The Wall Street Journal: For Money Managers, A Smarter Approach To Social Responsibility

The old strategy was simple: Avoid sin stocks. These days, it’s a lot more sophisticated — and attracting the attention of mainstream firms.

By CAROLYN CUI
November 5, 2007; Page R1

Changes in investing are bringing the methods of so-called socially responsible investors and those of more mainstream investors closer together. It’s a trend driven by increasing sophistication among the former group, and concerns about global warming and other social issues among the latter.

Traditionally, socially responsible investing boiled down to avoiding “sin” stocks — purveyors of tobacco and alcohol, and weapons makers. But in the past few years, that philosophy has changed significantly.

NET BIG RETURNS, MAKE A DIFFERENCE
 
Now, while socially responsible funds still shun certain industries completely, some are putting new emphasis on researching and spotting companies that have well-thought-out strategies for dealing with environmental, social and governance, or ESG, issues.

Investment managers and analysts are developing formulas that take into account such issues as executive pay, carbon emissions and workplace gender diversity, along with traditional financial fundamentals. The logic: Companies that think creatively about how these issues affect the bottom line are likely to have an edge over rivals that don’t.

Pax World Management Corp., founded in 1971 as a way to invest without supporting the Vietnam war, has discontinued its policy of shunning alcohol- and gambling-related stocks after its policy forced the company in March 2005 to divest from Starbucks Corp. for licensing the Starbucks name to a coffee liqueur. Now, while they still decline to invest in weapons and tobacco makers, portfolio managers at the Portsmouth, N.H., firm, with $2.6 billion under management, weigh potential investments based on a mix of financial and ESG metrics, including corporate governance, community relations, product integrity, human rights and climate change.

Pax Chief Executive Joe Keefe is a proponent of looking at ESG issues. “Ignoring these factors is failing to take into account a company’s entire profile,” he says. “We believe that over time the second layer of research can add significant value to a portfolio.”

Sustained Effort

The trend is starting to have an impact on pension plans, mutual funds, exchange-traded funds and other products for individual investors as well. This month, Northern Trust Corp. expects to introduce a mutual fund based on the new Global Sustainability Index developed by KLD Research & Analytics, a Boston-based company that creates indexes based on ESG considerations. KLD formerly avoided sin stocks. Now it includes alcoholic-beverage makers in the new index if a firm uses responsible marketing toward younger people. The biggest stocks in its 686-component Global Sustainability Index include Microsoft Corp., Royal Dutch Shell PLC, BP PLC, HSBC Holdings PLC and Procter & Gamble Co.

Goldman Sachs Group Inc. released a 179-page report in July titled “GS Sustain” in which it recommended 44 companies based on a combination of companies’ ESG performance and fundamentals. Goldman argued that its picks based on this formulation, both in the U.S. and abroad, outperformed the Morgan Stanley Capital International World Index by 25% over the past two years.

State Street Corp.’s State Street Global Advisors, meanwhile, has been moving into some ESG-applied research for the past few years, because “we are seeing these factors start mainstreaming,” says William Page, chairman of the company’s ESG Team. Mr. Page says the team is using ESG research for accounts of some rich investors and private institutional investors, such as endowments.

Specialized ESG research firms are making headway. This fall, Merrill Lynch & Co. Inc. entered into an agreement with ESG specialist Asset4 AG to acquire a license to incorporate the Zug, Switzerland, firm’s information into its investment research and product structuring. Another company, Innovest Strategic Value Advisors, of New York, was founded in 1995 by Matthew J. Kiernan, a former partner with accounting firm KPMG LLP. Mr. Kiernan says traditional financial analysis captures only a quarter of a company’s risk and competitive profile.

For now, much of the interest in the ESG approach to investing seems driven by environmental concerns. A slew of so-called green funds that invest in alternative energy, clean technology or water resources have sprung up in the past few years. PowerShares Capital Management LLC, for example, started WilderHill Clean Energy ETF in March 2005, and the fund has since ballooned to $1.28 billion. Through last week, the WilderHill ETF was up more than 40% for 2007, vastly outpacing the broader market. Following that success, the Wheaton, Ill., ETF provider has rolled out four more green ETFs.

DWS Scudder, a branch of Deutsche Bank AG, recently set up DWS Climate Change Fund, which pledges to invest at least 80% of net assets in companies engaged in activities related to climate change. The HSBC Investments unit of HSBC Holdings plans to launch a climate-change fund early next month, which will invest in companies that aim to address or develop solutions to the issues presented by climate change. The fund will be available for investors in 35 countries, not including the U.S.; HSBC says it plans to introduce a similar fund in the U.S. early next year.

Price of Pollution

Of environmental risks to companies’ bottom lines, carbon emissions is probably the biggest.

“If you look at the carbon emissions, it’s an environmental issue, but we argue it’s also a business issue, because there is a price attached to it and it can be potentially very expensive,” says Mary Jane McQuillen, director of Socially Aware Investment for ClearBridge Advisors, the largest stock-fund manager of Legg Mason Inc. ClearBridge, which manages $108 billion in client assets, has two analysts dedicated to ESG research for its stock-selection process.

Oil giants, power plants, mining companies and steelmakers get blamed for contributing to global warming. The business risk is that they will face taxes or penalties as legislators around the world increase their efforts to reduce pollution. For instance, as of January 2009, New York and nine other Northeastern states will start a program to cap and trade carbon-dioxide emissions. Last year, California passed an act aiming to reduce the state’s greenhouse-gas emissions. And earlier this year, the U.S. Supreme Court ruled that the Environmental Protection Agency has the authority to regulate greenhouse-gas emissions as pollutants.

Investment funds holding stocks of electric utilities, coal producers, oil companies and other carbon-intensive sectors are starting to measure their exposure to risks like these, partly under pressure from investors. In September, the Carbon Disclosure Project, a nonprofit coalition of institutional investors with $41 trillion of assets under management, released its annual report based on a survey of more than 2,000 companies around the world.

Soon, U.S. mutual funds themselves will get measured based on their carbon “footprints,” or the collective carbon emissions of the companies they invest in, by Trucost PLC, a London research company that focuses on the environmental impact of business activities. The firm released a report in July 2007 that surveyed 185 U.K. investment funds and found 37% of the funds were exposed to greater potential carbon liabilities than the U.K.’s broad stock-market index.

Apart from tracking carbon footprints, however, skeptics remain as to whether a broad ESG approach to investing actually works. Some say the new approach still shares too much ground with the traditional world of socially responsible investments — the blanket ban on sin stocks — and these funds historically have tended to trail the broader market, as the additional screening process narrows down the selection pool and increases research costs.

Not in Vanguard

Some giant mutual-fund firms, like Fidelity Investments and Vanguard Group, have yet to warmly embrace the trend. A spokeswoman for Vanguard, which manages $1.24 trillion in more than 140 U.S. funds, says that its main consideration in investment and product-development decisions is “to generate wealth” for its clients.

At Fidelity, investment managers look at a variety of factors, taking into account whether the factor “has or could have a real and measurable impact” on a company’s earnings, says a spokesman.

Critics of the ESG approach cite a scarcity of corporate information on nonfinancial issues such as human rights, and a lack of methods for quantifying such matters. Skeptics think some such indicators are too subject to personal choices.

Still, a Mercer Investment Consulting survey last year found that investment managers around the world expect ESG’s influence to rise. Those surveyed cited corporate governance, globalization, climate change, sustainability and access to clean water as top issues. “There are some encouraging steps” at mutual-fund firms incorporating ESG issues in investment decision-making, says Craig Metrick, a Mercer consultant on socially responsible investment Mercer.

“But these are investment folks,” Mr. Metrick adds, “and they need to be convinced that these issues are material and will impact financial performance.”

A common method employed by ESG specialists is the “best-of-class” approach, in which researchers identify the most material ESG indicators — and there are usually hundreds — for a particular sector, give different weights according to significance, and rank companies based on their ESG performance.

One criterion that is closely studied is supply-chain management, particularly where international outsourcing is involved. While some Wall Street analysts will smile upon the use of outsourced suppliers as a cost-saving strategy, ESG encourages researchers to look deeper, checking to see whether such companies have inspections and testing procedures in place to make sure the suppliers are maintaining high standards, says Win J. Neuger, chairman and chief executive of American International Group Inc.’s AIG Investments. The recent troubles at toy maker Mattel Inc. are a textbook example. After its recall of millions of Chinese-made toys in August, Mattel’s stock slid markedly.

Not having controls in place “has created significant risks” for a number of U.S. companies, Mr. Neuger says. AIG Investments, with $711 billion under management, both for clients and its parent company, says it expects all of AIG’s portfolio managers and analysts to incorporate ESG issues into their research of companies. “It has become a more important and a more regular part of the process,” he says.

–Ms. Cui is a reporter in New York for The Wall Street Journal.

Write to Carolyn Cui at [email protected]