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STANDARDS AND VALUES
The investment sector plays a unique role in promoting ethical practices throughout the economy. With well over three trillion dollars invested in socially responsible investments (SRI) worldwide, environmental, social, governance and ethical factors (collectively, “social impact factors”) have a demonstrable impact on investment practices. SRI investors utilise various methods of influencing corporate practice, including social screening of investments, that can ultimately reward positive social impact with greater access to financing. This paper proposes a method for incorporating social impact factors as a quantitative parameter in investment analysis and a means of facilitating such analysis in practice. These proposals have the potential to integrate social impact factors into quantitative portfolio management techniques that have traditionally been based only on risk and return.
174 Trust and Ethics in Finance
Social screening techniques within SRI
Very broadly, SRI is the inclusion of any social or ethical criterion in the investment decision-making process. The first instances of socially responsible investing may be the Quakers’ rules against investing in arms companies and engaging in the business of slavery as early as the mid-eighteenth century (Kinder, 2005; Kinder and Domini, 1998). Ethical exclusions remain common to this day, as they are applied by investors seeking to avoid companies that manufacture products such as weapons, tobacco, alcoholic beverages, gambling and controversial media. One shortcoming of this mode of SRI is that it is not often clear exactly which companies ought to be excluded from investment. Particularly as companies become larger, more global and increasingly diversified, it is not clear where to draw the line from an SRI perspective.
For instance, a large printing company that makes labels for cigarette cartons might be excluded by an absolute screen on tobacco if even a minuscule percentage of its profits are derived from such products. Furthermore, a company may be legally prevented from refusing to do business with a tobacco company, such as companies that are granted legally-protected monopolies (often in the transportation and telecommunication sectors) and can be required by law to serve all comers. The absolute nature of traditional ethical exclusions makes it increasingly difficult to apply them in a manner that reflects investors’ intentions without overly restricting the pool of investment opportunities for socially conscious investors.
Towards the end of the twentieth century the introduction of relative social impact ratings (in contrast with absolute ethical exclusions) enabled more fulsome comparisons of companies on the basis of their social impact. SRI research firms evaluate companies on the basis of a variety of non-financial criteria from a broad stakeholder perspective. Social impact ratings can incorporate environmental sustainability, labour relations practices, community involvement and corporate governance, Social Impact Ratings 175 among other factors. By relying on these broader social impact ratings, positive screening is able to overcome the identification problem encountered with ethical exclusions.
For instance, the social impact rating of a company that manufactures and promotes cigarettes would certainly suffer as a result of its product, while the social impact rating of a company that merely packages or transports the product may suffer only marginally, if at all. In addition, a relative social impact approach rather than ethical exclusion makes it possible to incorporate complex social and environmental factors that are not conducive to absolute determination of investment eligibility. Positive screening based on social impact ratings enables companies to be ranked along a spectrum of relative social responsibility.
A variety of social impact rating systems
Despite significant overlap in the factors assessed by social impact rating providers, the criteria and rating systems differ substantially among providers. Some examples are a numerical system of scores up to twenty (the Total Social Impact Foundation’s TSITM Ratings for S&P 500 companies), a letter category system ranging from AAA to D (Reputex Ratings & Research Services’ ratings for Australian companies) and a numerical range of positive and negative social impact ranging from +5 to -5 (dotherightthing Inc. ratings for specific events involving a given company). Other research providers offer a narrative assessment of a variety of social impact criteria for rated companies, rather than distilling the rating to a number or letter (e.g. KLD Research and Analytics, Inc. ratings for S&P 500 and Russell 3000 companies). A proposed means of moving toward a uniform social impact rating system is set forth below.
Social impact ratings can facilitate socially conscious portfolio management based on quantitative methods. In 2001, Summit Mutual Funds, Inc. introduced the Summit Total Social Impact (TSI) Fund. Rather than 176 Trust and Ethics in Finance resorting to ethical exclusions, the fund weighted its investments based on companies’ TSI Ratings. The fund included all S&P 500 stocks but re-weighted them on the basis of a social impact multiplier consisting of each company’s TSI Rating divided by the median S&P 500 score.
Thus, the fund over-weighted companies with higher social impact ratings and under-weighted those with lower ratings. Prior to its closure in 2005, the fund consistently outperformed the S&P 500 Index by about fifty basis points.
Portfolio social impact ratings
The assumption that investors make decisions on a portfolio basis is central to modern portfolio theory because the overall risk of a portfolio changes with the addition of investments that are not perfectly correlated. Hence the benefits of diversification, which can reduce portfolio risk without compromising the expected return of the portfolio. For socially conscious investors who adhere to modern portfolio theory, the introduction of portfolio social impact ratings can permit investment decisions made on a portfolio basis to consider social impact ratings as well as risk and return.
Unlike portfolio risk, which is a function of the correlation of returns from assets in the portfolio, the social impact ratings of individual companies are independent and uncorrelated. A portfolio social impact rating can be calculated simply as the weighted average social impact rating of the companies represented in the portfolio. Some issues that could make this calculation more complicated are whether equity and debt investments should be treated in the same manner, whether short positions should offset long positions in calculating social impact ratings and the treatment to be afforded to derivatives. Although these specific questions are outside the scope of this paper, the answers and the general calculation of social impact ratings would benefit from standardisation in order to achieve the full quantitative potential of social impact ratings.
Social Impact Ratings 177 Positive screening techniques demonstrate that social impact ratings can facilitate relative social impact weightings within portfolios rather than resorting to absolute ethical exclusions. Portfolio social impact ratings have the potential to promote a similar transition for the field of fund management as a whole, by facilitating social impact comparisons of all managed investment portfolios including SRI and mainstream investments. For example, retail SRI is presently dominated by a limited, albeit growing array of SRI mutual funds, so that there is an absolute distinction between SRI and mainstream investments for retail investors.
The application of social impact ratings to retail investments is particularly relevant, as SRI mutual funds have recently been the fastest growing segment of SRI in the United States. As there is already competition among SRI and mainstream fund managers for the attention of socially conscious investors, the ability to make social impact comparisons on the basis of portfolio social impact ratings could encourage mainstream fund managers to consider social impact in their portfolio management decisions, though not necessarily at the expense of traditional risk and return criteria.
The identification of a “socially dominant portfolio”
When selecting from among multiple portfolios with similar risk/return characteristics, the socially conscious portfolio investor prefers the portfolio with the highest social impact rating. In other words, a portfolio with a higher social impact rating and given risk/return characteristics dominates (is preferred to) a portfolio with a lower social impact rating and the same risk/return characteristics. Similarly, a portfolio with a given social impact rating and more favourable risk/return characteristics dominates a portfolio with the same social impact rating and less favourable risk/return characteristics.
In practice, the socially conscious portfolio investor first identifies the risk-efficient portfolio(s), relying on modern portfolio theory. Given 178 Trust and Ethics in Finance multiple portfolios with a similar degree of risk, the portfolio with the highest expected return dominates. Given multiple portfolios with the same expected return, the portfolio with the lowest degree of risk dominates. The Sharpe ratio is a convenient tool for analyzing expected return and risk in a single measure of the risk-adjusted performance of an asset, portfolio or trading strategy. The Sharpe ratio measures excess returns over the risk free rate divided by the variability of those excess returns, as measured by their standard deviation. According to modern portfolio theory, a portfolio with a higher Sharpe ratio dominates one with a lower Sharpe ratio, subject to any independent parameters, such as the investor’s minimum required return and/or maximum level of acceptable risk. The rational investor selects the portfolio with highest Sharpe ratio among those that satisfy the independent parameters, if any.
If multiple portfolios offer the same risk-adjusted returns as measured by the Sharpe ratio, those portfolios are equally risk-efficient. Provided more than one of these portfolios meets any applicable required return and/or maximum risk parameters, the investor must select from among multiple portfolios. In such cases, portfolio social impact ratings can facilitate the identification of a “socially dominant portfolio”. The socially conscious investor selects the portfolio with the highest portfolio social impact rating from the risk-efficient portfolios.
In search of social impact rating standards
Despite the analytical potential of social impact ratings, most investors are unable to implement even the simple portfolio management technique described above. Because fund managers generally do not release detailed information regarding their portfolio holdings, most investors lack the information necessary to calculate portfolio social impact ratings. Furthermore, the process of obtaining social impact ratings and most underlying company data can be time-consuming and costly, even in cases where it is publicly available. Finally, ratings prepared by difSocial Impact Ratings 179 ferent social impact researchers are not generally comparable, as there is no universal standard for the criteria and calculation methodology of social impact ratings. In order to fully harness the quantitative potential of social impact ratings, it is necessary to develop a widespread, standardised rating system.
The United Nations’ Principles for Responsible Investing (the “UN Principles”, launched in 2006 as an initiative of the UNEP Finance Initiative and the UN Global Compact) have been signed by over 150 signatories including institutional asset owners controlling over two trillion dollars, investment managers managing over three trillion dollars and professional service partners. The UN Principles could form the foundation for standardised social impact ratings. The first and third UN Principles (UNEP Finance Initiative and UN Global Compact, 2006) read, in
part, as follows:
1. We will incorporate ESG [environmental, social and governance] issues into investment analysis and decision-making processes.
• […] Support the development of ESG-related tools, metrics and analyses […];
• Ask investment service providers (such as financial analysts, consultants, brokers, research firms, or rating companies) to integrate ESG factors into evolving research and analysis […].
3. We will seek appropriate disclosure on ESG issues by the entities in which we invest.
• […] Ask for standardised reporting on ESG issues (using tools such as the Global Reporting Initiative);
• Ask for ESG issues to be integrated within annual financial reports […].
The signatories to the UN Principles clearly acknowledge that social impact factors are relevant to investment analysis. However, being basic 180 Trust and Ethics in Finance principles rather than clear rules, the UN Principles are not specific enough per se to facilitate the incorporation of social impact ratings into the quantitative methods that are central to contemporary investment management. The following discussion proposes a voluntary compliance system of uniform global social impact rating standards (the “Standards”) designed to standardise the criteria and calculation of social impact ratings in order to supplement these aspects of the general UN Principles with specific Standards. The Standards would afford incentive for companies and fund managers to comply voluntarily, despite the associated costs. By setting out clear requirements for compliance, the Standards would also provide a convenient avenue for focused investor pressure to encourage compliance by companies and fund managers.
Rules rather than principles
The most viable means of encouraging uniform social impact ratings and disclosures would be a system of voluntary compliance, similar to that employed by the existing UN Principles, but based on specific rules rather than broad principles. This means of implementation could be conceptually based on the Global Investment Performance Standards (GIPS®), which were introduced in 1999 and are administered by the CFA Institute’s Centre for Financial Market Integrity. The GIPS are based on rules rather than principles and are widely recognised as the current global best practice in investment performance reporting. While compliance is not mandatory, investment managers claiming compliance with the GIPS must make a variety of prescribed disclosures, avoid other prohibited disclosures and rely on pre-defined uniform calculation methodologies in reporting past performance. The GIPS have fostered investor confidence throughout the world by ensuring “fair representation, full disclosure and apples-to-apples comparisons” (CFA, 2005) among compliant fund managers. They have been adopted as the counSocial Impact Ratings 181 try standard for performance reporting in 26 cases, including several developing countries.
The issue of compliance The proposed Standards would require companies claiming compliance to publicly disclose a standardised rating calculated according to the prescribed methodology together with certain underlying factual disclosures (e.g. workforce demographics, details of environmental impact etc.). Like the GIPS, the Standards would be based on rules rather than principles. In practice, companies could engage independent rating providers to produce these ratings in much the same manner as companies engage credit rating providers to assess their creditworthiness. In turn, investment managers could claim compliance with the Standards only if the underlying company social impact ratings and the methodology used to compile the portfolio social impact ratings are prepared in accordance with the Standards. To be successful, the Standards would have to be general enough to provide meaningful data for comparisons among companies and fund managers yet specific enough for those comparisons to offer substantive value to socially conscious investors. They would also have to be adopted by a critical mass of companies and fund managers.