An adviser's guide to SRI

In this guide to sustainable responsible investment (SRI) Julia Dreblow explains what advisers should know about the history, regulations and fund options of SRI.

By Julia Dreblow

 
In this guide to sustainable responsible investment (SRI) Julia Dreblow explains what advisers should know about the history, regulations and fund options of SRI.
 
Over recent months I have received glossy, data-filled sustainability reports from Royal Dutch Shell, BP and BAT. If nothing else, the resources required to produce such detailed reports illustrate the lengths blue chip companies now go in order to manage and protect their reputations and related business risks.
 
Yet dealing with such challenges is not the sole preserve of multinationals. Recent media coverage of the Church of England's investment in payday lender Wonga has served to demonstrate that no organisation is immune to criticism – as well as highlighting the benefits of knowing where your money is invested.
 
SRI and includes green and ethical investment options as well as a range of other responsible and forward looking strategies. It offers clients the opportunity to reflect their own opinions through their holdings and benefit from investing in more positive companies and strategies.
 
With the growing importance of many environmental, social and governance issues, the potential benefits of offering SRI are significant. Discussing issues that are personally important to clients can also help build closer relationships by improving trust and understanding. Indeed doing so is a prerequisite for 'best practice', according to the Best Practice Standard for financial advisers, ISO22222.
 
As the dust settles post RDR, now is a perfect time to consider what all this might mean - and whether or not it is possible to offer top quality advice without offering clients the option to consider ethical, social or environmental issues. This guide text is an abridged version of one of the sections of my adviser website. The site includes a SRI fund database and client fact find tool and is based on over 20 years' experience this area. My experience in SRI includes 12 years at Friends Provident, where I ran their SRI proposition and seven years as a director of UKSIF, where I helped set up the first National Ethical Investment Week.
 
I hope you find this guide helpful and welcome any comments or questions.

What is SRI?

‘Sustainable and Responsible Investment’ (SRI), is the generic name for investment options which consider environmental, social, governance and/or ethical issues in detail. Within this field sits a diverse and dynamic range of investment strategies, styles and approaches.
 
Investment options which focus on ‘ethical’ or ‘values based’ issues are commonly known as ‘ethical investments’ - an area which in many ways represents the genesis of the now multi-trillion dollar international SRI market.
 
Many SRI options today focus on environmental, social and governance related business risks and opportunities rather than traditional ethical concerns.
 
Some SRI options invest widely across many sectors whereas others are highly specialised and concentrate stock selection in a small number of industries or types of business.
 
The diverse aims and objectives of different options result in a wide range of different investment strategies and outcomes which aim to meet many different client aims.
 
The issues that an SRI fund focuses on are often its primary ‘USP’ or ‘differentiator’ and the reason investors are attracted to it. However, not all SRI activity is restricted to specific funds. In some cases investment managers apply SRI strategies more widely, for example engaging with particular types of companies across their many portfolios to encourage more responsible business practices.
 
There are no fixed rules which specify how an SRI fund should operate or the issues they should consider. It is in fact incumbent on managers to decide whether or not their offering is promoted as being ‘SRI’ or ‘ethical’. The diversity which results offers advisers the opportunity to develop a wide range of tailor made investment solutions for clients and to demonstrate the benefits of seeking professional financial advice.

Regulatory considerations and best practice

As with any investment style there is no specific regulatory requirement for advisers to discuss ethical investment or SRI options with clients.
 
However, given the high profile of issues such as: directors' pay; climate change; the arms industry; corporate governance; human rights, and poverty, to name but a few, it is clear that public interest in SRI issues is high.
 
Enquiring as to whether or not a client wishes to reflect such issues in their investment strategy therefore makes sound business sense.
 
Although advisers are not obligated to ask clients about their ethical views, advisers are however required to assess investment needs and objectives on an individual basis.
 
Independent advisers are of course also required to be ‘fair, comprehensive, unbiased and unrestricted’, irrespective of chosen business models. As a result more and more advisers are including an ‘ethical question’ within their fact finds.
 
In addition to this, during 2012 the regulator (FCA) issued FG12/15 a document which mentioned SRI a number of times. The document stated that, for example, advisers who use panels should be able to ‘go off panel...for areas such as ethical/SRI investments...’. It also clarified that similar logic must be applied to model portfolios - stating that (to paraphrase) ‘solutions must meet individual client needs, rather than simply suiting adviser’s processes and tools’.
 
FG12/15 also used SRI as an example of an area that advisers can specialise in, stating that ‘Independent advisers can restrict themselves to only offering ethical/SRI products to clients who identify themselves as only being interested in that market’. This was however accompanied with the caveat that it is rare that entire product areas can be ruled out by any adviser – even those who specialise in particular areas – a caveat that ‘cuts both ways’.
 
In addition to this regulatory guidance there are also ‘best practice’ considerations.
 
Advisers who are working towards achieving the international best practice standard (ISO22222/BS8577) will be aware that fact finding clients needs in this area is part of this process.
 
In order for an adviser to achieve ISO status they must ask clients an SRI/ethical fact find question to identify whether or not there are: “... any ethical, social, environmental or religious issues you may like to take into account when considering where to invest.”

Additional research and analysis 

SRI funds are typically supported by specialist analysts who research relevant SRI issues for the benefit of investors. Their work typically complements, rather than replaces, research that is carried out by conventional fund analysts.
 
These researchers, who are often referred to as ‘ESG (Environmental, Social and Governance) analysts’, may work for a fund management firm or be employed by an external research organisation.
 
The level of integration between ESG analysts, conventional analysts and fund managers varies significantly.
 
In some organisations ESG analysts work closely with others sharing ‘material’ ESG information across all relevant investments. In other organisations these functions are separate and ESG analysts focus on gathering additional research and data for the benefit of ethical and other SRI portfolios only.
 
Other variations also exist, for example:

• some SRI fund managers are expert in their own field and do not require specialist support
• some fund management companies also employ external (sometimes ‘independent’) expert committees to guide the development of ethical strategies
• some funds have fixed SRI/ethical policies and make very few changes over time – whereas others have an ongoing programme of continual updates.

A shared history 

The first ethical funds which were made available to individual investors in the UK were launched in 1984 (the Friends Provident Stewardship range).
 
These and other early ethical funds initially adopted a range of largely traditional, ‘values based’ ethical criteria. They focused primarily on avoiding companies that were considered to be ‘negative’ or harmful to society, but also worked to support those that were considered to be more beneficial. From the early days those working behind the scenes also occasionally contacted companies to discuss contentious issues with their management.
 
Many of the ethical criteria - such as excluding companies involved in the manufacture of armaments, alcohol and tobacco, related to faith based concerns. These reflected the views of the earliest ethical investors many of whom were Methodists and Quakers. (The first ever retail ethical fund was launched in the USA in 1971 as a result of opposition to the Vietnam War.)

SRI and ethical issues

The main difference between SRI and other investments options is the level of attention they focus on ethical, social, environmental and governance issues which are often overlooked by other fund managers. The issues fund managers tend to focus on can be loosely grouped into the following four areas:
 
1. Ethical
 
The term ‘ethical’, as used by ethical and SRI fund managers, tends to refer to more traditional ‘values based’ issues (as well as referring to the funds that take these and other issues into account). This includes often not investing in area such as the following:

• tobacco
• armaments
• pornography
• alcohol
• animal welfare

2. Social 

The term ‘social’ is used by the SRI community to refer to issues that relate to people – and in particular the effect companies have on their many stakeholders. This includes areas such as:
 
• human rights
• labour standards
• child labour
• equal opportunities
• health and safety
• food supply chain

3. Environmental

The terms ‘environmental’ and ‘green’ are widely used by the SRI community. They generally relate to analysis of the ways in which investee companies are dealing with existing or emerging environmental challenges and opportunities. Examples include:

• climate change
• pollution
• loss of biodiversity
• resource management
• resource scarcity
• waste management
• nuclear
 
The terms ‘governance’ and ‘corporate governance’ relate to company management issues. Analysts are increasingly concerned with the way boards operate, as this is integral to long term business success. The recent financial crisis has raised the profile of this area amongst investors.

Example issues include:

• board structure
• executive remuneration
• bonus payments
• bribery and corruption
• tax
 
There are many different aspects of company activity which funds may be interested in. Some SRI fund options focus purely on what a company does, or manufactures – others pay close attention to the way they operate and how they treat their staff and other stakeholders. Many also take into account not only what a company is currently doing, but also its policies and plans.
 
The number of issues a fund, or other SRI options, is interested in also varies. Some are only concerned with how a company fares on a single issue (eg sustainability), whereas others take a range of considerations into account prior to deciding whether or not a company is suitable.
 
Across the entire SRI market there are hundreds of different issues which are researched by different fund managers and analysts. The lists above are simply a selection of common examples. Most of these can be broken down further into more specific areas which affect different industries in different parts of the world.

SRI and ethical investment approaches 

Sustainable and responsible investments offer a wide range of strategies by approaching different SRI issues in different ways. There are three main approaches. These are:

Positive selection, where a fund invests in companies that meet a certain set of criteria or standards. Themed SRI options generally ‘positively’ select organisations that fit within their stated objectives. Many ethical funds also employ positive screens.
 
Negative avoidance, where a fund excludes or ‘screens out’ companies that fail to meet certain criteria or standards. Ethically screened funds use a wide range of negative screens. Avoidance criteria may be extensive or limited, detailed or high level. Funds managers may exclude companies on an individual basis or avoid entire sectors.
 
Responsible engagement, where fund managers actively use their rights and responsibilities as investors to encourage companies to adopt higher environmental, social and/or governance standards - through dialogue or activism. Engagement of this kind normally only takes place when change is believed to be in the best interest of investors.
 
A fund may employ one, two or all three of these approaches within their SRI strategy, perhaps employing different approaches to different issues or challenges. In fact, most ethical funds use positive and negative criteria in tandem and many themed funds have areas they either explicitly avoid or do not hold because they do not fit with the fund objectives. The same fund managers may also work behind the scenes, engaging with companies.

SRI options in practice

Sustainable and responsible investment options combine issues and approaches in many different ways. Although SRI fund managers may agree on many things, they rarely have identical SRI strategies.

There are however some useful ways of grouping together funds which have broadly similar SRI strategies - by focusing on their dominant ethical, social and environmental characteristics. Although not scientific (as there are many areas of crossover), grouping funds into segments or styles can help advisers to make ‘like for like’ comparisons and identify relevant fund options more easily.

Ethical fund options

Ethical funds are those which consider ‘ethical’ or ‘values based’ issues, such as those listed above. Most however go well beyond considering such issues and consider environmental, social and/or governance matters also.   A common feature of ethical funds is negative screening - and this is perhaps the aspect these funds are best known for.
 
In many cases however this is not the full story as many ethical funds combine both positive and negative criteria.
 
Understanding how funds screen are combined is essential to understanding the ‘ethical’ area of the SRI market.
 
As a rule of thumb there are two prevailing ethical fund styles:

• Ethical funds which primarily apply strict negative criteria and consistently exclude certain industries or activities

• Ethical funds which combine and/or balance positive and negative policies in order to identify suitable investments

Example variations include the following:

• Some funds allow positive attributes to outweigh certain negative criteria - others do not.

• Many ethical funds allow limited levels of involvement in some excluded activities, for example allowing up to 10 per cent of company turnover from an excluded activity.

• Some funds invest in ‘best in sector’ companies across most business sectors and may have limited avoidance criteria.

• Some ethical funds are also subject to engagement strategies and some fund managers may engage with companies prior to disinvesting

Other less common ethical options include:

• ‘Faith Based’ funds, such as Shariah funds

• Lightly screened funds which exclude only a tiny fraction of the stock market (eg manufacturers of certain weapons)

Themed SRI options

Themed SRI options invest according to broad aims or themes which normally relate to environmental and/or social challenges or opportunities. These options have become popular over the last 15 years or so as they reflect emerging business and societal trends.
 
Managers of themed funds generally publicise the types of businesses they wish to invest in and work to identify potentially attractive holdings that fit within their stated aims.
 
These funds tend not to have screening criteria, although in terms of where they invest some funds are similar to ethical funds, others however are very different.
 
The need to move towards more sustainable lifestyles and business practices is essential to the long term success of many organisations and is rapidly emerging as a key ‘theme’ of our age. Improving levels of efficiency and developing new technologies to cope with resource scarcity and other environmental and social challenges is therefore increasingly important.
 
Managers of SRI themed funds recognise the growing importance of such issues to investors and are at the forefront of understanding how to integrate them into investment strategies. Some of the most common themed SRI approaches include:

• Sustainability themed funds – which select market leaders in industries such as transport, health, food, management of resources and waste

• Environmental funds - which invest in companies with strong environmental credentials • Funds that focus on a single issue eg climate change

• Funds that focus on a single resource or sector e.g. water

• Funds that specialise in market leading technologies and environmental solutions eg clean technology These highly diverse themes lead to a wide range of investment strategies and stock selection decisions. Some funds invest, or can invest, very widely and may suit a wide range of investors. Others are more specialist and are only likely to suit more experienced investors or those with larger portfolios. Again, this diversity can help demonstrate the benefits of seeking professional financial advice.

Engagement options

Responsible engagement strategies encourage companies to improve their management of environmental, social and governance risks and opportunities for the long term benefit of investors.
 
A pension disclosure requirement which was introduced in July 2000 meant that the first branded ‘engagement only’ SRI options were an immediate success with institutional investors. The new rules obligated schemes to disclose their approach to ‘Social, Ethical and Environmental’ issues for the first time.
 
Since that time ‘responsible engagement’ has gone from strength to strength, with major investors becoming increasingly interested in the way companies manage such issues.
 
Engagement strategies relate to assets already held by fund managers rather than to ‘buy/sell’ decisions. When applied on their own they do not normally directly impact investment management decisions. Strategies employed by these ‘responsible investors’ include dialogue with senior management and actively voting at AGMs and EGMs. Some fund managers now have significant teams which carry out activity of this kind.
 
Investor/investee relationships are generally respectful, with engagement largely conducted out of the public eye. Public spats are seen as neither helpful to the business (investee companies) nor to asset owners (fund managers and other investors) as they can impact share values.

But in 2012, in the wake of the financial crisis, this started to shift. Shareholders found their voice during what has been called the ‘Shareholder Spring’. A few (mainly governance related) disagreements spilt into the public domain and resulted in a number of high profile board level resignations.
 
‘Responsible engagement’ strategies are applied to tens of trillions of dollars of funds internationally, much of which is managed by fund managers with a strong UK presence.
 
This activity is generally under publicised in the (retail) advisory market. It is however potentially very useful for clients who are keen to encourage positive change and has the benefit of significantly expanding their range of options.

Meeting clients' needs

The SRI market is both diverse and dynamic. A wide variety of strategies and constant evolution is essential for a range of reasons, such as:

• individual investor's opinions, values and attitudes vary

• people’s investment aims, objectives and timescales vary

• few issues are truly ‘black or white’

• fund managers have different strategies and opinions

• most challenges and opportunities can be addressed in a number of different ways

• funds are run by different organisations

• ethical, social, environmental and governance related risks and opportunities are constantly evolving

• new issues emerge and existing issues can become less important or even irrelevant
 
In the early days of ethical investment issues such as opposition to Apartheid in South Africa and the hole in the ozone layer were key concerns. Environmental and social concerns remain important of course; however neither of these are viewed in the way they were twenty years ago.
 
Today new issues are increasingly taking centre stage which may or may not significantly impact company's ‘licence to operate’ or their ability to generate returns for investors. New and emerging issues include opposition to fracking, corporate taxation avoidance, water scarcity, food related challenges - such as rising prices and over-nutrification (obesity) – and of course, ‘pay day’ lenders.

Diverse and dynamic

Understanding how funds work in practice is essential as clients may be variously delighted or disappointed, depending on whether or not an investment matches their aims and expectations.
 
The diversity of fund strategies makes this quite complex - but it is always worth remembering that in terms of performance, generic fund management issues such as asset types, geographic exposure, fund manager skill, charges and timing often a have a far greater impact than SRI strategies.
 
In addition, investors’ aims and motivations can change over time. Today, many investors are keen to bring elements of their personal opinions into their financial decision making. Some are primarily motivated by profit, some are driven by clear ethical values – but most fall somewhere between these two groups and want to make money in a way that they feel makes sense.
 
One aspect that often surprises advisers is clients’ willingness to compromise if they cannot find a solution which matches their views precisely. It is common for investors to combine different SRI options and many people invest only some of their money in SRI options.
 
This does not mean a client is any the less interested in SRI or that an adviser should be put off discussing the area with them. Quite the opposite. It is more likely to be an indication that they are accustomed to making compromises in everyday life - and as such will be satisfied providing their views are understood and taken into account.

Next steps

Advising on this diverse and dynamic area can be both interesting and rewarding. With rapidly changing business strategies and high levels of public and media interest there is always a great deal to talk about with clients.
 
Once you feel comfortable with this area the best way to start is by adding an SRI question into your client fact find questionnaire. You can then consider the types of SRI options that may appeal to different clients. We hope you have found this guide of use and look forward to receiving your comments, questions or other feedback!

Please note: The opinions, beliefs and viewpoints expressed by our contributing authors do not necessarily reflect the opinions, beliefs and viewpoints of unbiased.co.uk.


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