Getting to Grips with Some Ethical Issues

Financial Times. 7/11/01

Getting to grips with some ethical issues

Elizabeth Wine

With yesterday’s launch of the FTSE4Good socially responsible indices, ethical investing takes another step forward.

It’s high time. The movement for ethical, or “socially responsible”, investing (SRI) has been gathering steam, moving from the purview of a handful of principled—yet very different—retail investors to the big money institutions.

This week ABP of the Netherlands, the world’s largest pension fund with about $175bn in assets, said it would soon invest $200m in a socially responsible way. This is one of the most substantial steps on ethical investing by a pension fund, showing that large investors are willing to test the idea that SRI can produce market-beating returns as well as a clear conscience.

ABP is not alone. The California Public Employees Retirement System (Calpers), the world’s second largest pension fund, is interviewing managers to run its $1bn emerging markets portfolio in the SRI style.

The process has been under way in Britain. Last year the UK government required pension funds to disclose if they were taking environmental, social and ethical questions into account when investing. In April, Monetary Fund Management, which manages £100bn ($140bn) in assets, said it would vote against any FTSE 100 company failing to report on its environmental practices.

Those investors want standardization and benchmarks, which FTSE (owned by the Financial Times and the London Stock Exchange) and Dow Jones, with its own “sustainability index”, are trying to give them. So it would seem the efforts of the indexers are perfectly timed.

But even FTSE says its four indices—tracking 100 companies in the US, the UK, Europe and the world—are a work in progress.

For years the SRI movement has gained steam but the funds have been as varied as individual morality, making it very difficult for investors to make comparisons. Hence, the indexers’ attempts at standardizing what is essentially a subjective endeavour.

The original SRI funds simply omitted so-called sin stocks, widely recognized as makers of tobacco, alcohol, pornography, and weapons. This was OK for performance during a bull market, perhaps not so good during a downturn when these stocks can be good defensive choices.

The next step in the evolution was “green” funds whose primary concern was a company’s environmental practices. These avoid the obvious polluters, such as oil and gas companies. Again, fine during the bull market, but they have faltered since the downturn.

There were also funds focusing on social issues, such as a company’s record on promoting women and minorities to executive positions. Their performance has also been variable.

The trouble with these approaches, say some SRI specialists, is that they are all based on the principles of exclusion, rather than seeking the companies with the best overall records across the board—in ethics as well as financial performance.

These investors argue you should not exclude any company in any sector outright. Give Philip Morris a chance, they say.

But the committee of investors FTSE assembled to set the criteria of what is ethical decided against it. For now, anyway.

The committee based its choices for inclusion on three criteria: environmental practices, human rights, and relations with stakeholders—shareholders and companies with whom it does business.

Importantly, it allowed room for companies with flawed environmental or social records but a willingness to work on them.

If exclusion were permanent, there would be little incentive for companies to improve their practices. More pragmatically, if only the perfect made the cut, the index would be too small to be of use to investors.

But in the end, the committee opted to exclude some industries outright—there will be no tobacco, arms or nuclear power companies in the FTSE indices.

Mark Makepeace, FTSE chief executive, said the criteria would continue to evolve and these sector bands would not be permanent.

Other companies missed the cut simply because there was not sufficient public information to judge how good a job they were doing on social issues.

The expectation is that this will change. As regulators require more information, the indexers will improve their databases, enabling the ability to screen on a company by company basis.

Yet, even after the indexers have ironed out kinks in their methodology, ethical investing is likely to remain a retail niche if institutional investors do not see the impressive returns promised by SRI advocates.