Handling with care
With growing interest from
institutional clients, ethical funds are on the rise. While the challenge for
fund managers to meet both financial and ethical demands remains, Frank
Figge says sustainable development and socially responsible investing go
hand-in-hand.
The market for investment products that
take environmental, social or ethical criteria explicitly into account has seen
impressive growth rates over the last few years.
However, ethical funds, as they are
often referred to, have not only outpaced conventional products in many
markets, they are now also making their appearance in markets which, according
to many experts, were unlikely candidates for ethical investment. This is the
case in Japan, for instance, where the first socially responsible investment
(SRI) product, launched in August 1999, raised more than US$ 1bn in its first
five months.
In recent months Europe has seen not
only keener interest on the demand side hut also broader product
diversification on the supply side. One reason for this is the mounting
interest of institutional investors which called for concepts that take their
specific investment needs into account. The new pensions regulations in the UK
are widely expected to fuel this demand further.
There are a number of terms used to
describe investments that take environmental, social and ethical criteria
explicitly into account in their investment processes. In the UK, the terms
'ethical investment' and 'socially responsible investments' are predominantly
used while the term 'sustainable investments' is starting to prevail over
'environmental' or 'eco-efficiency investments' in continental Europe. The
confusing use of such terms reflects the different expectations that investors
have with respect to this new investment style.
These expectations relate not only to
the environmental, social and ethical performance of these funds, but also to
their financial performance. Institutional investors, in parncu1ar are often
required by their own clients, or even by law, to aim for at least a return in
line with the market performance. Fund managers face the challenge of
constructing portfolios that fulfil all these expectations.
It is not the inclusion of
non-financial criteria that poses a serious challenge to fund managers. The
inclusion of non-financial criteria in investment decisions is actually not
even new for most banks. With its line of Islamic Funds, Pictet & Cie has,
for example, successfully managed funds that respect Koran investing laws for
several years.
Portfolio problems
The challenge lies in incorporating the
criteria in such a way that all expectations are fulfilled simultaneously. In
practice, most fund managers will struggle to construct a portfolio that meets
financial expectations while, at the same time, fulfilling environmental,
social and ethical expectations. This is distinct from the question of whether
good environmental or social performers are also good financial performers.
Most institutional clients need to
quantify the risk they are taking relative to a benchmark. The more the
universe which a fund manager can choose from differs from the benchmark, the
more difficult it becomes for the fund manager to construct a portfolio that
deviates only slightly from the benchmark.
The extra screening can impact the
universe in two ways. It can, on the one hand, have a limiting impact on the
number of companies which a fund manager can choose from. The smaller the
number of acceptable companies, the more difficult portfolio construction
becomes for the fund manager. It can, on the other hand, lead to a systematic
distortion of the universe.
If, for example, technology stocks
obtain, in general, a good ethical rating whereas automobile stocks are
generally qualified as ethical laggards, then the fund will be biased towards
technology stocks, thereby making sector diversification difficult. In such a
situation, financial performance will not necessarily be driven by
environmental or social performance, but by the sector allocation.
Whether a fund manager succeeds in
meeting investors' environmental, social, ethical and financial expectations
depends on two aspects.
On the one hand, investors will need to
give the fund manager the financial latitude to implement non-financial
criteria. A fund manager that needs to follow a non-ethical benchmark closely
will find it difficult to favour ethically-sound stocks in the portfolio.
On the other hand, fund managers are
likely to find it easier to implement investment concepts where financial and
non-financial criteria are mutually supportive. It is particularly in this area
that further progress needs to be made.
The concept of 'sustainable
development' forms a sound methodological basis for SRI for several reasons.
First of all, there is an overall consensus concerning the objective of
sustainable development. Secondly, it is in line with the explicit objectives
of many institutional investors.
With pension funds, for instance, their
function is to ensure payments in a distant future. Sustainable development is
fundamental in this context. Sustainable development encompasses, thirdly,
environmental, social and economic aspects, thus covering most of those aspects
that the majority of ethical investors would like to see included.
Sustainable development, therefore,
also forms the basis for the concept developed for Pictet Sustainable Equities.
Within this concept, investors can both choose and prioritise environmental,
social or financial objectives. An investor can, for instance, choose to accept
only a limited risk. The fund manager will then determine the degree to which
the other objectives can be taken into consideration in the portfolio.
For this purpose, he will be able to
use an optimisation technology developed for Pictet Sustainable Equities, which
allows him to maximise the environmental and social objectives within the
Constraints laid down by the investors. Portfolios created using this
technology go beyond the traditional financial efficiency of investments. They
are sustainably efficient.
Frank Figge is a consultant at Pictet Asset Management.
Pensions Week
24 July, 2000
Return to News Index |
