny, a longstanding pillar of socially responsible investing is being called into question. Stakeholders are asking whether investors need exposure to all major sectors, even problematic ones, and what differencediversification-divestment those investments really make.

Among the factors driving this reexamination is a new push for divestment from environmental activists. Nearly 500 local campaigns have cropped up to urge governments, religious institutions and other institutional investors to phase out their fossil fuel holdings, including equity shares and bonds issues issued by some of the world’s largest, blue-chip companies.

For American colleges and universities managing more than $400 billion in endowment assets, a question surrounds the SRI industry’s traditional quest to find the best miners, oil majors and others to encourage through investment: why bother?

Does Taking the Least Bad Count?

“The best-in-class kind of strategy is not something that I have seen or am seeing in the higher ed sector,” says Mark Orlowski, executive director of the Sustainable Endowments Institute, a Cambridge, Mass.-based non-profit that encourages impact investing. For asset managers, “It’s really about, ‘either we invest for best return regardless of [SRI] criteria, or we engage [in dialogues] with the companies we already own, or we consider divestment’.”

Proponents of best-in-class say the method is as effective and important as ever. It’s commonly used in SRI mutual funds. The Legg Mason Social Awareness Fund, for example, had at least six oil industry holdings as recently as last summer. The fund has latitude investment in any industry, even weapons manufacturing, as long as analysts deem a stock to rank higher than its peers on social or environmental benchmarks.

Best-in-class has a financial raison d’être: performance. Portfolio theorists agree diversification helps mitigate risk. A portfolio that shuns particular sectors in the name of social responsibility theoretically runs higher risks – those not necessarily much higher – than one with broad market exposure for weathering ups and downs.

“The basic story that one needs to have a well-diversified portfolio hasn’t changed,” says Christian Lundblad, a finance professor at the University of North Carolina. “People still buy in deeply to that argument, and the research hasn’t altered much.”

The Risks of Owning It All

However, new studies suggest the upside to owning all sectors can be small and is sometimes offset by sector-specific risks.

Research from the Sausalito, Calif.-based Aperio Group finds that portfolios aren’t devastated by dropping exposure to controversial sectors. The increased risks are tiny when a portfolio manager best-in-class-risksshuns sectors that are small fractions of the economy, such as tobacco.

It’s riskier to eliminate large sectors of the economy such as energy or financials, according to Aperio Group’s Chief Investment Officer Patrick Gettes. But many risks can be managed, Gettes says, by overweighing elsewhere to compensate for what’s been removed, such as by increasing exposure to comparable large cap international stocks in other industries. Hence investors need not assume they must have exposure across the board.

Just Measure It

“Best-in-class is a blunt instrument. It’s too rigid,” Gettes says. “The focus should not be on the simplistic idea of, ‘don’t we have to hold every industry?’, but rather, ‘what incremental risk am I introducing with any of these screens?’ Just measure it.”

When Impax looked at the effects of removing fossil fuels from a portfolio, it found five-year performance actually improved by 10 to 50 basis points, depending on management style and whether renewable energy stocks were added. Because some sectors like carbon-intensive energy carry specific risks, investors would do better to avoid them than to assume they need exposure everywhere, Dhillon says.

Not all researchers reach the same conclusion, however. MSCI finds that removing fossil fuel holdings from a broad index can diminish returns by 70 to 80 basis points over a five-year period. Broad market exposure, reflected in a best-in-class approach for SRI investors, remains important for ordinary investors who need to hedge against downside risk, according to Jennifer Bender, vice president for index research at MSCI.

“Walking away from certain sectors is … affecting your long-term return,” Bender says. “You definitely want to have a balanced [approach] across sectors.”

Money Talks, But Not Always the Loudest

In terms of working toward a better world, best-in-class gives investors a voice within companies that have the resources and reach to have significant impact, according to Laura Berry, executive director of the Interfaith Center for Corporate Responsibility (ICCR).

She notes how SRI fund investors roundly praised British Petroleum (BP) for pioneering solar energy and other renewables. That praise vanished after BP presided over the massive 2010 oil spill in the Gulf of Mexico, but Berry says it’s still crucial for investors to be at the table with major industry players.

“Who has the funding and the bandwidth to actually make a difference?” Berry asks. “Who underwrites academic research? Who spends lobbying dollars in the United States to influence regulations? I would argue that best-in-class investing … is going to influence companies with enough heft to deliver large-scale changes.”

Lobbying hard for better practices would be great, critics say, stocks-and-glassesif that’s what SRI funds really did.

Too often, they merely hold positions in companies deemed to be more responsible than their peers, or they press for disclosure reports that track – but do nothing to change – environmental or social footprints. That’s according to Michael Kramer, managing partner at Natural Investments, a Hawaii-based financial planning firm that rates SRI funds and gives mediocre marks for many that use best-in-class.

“Disclosing how you’re destroying the world doesn’t stop it,” Kramer says. “It doesn’t go far enough.”

Devotees to best-in-class investing say they remain committed to the approach as a means to hold down risks and press for social change. But as scrutiny grows, they’ll need to keep producing data to prove it’s working.

About the Author:

G. Jeffrey MacDonald is an award-winning journalist and author. He covers religion, ethics and social responsibility among other subjects for national news outlets. His stories have appeared in TIME magazine, The Washington Post, The Christian Science Monitor and many other publications. Check out his latest book, Thieves in the Temple: The Christian Church and the Selling of the American Soul, here.

The opinions, beliefs and viewpoints expressed by CSRwire contributors do not necessarily reflect the opinions, beliefs and viewpoints of CSRwire.

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