Values-Based Investing Moves Into the Mainstream

Jan 09, 2014

As companies awaken to the financial potential of sustainable practices, investors have more opportunities than ever to align their personal values with a growing portfolio.

In August 2011, we published the whitepaper "Values - Based Investing Comes of Age," detailing the rapid rise of investor interest in strategies that help society and the environment while also seeking competitive returns. That momentum continues. In the past two years, 387 more fund managers have signed on to the United Nations Principles for Responsible Investment — bringing the total to 1,100 managers representing $32 trillion committed to values-based investing (VBI) worldwide1. In the United States alone, according to a new study by US SIF Foundation, VBI accounts for $3.74 trillion, or roughly one in every eight to nine dollars under professional management. That is up 22% from $3.1 trillion in the organization's 2010 report, and 38% from its previous study released in 2007, compared to a 33% jump for U.S. assets under management in general.

With this trend has come a similar expansion in the array of VBI approaches and strategies, along with a noticeable uptick in their sophistication. Equally striking is the shift in attitudes toward VBI in the business and financial communities. Those of us who have closely followed the rise of social investing recall the not-too-distant days when companies could (and largely did) ignore the phenomenon. Investing with values rather than pure returns in mind was seen as a feel-good gesture practiced by a relative handful of outsider investors. Companies, meanwhile, stressed their responsibility to maximize shareholder value — businesses, after all, are businesses, not nonprofits, corporate managements were quick to point out.

Now companies routinely tout their commitment to ESG — that is environmental, social and governmental issues. Some of this is no doubt motivated by public relations — a practice sometimes referred to as "greenwashing" in the environmental context. But more companies also seem to recognize the logic of what VBI proponents have long understood: Contrary to being a drag on a company's investment profile, sustainable and socially responsible practices may actually correlate with higher returns.

The data are certainly compelling. A May 2012 Harvard Business School study, for example, found that $1 invested in a portfolio composed of "high sustainability" companies (those that voluntarily adopted VBI-friendly social and environmental policies) in 1993 would have been worth $22.60 by 2010. That same dollar, invested in a control group, would have grown to only $15.40.2 A more focused September 2012 report by Osmosis Investment Management, published online by Harvard Business Review, found that a portfolio of global companies meeting high standards for energy efficiency outperformed the MSCI World Index in each year from 2005 to 2012.3 The Osmosis study even seemed to draw a positive connection between the level of commitment displayed by corporations to sustainability and the size of their profit margins. Over the last seven years, energy-aware companies produced wider net margins by a factor of two — 12.7% vs. 6.3% — compared with the average of the companies in the MSCI World Index.

Of course, it's important not to draw too many conclusions about the exact relationship between sustainability and profitability. Few studies have been able to tease out whether it's sustainable practices, per se, that drive higher profit margins, or whether the corporate cultures and managements of companies committed to environmental, societal and governance issues are just generally more innovative and efficiency-minded than those at companies with lower ESG grades, and would tend to be more profitable and beat the stocks in the benchmarks anyway. But from the perspective of investors, and increasingly companies themselves, it almost doesn't matter. "I've been looking at shareholder advocacy for decades, and I've definitely seen a sea change in corporate attitudes in recent years," says Meg Voorhes, deputy director of US SIF, and co-author of her group's 2012 study. "More and more managements seem to realize that a solid commitment to sustainability is good for their image with the public and their customers, and for their corporate financial performance over time."

The Sustaining Power of Sustainability

It's still too early to call VBI the "new normal." Despite its increasing popularity, the approach still represents a segment of the overall investing market rather than a pervasive set of principles that are part of the standard process by which institutions and individuals make their investment decisions. Powerful forces are afoot, however, that could eventually make VBI as integral to crafting an overall portfolio strategy as paying attention to interest rates or commodity prices.

With rapidly growing emerging markets creating hundreds of millions of new consumers and vying with the developed world for finite resources, the next several decades are shaping up as a make-or-break era for a number of critical global concerns with far-reaching economic as well as social and environmental implications. The Sustainability Research team for Bank of America Merrill Lynch Global Research has identified several of these "sustainability megatrends" that are likely to inform international markets and politics for decades to come. Rising global water demand, for example, may mean that half the world will live in a state of "water stress" by 2030, but it also creates opportunities for companies (and their investors) that come up with innovations for water treatment and infrastructure, or that simply find ways to use water more efficiently in their own operations. Similar opportunities arise from surging energy needs, with global demand expected to rise by 50% by 2030, and even in solving the global obesity epidemic. Given the number of companies and sectors (technology, energy, agriculture, pharmaceuticals, etc.) that will either meet these challenges or fail by not meeting them, sustainability begins to look less like a niche and more like a mirror image of the economy itself.

Seeking the Best Managers

Investors now have access to an unprecedented array of vehicles to access VBI strategies. They include not just the socially responsible mutual funds that have long dominated the segment, but also exchange-traded funds (ETFs), private-equity (PE) funds, venture capital funds and closed-end funds, almost all with specific SRI mandates. There are faith-based funds that strive to invest in companies committed to responsible labor practices, and environmentally focused funds that make energy efficiency a high priority. Advisors can play an important role here: in tailoring a portfolio of managed solutions that meets specific values while accounting for time horizon and a risk profile to achieve your particular investment objectives.

However, the profusion of choices also increases the importance of due diligence in narrowing the field to the managers with the most active, innovative values-based strategies, says Anna Snider, global head of Equity Due Diligence at Bank of America Merrill Lynch. In part, that's because VBI standards are in flux. There are no universally agreed-upon methods for evaluating companies — their risks and their growth potential — along socially responsible lines. What's more, the mechanisms that VBI fund managers use to isolate investment opportunities are mostly proprietary. But that's where Snider's group comes in. Searching from a pool of, say, 30 fund managers offering values-based public equity strategies, "we may wind up focusing on three to five to offer to our advisors and their clients," she says. "And the mechanisms they use have to make sense to us. You have to prove that there is some experiential or academic basis for the use of any particular ESG factor. Not everyone's going to get this approach right, and it's a skill that not everyone has, especially because this is still a relatively young field."

In the early days of socially responsible investing, the process used by fund managers to build their portfolios chiefly entailed screening out companies deemed undesirable because of their practices or industries — big polluters, for example, or manufacturers with poor records of occupational health — a relatively straightforward if somewhat crude approach. So-called "negative screens" are still used to reduce the universe of investment possibilities to a manageable set of potential targets; but increasingly, Snider explains, the best fund managers apply a much more rigorous fundamental analysis to each stock. "Today we're looking for managers who take a deep dive, company by company, and are using ESG-based policies and practices to unlock additional value relative to others in their sector," she says.

The sweet spot for a VBI is often where a company has discovered how to use socially responsible behavior to actually improve its operations. For example, an innovative process designed to recycle a manufacturer's factory waste might give the company a competitive advantage over its peers. Or a company's effort to promote diversity on its board of directors could lead to better decision-making and a stronger business over the long haul.

The successful VBI fund managers, Snider says, also know how to balance their portfolios against other macro risks. Many funds that have environmentally sustainable mandates are light on exposure to oil producers, for example. If petroleum prices spike, these funds could risk underperforming the broader market, but well-managed funds will try to make up for that variance by replacing the exposure with other, more environmentally friendly energy companies.

Metrics to Identify Risks

Along with the growth in VBI choices has come increasing sophistication in the metrics by which individual, private investors can gauge their values-based investments. In place of screening techniques that once ruled out entire sectors for their environmental and societal costs, today there are tools like the Who Does What Where (WDWW) service from Merrill Lynch that go stock by stock to analyze the ways that ESG considerations can affect a company's (and an investor's) financial performance. Based on the thesis that there are inherent risks for operating in countries or regions with poor records on environmental controls, limited political freedoms or rampant corruption, WDWW ranks 214 countries and then rates the approximately 5,000 stocks covered by BofA Merrill Lynch Global Research on a scale of 0 to 100 in accordance to its geographic sales and assets exposure.

Now Merrill Lynch has teamed with London-based CAMRADATA Analytical Services to enable institutional and select wealthy individual investors to personalize this global WDWW data to systematically quantify the level of ESG risk across their entire portfolios. The 20-page ESG Geographic Portfolio Analysis assesses an investor's holdings based on the WDWW risks of the companies and funds in the portfolio, then compares the results to a variety of global indexes to arrive at a kind a of VBI beta, if you will.

"The report sheds light on where your risks are, your highest-risk stocks and how your risk has been evolving over time," says John King, vice president with the BofA Merrill Lynch Global Research ESG & Sustainability Research team. "It's like any stress-testing we might do to model out the risks posed by recession or higher energy prices or any other sort of economic headwind."

Inroads to Shareholder Advocacy

Socially responsible investing doesn't begin and end with gaining exposure to companies already behaving in line with your values. In an age when more and more company managements are recognizing that a commitment to ESG can improve shareholder value — and the CEO's own job prospects along with it — individual investors have the power to effect real change.

The primary vehicle is the shareholder resolution and the proxy vote. Akin to plebiscite legislation in government, shareholder resolutions submitted as part of companies' annual proxy statements may call for a company to clean up emissions, for example, or to rein in executive pay, limit political spending, eliminate animal testing or ensure that its overseas partners pay their workers fair wages.

In past decades, corporate boards often dismissed shareholder advocates and their resolutions as irritants or gadflies — unless those shareholders owned enough stock to demand a seat at the negotiating table. Even other shareholders tended to view resolutions as coming from cranks and malcontents working against the interests of the company, according to the Social Investment Forum.6 Today, however, shareholder resolutions are greeted with much greater respect. Although shareholder resolutions must win the support of more than 50% of the shares voted to pass, Securities and Exchange Commission rules generally allow resolutions that achieve at least 10% support to be resubmitted in the next proxy.7

While only the most active and vocal shareholders (often large institutions) have the resources to draft and submit resolutions, any shareholder can have a voice by voting on those resolutions. In particular, wealthy investors with holdings in managed accounts enjoy extraordinary (though often untapped) voting leverage. Unlike investors in traditional mutual funds, whose managers hold company shares and voting privileges, investors in managed accounts own the underlying shares and hence have the right to vote. Just a handful of managed accounts in a portfolio may represent ownership stakes and voting rights in hundreds of companies. "Investors sometimes aren't even aware they have this power," says Kimberley C. Paris, a director of the Merrill Lynch Managed Solutions Group.

Actually harnessing that power, though, presents logistical challenges. It's time-consuming enough to read and digest a single corporate proxy statement. Plowing through 300 to 400 proxies would amount to a full-time job. As a result, many potential votes remain uncast, Paris says.

To ease the burden on individual investors, a number of corporate governance specialists have developed services that enable investors to vote their shares easily and seamlessly. As of this fall, for example, clients holding managed accounts through the Merrill Lynch Private Banking and Investment Group can access a service whereby Institutional Shareholder Services (ISS), a leading corporate governance specialist, will comb through all the pending ESG-related resolutions in their portfolios. Clients can authorize ISS to then vote all of their shares automatically based on criteria from the United Nations Principles for Responsible Investment, European Union directives, the Interfaith Center on Corporate Responsibility and other established ESG authorities.

One person's vote still isn't likely to tip the scales on a specific shareholder resolution. But voting on hundreds of resolutions rather than on just a few amplifies an investor's voice substantially, Paris observes. "There's a real ripple effect in more people casting more votes," she says. "Shareholders are figuring out ways to come together and have an influence."

Those words might also apply to VBI as a whole. Values-minded investors have always been driven by the motivation to do good and have an influence. Indeed, it's the ability to maintain a healthy balance between helping the world and looking after one's own best interests that has helped VBI move into the mainstream. With the business community recognizing that its own motivations are much the same, VBI looks less like a trend and more, perhaps, like the face of a future where everyone stands to profit.

1 United Nations Principles for Responsible Investment Annual Reports 2011 and 2012

2 Robert G. Eccles et al., "The Impact of a Corporate Culture of Sustainability on Corporate Behaviors and Performance," Harvard Business School, May 9, 2012,

3 "Companies That Invest in Sustainability Do Better Financially," HBR Blog Network, Sept. 19, 2012, Past performance does not guarantee future returns.

6 US SIF Foundation, 2012 Report of Sustainable and Responsible Investing Trends in the United States, page 70.

7 Ibid, page 50.

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