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Monday, 3 September 2007

Investing beyond the bottom line - what does socially responsible investing mean and what role can the new index play?

Socially responsible investments (SRI) may currently account for less than half-a-percent of the South African investment market, but as an investor and a retirement fund member, you are likely to hear more and more about this kind of investing. Financial services companies are committed to promoting the social and economic empowerment goals in the Financial Sector Charter, and it is possible that if not enough is achieved voluntarily, the government may force your retirement fund to invest some of its money in these kind of investments. To focus attention on the triple bottom line of listed companies, the JSE Securities Exchange recently launched an SRI index. What does socially responsible investing mean and what role can the new index play?Socially responsible investing is the term used to describe investment decisions that are not based solely on financial grounds. Social and environmental considerations are also taken into account in the investment decisions.These investments are said to focus on the triple bottom line – society, the environment and the economy. In addition, socially responsible investors look for good corporate governance, which is regarded as the foundation for a focus on the triple bottom line.Socially responsible investors are said to be aware of the impact of their investments on the economy and seek to use that influence.Michael Leeman, a consultant to Frater Asset Management, says socially responsible investments (SRI) fall into two broad categories: primary investments and secondary investments.Primary investments are direct investments in companies, including small-to-medium enterprises, or projects, including infrastructure development. What are termed "real economy" or "targeted investments" fall into this category. The real economy, Leeman says, is an apparent reference to financing black economic empowerment (BEE) and targeted investments.In the Financial Sector Charter, he says, targeted investments are defined as the debt financing of, credit extension to, or equity investment in South African projects that address: Infrastructure, such as transport, telecommunications, energy, water, social infrastructure (health and education) or municipal infrastructure in underdeveloped areas; Agricultural development; Low-income housing; and Black small-to-medium enterprises.Most of the local SRI funds that focus on primary investments are bond funds, although there is one property fund, and about four funds that invest across asset classes – primarily or exclusively in private equity, unlisted bonds and project financing.Secondary investments are those in existing financial instruments, such as shares. These investments do not directly create jobs or provide infrastructure, Leeman says, but they give the investor the power to positively influence the behaviour of corporates and this, in turn, can have an effect on the real economy.The new indexIn May last year, the JSE Securities Exchange, together with the FTSE, launched the Social Responsibility Investments (SRI) index, which is made up of companies that comply with socially responsible criteria.The purpose of launching the index, the JSE says, is to "help focus the debate on triple bottom line practices", and recognise the tremendous efforts already made by South African companies in this area.The index should also make it easier for individual and institutional investors, including retirement funds, to identify secondary SRI opportunities.The launch of such an index may seem particularly pertinent in a developing country such as South Africa, but the local market is not breaking new ground by establishing an SRI index. Many established markets have socially responsible indices. The Dow Jones launched its first socially responsible indices in 1997. The South African index is made up of companies that are included in the JSE’s All Share index (Alsi). Participation in the screening process to become one of the companies included in the index is voluntary. If a company is excluded from the SRI index, it does not mean that it has failed to comply with the criteria. Some companies do not have the resources to participate in the screening process.However, some companies did fail the initial test to become part of the index when it was launched – of the 150 companies in the Alsi, 74 companies participated in the initial screening process and only 51 made it into the index. These 51 companies represent all sectors of the market, from banks to mines, healthcare companies and hotels. To be included in the index, companies have to complete a questionnaire, which is evaluated by an independent company, Sustainability Research and Intelligence. The JSE has also appointed auditing firm KPMG to assess independently the evaluation process and the reliability of the data submitted.Companies score points for the answers provided in the questionnaire. They have to achieve a minimum score, and they also have to score minimum points for each of the four evaluation criteria before they will be included in the index.Companies’ social responsibility is judged on the following criteria: Environmental sustainabilityCompanies are expected to answer questions about the impact of their activities on the environment and to ensure that they use resources in a sustainable way.The issues that are considered include the effect of the company’s activities on biodiversity, and whether it is responsible for any harmful emissions, abstraction of ground water and environmental rehabilitation.The indirect impact of a company’s activities is also assessed. The companies have to answer for projects in which they are involved or finance, the activities of their contractors or suppliers, and the use of their products or services.Companies are classified as low-, medium- or high-impact companies depending on the extent to which their activities have the potential to affect the environment. High-impact companies have to score more points on the environmental sustainability criteria than low-impact companies.
Economic sustainabilityCompanies are expected to show that they have a policy designed to ensure their own long-term economic stability and appropriate use of resources, and that they have not just positioned themselves for short-term profit-taking.Companies should have business targets and performance indicators or scorecards. In addition, they should be monitoring the economic impact of the company in the sector in which it operates, and should have an understanding of strategic risks and opportunities over the medium and long term. There should also be a commitment to protecting and valuing the company’s assets and intellectual property.A company’s focus on economic sustainability should be evident in its proper management of share incentive schemes, its insurance and contingency plans, the accountability of its board for remuneration, and sound auditing. Social sustainabilityCompanies that actively promote the development and empowerment of their employees – with set objectives relating to equal opportunities, including gender equality – will score some points. But companies also need to demonstrate that they are working on retaining, developing and satisfying their employees. They need to adhere to accepted labour standards and have good health and safety policies.Companies are expected to report on issues such as their principles of ethical conduct, how they deal with bribery and corruption, how they engage with stakeholders, HIV/Aids and corporate social investment. Corporate governance: Corporate governance issues include fairness, accountability, responsibility and transparency to all stakeholders. Companies are expected to demonstrate that they have policies and strategies that will lead to the achievement and maintenance of internationally recognised corporate governance standards and principles, such as those embodied in the King II report – a report released in 2001 outlining what local companies need to do to achieve good corporate governance.Companies have to pay attention to what their direct suppliers are doing, and ensure that their labour practices and environmental principles are sustainable.From time to time, an SRI Advisory Committee will review the criteria on which the social responsibility of companies is assessed. Companies included in the index will be reviewed annually in December. Results of the December 2004 review were not available at the time of going to press.Although the review is conducted once a year, companies can be included in the JSE SRI index or removed from it quarterly if, for example, they have been included or excluded from the Alsi.What to expect from the SRI indexThe JSE says of the 51 companies in the SRI index, 31 are large caps, 17 are mid caps and only three are small-cap companies.An analysis of the companies included in the SRI index at its launch by Dr Jaco Maritz, of Cadiz Financial Strategists, shows that 94.7 percent of the shares in the index by weight are constituents of the Top 40 index. The index is therefore expected to perform in line with the Top 40 index, but to under-perform it when large-cap shares are running and lose less when the prices of these shares decline. Maritz found that, as is the case with the Top 40 index, the SRI index is highly concentrated in the largest stocks, with Anglo American comprising 18.4 percent of it, BHP Billiton making up 12.6 percent of it and SABMiller 7.4 percent.Maritz also found that the SRI index was almost six percent overweight in resources when compared to the Top 40 index – a position that was largely offset by fewer industrial shares. As a result, he says, the SRI index is likely to underperform the Top 40 index when industrials rally, and to out-perform it when resources are doing well.Looking at volatility, Maritz says, the SRI index will have a higher volatility than the Top 40 index, probably as a result of the higher concentration in large-cap shares. The Top 40 index has a volatility of 21.4 percent – this means that the index can vary by 21.4 percent in a year, and there is a 66 percent likelihood that the index will move up or down by more than 21.4 percent in a year.The SRI index has a volatility of 21.8 percent, while the Alsi’s volatility is 20.3 percent.As a result of the similarity in the performance and risk profiles of the SRI index and the Top 40 index, Maritz says, it is likely that the SRI index will be most useful as a screening tool for SRI funds, rather than a performance benchmark or an index to be tracked by passive funds.He says any fund tracking or benchmarked to the index will perform in line with the Top 40 index and will have a similarly high concentration in certain shares as that index. It is more likely, Maritz says, that managers will use the SRI index as their universe and then take bets on shares within that universe.Nevertheless, the first retirement portfolio using the shares in the JSE SRI index as its investment universe has been launched: Futuregrowth’s SRI Equity Fund.Van der Vent says the fund has attracted R30 million of investors’ – mainly retirement funds’ – money since it opened in July last year. He says Futuregrowth will probably open the fund to retail investors as a unit trust fund next year.Why should you care about SRI?Alexander Forbes conducts a quarterly survey of Targeted Development Investments (TDI). According to this survey, about R9 billion is invested in socially responsible portfolios, such as retirement portfolios and unit trusts, in South Africa. This amounts to about 0.5 percent of the R1 700 billion invested in unit trust funds, shares, life assurance portfolios and retirement portfolios.Wayne van der Vent, a director of Futuregrowth, says the SRI market has shrunk from about one percent a year ago. Quite a few funds have been withdrawn as a result of poor performance, and others, such as those investing in black chips (companies owned by black people), found that their investment universe had become too small. top. One of the funds that disappeared was the Nedbank SI Index Fund, which was merged with the FTNIB Quants Core Equity Fund in November 2003, just over a year after the Nedbank SI Index Fund was launched in August 2002.Paul Hutchinson, the head of marketing at Nedcor Collective Investments, says the fund was closed for two reasons. Firstly, the fund had few assets under management – just over R1 million, which included the fund’s seed capital, and, secondly, it had less than 50 investors.Hutchinson says while Nedcor supports the launch of the JSE SRI index, it does not believe that such an index will result in greater flows into SRI index-type funds. Rather, it will provide these funds with a relevant benchmark against which to measure their performance, he says.Overseas there has been some demand for SRI funds, which started with institutional investors, Hutchinson says. This demand from institutions has not taken off in South Africa as yet.However, this may soon change following a Retirement Fund Reform discussion paper released recently by a National Treasury task team.The discussion paper recommends that retirement funds be allowed to invest up to 10 percent of their assets, by value, in "socially desirable investments" through collective investments or private equity schemes, "provided that it can reasonably be expected that such investments will yield a return of not less than the increase in the rate of inflation over the period of investment".The discussion paper also recommends that retirement funds be required to "state in writing, in a document to be distributed to their members and participating employer, whether they intend to invest any part of the assets of the fund in socially desirable investments which are likely to yield returns lower than those which may be expected of other investments by the fund".The National Treasury task team notes that fund trustees and asset managers have a tendency to take too short-term a view of investments and avoid making socially desirable investments unless they are "the least controversial" type – involving screening for good corporate governance, sound labour relations, environmental friendliness and so on."They appear not to appreciate that, unless there are fundamental changes to our economy, such as significant increases in employment, all retirement income is at risk. While fund trustees are not expected to make investments that will not result in a real turn, a measure of social investment by funds is appropriate and can contribute to our financial security and economic growth," the paper says.Leeman says a number of parallel trends are likely to stimulate socially responsible investing.One of these trends is evident in the Financial Sector Charter – a document signed last year in which 11 key financial sector groupings committed themselves to, among other things, empowerment financing and shareholder activism. The Financial Sector Charter and subsequent agreements, Leeman says, commit the financial services industry to spending R122.5 billion on empowerment financing.Empowerment financing is defined as the provision of finance for, or investment in, targeted investment and BEE transactions.BEE transactions, he says, are defined as those that enable black people to acquire direct ownership of an entity in the economy or for BEE companies to participate in joint ventures by way of debt financing or some other form of credit extension.In terms of the charter, each financial institution will have an empowerment-financing target equal to a percentage of its assets.Besides the Financial Sector Charter, Leeman says, at the Growth and Development Summit, which was held under the auspices of the National Economic, Development and Labour Council (Nedlac) in June 2003, business, labour and government agreed to work towards investing five percent of institutional funds in the real economy.In explaining its investment philosophy, African Harvest, which has two funds with socially responsible objectives, says it believes that investors need to take a wider view of their post-retirement standard of living, instead of only focusing on maximising the returns on their investments. African Harvest believes investors should also aim to achieve a prosperous and safe social environment and a country with sound infrastructure.Heather Jackson, the portfolio manager of the African Harvest/Nedcor Renaissance Fund at African Harvest, says the lack of any incentives or compulsion on retirement fund trustees to invest in socially responsible funds is a stumbling block to greater investment in the sector.Jackson says trustees are mindful of the responsibility they have and the fact that they may be held personally liable for decisions taken on behalf of retirement funds. This can deter them from making investments in terms of socially responsible criteria, she says.Leeman says the government will be loathe to make SRI mandatory for retirement funds, and will only do so if, within a reasonable period of time, there is little or no voluntary move to this kind of investing.Nevertheless, he says the mood towards socially responsible investing is changing and that role players are beginning to accept that it is a fact of life in South Africa. They are no longer debating the merits of socially responsible investing, but are discussing how to do it and what vehicles to use, he says.Different types of SRI fundsThe process of sorting companies into those that comply with certain socially responsible criteria and those that do not, is often referred to as screening.The kind of screening that is used to identify companies to be included in the SRI index is referred to as positive screening. Some investment managers also use what is known as negative screening, a process in which unsuitable investments are weeded out, because they do not comply with certain ethical or religious mandates. Funds that avoid the "sin stocks" – the shares of companies involved in alcohol, tobacco and gambling – use negative screening.Another kind of fund that uses negative screening is those that comply with sharia (Muslim law). Sharia-compliant funds avoid investing in companies that make money from interest or are involved with alcohol, pork products, gambling and tobacco.There are currently two sharia-compliant domestic equity unit trust funds, the Oasis Crescent Equity Fund and the Futuregrowth Albaraka Fund, and one sharia-compliant international equity unit trust fund, the Oasis Crescent International Feeder Fund.Van der Vent says arguments for classifying stocks as socially responsible can be equally countered with arguments for classifying them as socially undesirable.Tobacco manufacturing companies are a prime example, Van der Vent says. Although the nature of the business may be regarded as undesirable, a tobacco manufacturer’s business activities may be socially responsible. It may be a good corporate citizen, paying its taxes, treating all its employees and customers fairly and contributing to medical research.A fund that screens the companies in which it invests according to sharia may exclude a tobacco manufacturer, but other SRI funds will not.Leeman says some socially responsible investors do not screen their shares. Instead, they engage with the companies in which they invest, in an attempt to influence them to improve their social responsibilities. This is also called shareholder activism.The Fraters Earth Equity unit trust fund is actively involved in shareholder activism and the Community Growth Fund will also engage with the management of companies the fund believes are not complying with the fund’s own criteria.African Harvest offers another type of socially responsible fund. The African Harvest/Nedcor Renaissance Fund is an asset allocation fund, which makes equity investments that are not constrained by socially responsible criteria. Instead, a portion of its management fee and the initial fee (in the case of unit trust investments) is donated to organisations that oppose violence against women and children.Jackson says the benefit of operating such a fund is that its contribution to social development is immediate, transparent and measurable. However, she admits that donating management fees is not appropriate for all investments, because it may not be possible for asset managers to run a business profitably in this way.PerformanceSupporting a good cause does not necessarily mean compromising performance. In fact, two of the five equity unit trusts that invest in terms of socially responsible criteria, the Oasis Crescent Equity Fund and the Futuregrowth Albaraka Fund, have both recently had spells at the top of the performance rankings in the domestic general equity category.The Oasis Crescent Equity Fund was ranked first over five years to the quarter ended September 30, 2004, with an annual return of 25.02 percent after costs, according to the figures published by Professor Hugo Lambrechts. The Albaraka fund was third over the same period, with an annual return of 22.13 percent after costs. Over three years, the same funds were ranked eighth and seventh respectively.Adam Ebrahim, the chief executive of Oasis Group Holdings, says the reasons for the Oasis Crescent Equity Fund’s good performance include: A focus on shares that are "fantastically valued" – the fund takes a long-term view without worrying about short-term dips in performance. Thus, it looks for shares that will do well over five years and tries to buy them at the right time – when the market is softer or when interest rates or the exchange rate have brought down the price. Avoiding shares that are "big losers", such as those of companies that may collapse or have corporate governance shortcomings. The Crescent fund would not, for example, invest in companies with a high level of debt, a poor business model, or an inability to explain how they make their money. It would also avoid companies that damage the environment and are at risk of litigation. It would try to invest in companies that treat their workers well and therefore have higher productivity and less risk of strikes.The Alexander Forbes TDI Manager Watch survey records local SRI portfolios available to institutional investors that have a track record of more than a year. In the survey to the end of September 2004, most of the socially responsible funds outperformed their benchmarks over the longer three-year and five-year measurement periods (see page 40). The only exception was the Community Gilt Fund, which, over the five-year period, underperformed its benchmark. The survey also shows that the volatility of most of the equity, balanced and bond SRI funds is lower than the average volatility of all the funds in these categories.But good returns and relatively low risk have not always been the hallmark of socially responsible funds. Leeman says there is "unfortunately ample historical empirical evidence of significant funds being lost by retirement funds and others due to poorly conceived, mismatched and misunderstood SRI policies".He says in the mid-1990s, for example, there were significant misvaluations of infrastructure products and structured BEE transactions.The risk involved in SRI varies greatly, depending on what the fund invests in – listed instruments, or private equity and projects. In many cases, Leeman says, people’s perceptions about the risks involved do not match reality and do not take cognisance of the fact that risk can be managed. If we can manage the risks of mining gold, he says, why can’t we manage the risk of investing in toll roads, for example? - (PF, 3 Sep 07)
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