Chapter 8: SOCIALLY RESPONSIBLE INVESTING: A NEW TREND WHERE ETHICS DO MATTER

CHAPTER 8

Socially Responsible Investing: A New Trend Where Ethics DO Matter

WE MUST MAKE THE WORLD HONEST BEFORE WE CAN

HONESTLY SAY TO OUR CHILDREN THAT HONESTY IS THE BEST POLICY. – GEORGE BERNARD SHAW

FOR MANY INDIVIDUAL INVESTORS WORLDWIDE , it is no longer enough to know if a company makes money, but rather how it makes money. Socially Responsible Investing (SRI), virtually unheard of 30 years ago, has grown into an important component of global capital markets. According to the nonprofit Social Investment Forum, over US$2 trillion, or one dollar out of every eight dollars managed professionally, is invested according to some social criteria. SocialFunds.com reports that there are now almost 200 mutual funds utilizing social screens to select investments.

Shareholder Activism as an Important Economic Tool

Proponents of SRI use social or moral criteria when researching and selecting investments. SRI considers both the investor’s financial needs and an investment’s impact on whatever the investor uses as the ethical base. SRI incorporates three main strategies that work together to promote socially, ethically and environmentally responsible business practices, which, in turn, contribute to improvements in the quality of life throughout society. The three strategies are: screening companies for morally or ethically objectionable practices; engaging in shareholder activism to persuade companies to change certain behaviors; and community investing, which involves direct investment in disadvantaged communities.

Screening is the practice of including or excluding publicly traded companies from investment portfolios or mutual funds based on social, ethical and environmental criteria. Generally, social investors seek to own profitable companies that make “positive” contributions to society. Buy lists include enterprises with outstanding employer-employee relations, excellent environmental practices, products that are safe and useful and respect for human rights around the world. Conversely, they avoid investing in companies whose products and business practices are construed as harmful. WARNING : Terms like “positive,” “excellent” and “outstanding” listed above are relative to each culture or economy while the term “human rights” is considered by many Asian and African societies to be an invention of the West. For most of the world’s poor, responsible investing is a rich person’s game they may never get to play.

Community investment provides capital to people who have difficulty attaining it through conventional channels or are underserved by conventional lending

institutions. Of course, community investment means different things depending where you are in the world. Perhaps the best known community investment program in the world, micro-credit, originated two decades ago in Bangladesh with the Grameen Bank (winners of the Nobel Prize in 2006). The program targets landless/assetless borrowers (women are given preference and make up 90 percent of total borrowers). The loans, usually small (between US$25 and US$75), are collateral-free, and usually have a maturity of 50 weeks with weekly repayments. Borrowers have full freedom to choose the activity to be financed by the loan, which are mostly rural activities with short gestation and daily sales, such as poultry farming, petty trade and shop-keeping, cattle raising or handicrafts.

And if you are not looking to invest in the stock market, Australia’s Bendigo Bank has come up with what it claims to be the first “Ethical Investment Bank Account.” The unique option of this account: you can increase your support for the work of Oxfam Community Aid Abroad by electing to forego all or part of the interest on your savings. These proceeds are paid by the Bendigo Bank to The Ethical Investment Trust which then sends the funds to Oxfam Community Aid Abroad.

A Brief History of Socially Responsible Investing

The origins of ethical investing go back millennia. Early Jewish, Christian and Islamic laws laid down directives on how to invest ethically while Hindu and Buddhist doctrine dealt extensively with issues of wealth and its use. More specifically, Socially Responsible Investing grew out of opposition to US involvement in the Vietnam War. Many chemical and weapons companies were targeted by political campaigns because of their manufacture of weapons used by US forces. Also, during that decade, a series of social and environmental movements from civil rights and women’s rights to environmental movements captured media attention and raised issues about the social responsibility of world businesses. These concerns broadened to include management and labor issues as well as anti-nuclear sentiment.

The concept of social investing attracted even more media attention when it focused on ending apartheid (a formalized system of racial segregation) in South Africa. The South African divestment campaign, supported by both academic and international governmental institutions, eventually forced major multinational corporations out of South Africa. Soon after, partly because of this economic pressure, apartheid ended and democracy was brought to South Africa. SRI, which until then had been considered by big business to be nothing more than “feelgood investing,” finally matured into a major global investment phenomena.

The next step was logical. Investors began asking themselves if they could apply these same tactics to force change or divestment from corporations that were polluting, fostering abusive work regulations or supporting oppressive political regimes.

The Global Growth and Role of SRI

There are now at least three major stock indices that track the performance of global stocks that meet specific requirements for socially responsible investors. The best known and oldest of the three is The Domini 400 Social Index—a market capitalization-weighted common stock index. It monitors the performance of 400 US corporations that pass multiple, broad-based social screens. The Index consists of approximately 250 companies included in the Standard & Poor’s 500 Index, approximately 100 additional large companies not included in the S&P 500 but providing industry representation and approximately 50 additional companies with particularly strong social characteristics.

Second, the Dow Jones Sustainability Index was launched in 1999 as a group of indices (Dow Jones Sustainability Group—DJSG) that tracks the performance of the top 10 percent of the leading sustainability-driven companies in the Dow Jones Global Index of 2,000 firms. Corporate sustainability is a business approach that creates long-term shareholder value by embracing opportunities and managing risks deriving from economic, environmental and social developments.

In each of the 64 industry groups, the top 10 percent of companies in the investable universe is selected according to their sustainability performance score. The investable stocks universe consists of the 2,000 largest capitalized companies in the Dow Jones Global Index. Alcohol, gambling and tobacco companies are excluded. Also excluded in all DJSG indices are companies with more than 50 percent of sales derived from weapons and armaments (their weighting in the index is reduced in case 5-50 percent of sales are derived from weapons and armaments).

Finally, ARESE (a Paris-based investment firm that conducts research on corporate social, environmental and sustainability performance) recently announced the introduction of the ASPI Eurozone, which will track the financial performance of companies in the Eurozone that are leaders in sustainability. The Eurozone comprises the European Union member countries that have adopted the Euro.

Japan Gets in on the Act

A growing niche sector within the Japanese fund management industry is the so-called eco-fund market. Five major funds have so far attracted 190 billion yen (about US$1.75 billion), and their rate of growth is even faster than SRI funds in the US and Europe. The Japanese eco-funds, however, are not true SRI funds. Asset managers do not apply full social and environmental criteria in selecting companies for investment.

What selection that does occur is based on a combination of two criteria. In the first place, within an initial 600 Japanese company investment universe, the Nikko Eco Fund, for example, in co-operation with Good Bankers Co., applied a financial screen aimed at assessing the companies which show the best long term growth perspective. Secondly, an “ecological” screen was applied, comprising two

appraisals. The first one rated the company according to its “positive contributions to the environment” while the second one estimates to what extent—and how successfully—the company was “engaged in activities oriented towards environmental protection.” At the end of the process, the Nikko Eco Fund selected less than 100 of 150 companies considered as “candidates for investment.”

So far, none of the eco-funds in Japan have stated that they will shun certain sectors or companies on ethical grounds (e.g. tobacco, nuclear power, labor abuse). However, as competition in the eco-fund market heats up and differentiation becomes increasingly difficult, it is likely that ethical funds of varying themes will emerge in Japan.

Does it Cost You Money to be Socially Responsible?

There is no clear answer as yet. The fund rating service known as Morningstar analyzed 47 US mutual funds claiming to have socially responsible records of at least three years. Of those, 19 funds—or 40 percent—received a rating of four or five stars. Only 32.5 percent of all funds make it into these top two categories. US Domestic SRI funds returned 12.32 percent, beating the average US fund by 11.34 percent in a five year study ending in 1995. Also, the Domini 400 Social Index occasionally outperforms the S&P index.

But the results are not as compelling or as impressive as they may seem. The difference in performance of the Domini funds does not signal an inherent superiority of SRI funds but rather reflects the results of different industry “bets” implicit in the social screening process the index uses. If the Domini index had been re-weighted so that it matched the S&P 500’s macro-economic and industry exposures, the result would have been the same. NOTE : Of course, the statistics above do not include the foregone opportunity costs of not investing in some very profitable, but possibly questionable, firms. People pursuing an SRI strategy turn a blind eye to this cost in the name of virtue -- just like other investors do when a stock they didn’t invest in does well.

SRI and God: Investing Methods Based on Religious Values

Socially Responsible Investing now encompasses practically every set of values on the planet. There are funds for Christian Scientists (which don’t invest in pharmaceuticals), for orthodox Muslims (no investing in banks, due to Islamic principles proscribing the charging of interest), for conservative Christians (which avoid companies involved in pornography and abortion) and funds that screen for the more obvious “sin” industries, like traditional tobacco, alcohol, weapons, and gambling concerns, as well as for companies that fall short of various environmental, labor, and diversity criteria.

Islamic Investing

Islamic investing is a complicated business based on Islamic ethics and the body of law called SHARI’AH . Those ethics prohibit money going into companies involved in alcohol or gambling, for example. Also excluded are companies that make profits from interest (usury) payments, such as banks and insurance groups. That means 16 of the 30 stocks on Wall Street’s Dow Jones Industrial Average fall outside SHARI’AH .

Islamic investing, however, is probably the fastest-growing area of faith-based investing in the world. Islamic mutual funds worldwide are worth over US$500 billion and increase annually by 10-15 percent. Nearly half of them have been launched in the last 10 years. Dow Jones launched its own Islamic Market Index to track SHARI’AH -compatible companies and Germany’s No. 4 lending institution, Commerzbank, has launched its AlSukoor European Equity Fund, targeting Muslims in the Middle East as well as those living in Europe. AlSukoor raised US$50 million in its first three weeks alone.

Perhaps not so coincidentally, Islamic investing products are a suitable alternative for investors of other faiths, especially conservative Christians. Islamic funds avoid the same so-called sin stocks: alcohol, tobacco and pornography. They also avoid most conventional financial companies because Islamic law prohibits collecting interest on debt, and the ban extends to making money from a company that acts as a lender or a borrower. NOTE : Some of these Islamic funds faced their own ethical dilemma when it was discovered that some of their participants had links to terrorist organizations. A good faith attempt at ethical behavior often raises a new and unexpected ethical question.

Islamic funds avoid companies with debt-to-asset ratios higher than 33 percent and accounts-receivable-to-asset ratios above 45 percent. In addition, to be considered as an investment candidate, a company’s combined interest income and income from what Islamic law calls “inadmissible revenue”—revenue from sinful activities—must not top 5 percent of total revenues. That limitation necessarily excludes a lot of popular companies; Apple Computer and IBM Corp., for instance, carry too much debt. But it leaves roughly 650 global companies, worth nearly US$10 trillion, to choose from in the portfolio. A little sin is tolerated, but not too much.

Because of the prohibition on interest associated with debt, Islamic markets are also beginning to come up with alternatives to traditional bond investments. One US management firm is working with leasing companies to develop securities backed by operating leases, which don’t pay interest but rather a share of the leasing revenues, and could therefore be bought by Muslims. Firms are also working to develop a US version of a TAKAFUL , a kind of mutual-aid society that serves as an alternative to conventional insurance for Muslims.

NOTE : A good deal of Islamic strictures on “usury” rely on a very flexible set of semantics. House and car loans, where no profit will ever be derived through generation of business revenues, are structured so that the would-be owner of the house or car “buys” the bank out of the loan over time. Unsurprisingly, the buy out includes additional money that bears a striking resemblance to interest. Ethics can be flexible.

How an Islamic Mutual Fund Works

Islamic principles guide the US$24 million Amana Mutual Funds Trust Growth fund. Its return places it in the top 5 percent of Morningstar’s large-cap growth category. The fund shuns investments in businesses such as liquor, pornography, gambling, and banks and avoids bonds and other fixed-income securities. Any company dealing with pork or pork-related products is banned. All stock picks are submitted to a board of Islamic experts for review.

Muslims are encouraged by their faith to invest for the long-term, but Islamic ethics demand that Muslim investors pay ZAKAT —money or charitable works, which a Muslim of means must distribute among the poor every year. While its intention—to foster in Muslims the qualities of sacrifice and rid them of selfishness and greed—is highly noble, ZAKAT can play havoc with Muslim investment portfolios, especially if their portfolio gains may not be realized for years. Islamic jurists have agreed that to distribute ZAKAT sooner rather than later it is allowable to consider the difference in the market value of a portfolio from the beginning to the end of each Gregorian calendar year and pay 10.3 percent (10 percent for lunar calendar) of the gain, if any, as ZAKAT . There are dozens of ZAKAT calculators available on Islamic investing Web sites. The amount of ZAKAT an investor actually distributes remains an individual decision and most Islamic funds will allow investors to transfer shares directly into a charity’s account.

Values-based Investing: Down with Cultural Polluters

Values-based Investing is a strategy for people with a strong sense of religious or social belief wishing to invest in companies that operate in line with their personal values. For example, if pornography is offensive to you, would it bother you to learn that one of the companies in your portfolio was distributing pornography through a subsidiary business? What if you owned stock in a company that sounded harmless, but was actually a hard-core porn company?

By applying Values-based Investing filters to an investment strategy, an investor can rest assured that their portfolio is as clean as their conscience.

One of the better known filters is The Investigator. It began as a tool for investment professionals when the Institute for American Values Investing, an independent research firm, discovered that there were no opportunities for investors to screen their investments according to their values. The Institute defined the “negative” issues most important to the investors they represented. It identified pornography, abortion, anti-family entertainment and the active promotion of non-marriage lifestyles.