On Monday George Osborne, Shadow Chancellor of the Exchequer, announced his plans for a Green Environmental Market (GEM). This GEM, supported by The London Stock Exchange, will enable investors to track and invest in green firms in a simple way. Fiscal incentives are also promised. Ed Milliband has for some time been discreetly pushing the concept of a Social Stock Exchange. Later this week, at the Voice 08 conference hosted by the Social Enterprise Coalition in Liverpool, four of us will debate the merits of such an exchange—where “social” enterprises may access capital from social investors.
Is this just another bidding war between the two major parties trying to out-do each other in bold initiatives? Or is something more sustainable under way? In my view, we are witnessing the birth of a new investment concept namely, the social dimension to financial investing.
On entering the financial markets in the 1980s as an equity research analyst with PaineWebber, the influence of risk, or volatility, on financial returns was the “new frontier”. Fortunately, I had recently left business school and was fully clued up on beta and its impact on returns.
Decades of portfolio management thinking has developed around the concept of beta. Certain investors might have a higher tolerance for risk, purchase riskier assets and thereby, over time, enjoy commensurately greater than average returns. But these did not come for free; they were merely a compensation for the incremental risk assumed.
This has led to different risk profiles leading to vastly divergent portfolios. Those of pensioners would be heavily tilted towards lower risk assets; government guaranteed obligations, high-grade corporate debt, and perhaps some blue chip equities, while those at the other end of the spectrum, would contain high-risk assets such as growth stocks, riskier classes of debt, venture capital etc.
Now we appear to be crossing a new investment frontier. Sophisticated investors are voluntarily taking social, ethical and environmental “returns” into account in their investment decisions. These decisions have led to the very rapid growth of the socially responsible investment (SRI) fund management sector. This has mushroomed from zero to around £6 billion (IMA, Q4 2007) between 1984 and today. In this segment investors seek to varying degrees to deploy investment strategies that contain social, ethical or environmental elements.
There are varying approaches to SRI. One is called “negative screening”, wherein certain equities are excluded from investment based upon criteria of a purely ethical nature. Many proponents of the SRI approach argue that over time such an approach will actually yield better risk-adjusted financial returns, because social or ethical and environmental businesses are operating in sync with longer-term fundamental trends. Furthermore, these advocates contend that such companies are less likely to be prone to the kinds of accident which destroyed Enron. Another segment of the SRI market is commonly referred to as the “engagement” sector, where investors engage with corporates to improve their moral behaviour. Again, it is argued that this will also improve financial returns over time. However, there is little evidence that SRI funds consistently outperform the mainstream. On the other hand, there is little evidence that they under-perform the market. Thus investors in SRI funds, secure social returns for free.
There is also a growing number of companies that transparently offer investors below-market returns, which are increasingly being invested in by investors who are looking for social returns.
A good example of this is the Ethical Property Company (EP), on whose board I sit. EP has raised equity (roughly £10 million) from small investors and a few institutions in the UK. This is then leveraged with debt to purchase commercial property, which is then let to “social change organisations” (like Oxfam, Greenpeace, etc.) at a meaningful discount to market rents and managed in a more environmentally conscious fashion. Investors in these shares have, over time, earned a 5-6% return (half in dividends). This is a discount to listed property shares, but the investors make this trade-off consciously in order to gain the social returns generated by EP. Other examples of investable companies that offer a social return would be Cafédirect (Fairtrade hot beverages) and Divine Chocolate (Fairtrade chocolate). Rational investors will make such trade-offs in cases where they value the social returns generated more highly than the financial returns forgone.
In the early days of social investing, it was common to disparage such social investors. I believe that they are, in fact, making a sophisticated and rational trade-off between incremental financial and social returns. Companies and observers who continue to disparage such choices do so at their peril. Each of us, in our everyday lives, “purchases” social returns. We do so through charitable donations, in buying higher priced fair trade foods, through the installation of un-economic (still) solar panels on our roofs, etc. This is normal behaviour from an increasingly affluent society and is beginning to extend into the investment sphere.
Firms such as Investing for Good have sprung up to try to measure these returns. In various discussions with private bankers, IFAs and other financial intermediaries I have discovered a booming demand for such “socially advantaged” products. I confidently predict that measuring, accounting for and reporting on such social returns will be one of the fastest growing fields in the investment management industry over the next few decades. This is hardly surprising in our increasingly wealthy society, where non-financial returns are taking on an increasing importance.
So, in the new investment frontier, portfolio and share analysis will not only look at varying tolerances for risk but also divergent preferences for social, ethical and environmental returns. These returns are extraordinarily difficult to measure; it is impossible, for example, to compare the social worth of a school in Burma, with that of a 1% reduction in a company’s carbon footprint, or indeed an investment in a clean water supply in Mali. These are complex and probably unanswerable questions, but investors are demanding answers, or at least some guidance. Sophisticated firms servicing the investment community would do well to try to meet these needs.
Perhaps it’s time for me to go back to business school?
First published in the Financial Times in March 2008.