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Home > Asset Management Best Practice > Ethical Funds and Socially Responsible Investment: An Overview

Asset Management Best Practice

Ethical Funds and Socially Responsible Investment: An Overview

by Chendi Zhang

Executive Summary

  • Ethical funds, also known as socially responsible investment (SRI) funds, have experienced rapid growth around the world. Issues such as global warming, corporate governance, and community involvement have gained significant attention from governments and investors.

  • Maximization of stockholder value often conflicts with the interests of other stakeholders in a firm. Corporate social responsibility (CSR) plays a role in reducing the costs of such conflicts.

  • Empirical research shows that the following components of CSR are associated with higher stockholder value: good corporate governance, sound environmental standards, and care of stakeholder relations.

  • Existing studies hint, but do not unequivocally demonstrate, that SRI investors are willing to accept suboptimal financial performance to pursue social or ethical objectives.

  • Given the growing social awareness of investors and the increasingly positive regulatory environment, we expect SRI to continue its growth and relative importance as an asset class.

The Rise of SRI

Ethical funds, often also called socially responsible investment (SRI) funds, integrate environmental, social, and governance (ESG) considerations, or purely ethical issues, into investment decision-making. SRI has experienced a phenomenal growth around the world. According to the Social Investment Forum, the professionally managed assets of SRI portfolios in the United States, including retail and, more importantly, institutional funds (for example, pension funds, insurance funds, and separate accounts), reached US$2.7 trillion in 2007, or approximately 11% of total assets under management in that country. The European SRI market is also growing rapidly. In 2007, SRI assets in Europe amounted to €2.7 trillion, representing 17% of European funds under management (European Social Investment Forum).

Although ethical investing has ancient origins that were based on religious traditions, modern SRI is based more on the varying personal, ethical, and social convictions of individual investors. Issues such as environmental protection, human rights, and labor relations have become common in the SRI investment screening process. In recent years, a series of corporate scandals has turned corporate governance and responsibility into another focal point of SRI investors. Hence, criteria such as transparency, governance, and sustainability have emerged as essential in SRI screening.

Over the past decade, a number of national governments in Europe have passed a series of regulations on social and environmental investments and savings. For instance, the United Kingdom was the first country to regulate the disclosure of the social, environmental, and ethical investment policies of pension funds and charities. The Amendment to the 1995 Pensions Act requires the trustees of occupational pension funds to disclose in the Statement of Investment Principles “the extent (if at all) to which social, environmental and ethical considerations are taken into account in the selection, retention and realization of investments.” This has contributed considerably to the growth of the SRI industry.

Should Companies Be Socially Responsible?

Finance textbooks tell us companies should maximize the value of their stockholders’ equity. In other words, a company’s only responsibility is a financial one. In recent years, corporate social responsibility has become a focal point of policymakers (and the public), who demand that corporations assume responsibility toward society, the environment, or stakeholders in general. SRI investors thus aim to promote socially and environmentally sound corporate behavior. They avoid companies that produce goods which may cause health hazards or exploit employees (negative screening), whether in developed or developing countries. They select companies with sound social and environmental records, and with good corporate governance (positive screening). In general, SRI investors expect companies to focus on social welfare in addition to maximizing value.

At the heart of the SRI movement is a fundamental question: Is a firm’s aim to maximize stockholder value or social value (where social value is defined as the sum of the values generated for all stakeholders)? Classical economics (for example, Adam Smith’s “invisible hand” and the social welfare theorems) states that there is no conflict between the two goals: In competitive and complete markets, when all firms maximize their own profits (value), resource allocation is optimal and social welfare is maximized. However, modern economic theory also tells us that in some circumstances, namely when some of the assumptions of the welfare theorems do not hold, profit-maximizing behavior does not necessarily imply social welfare-maximizing outcomes. One of such circumstances is the existence of externalities that arise when the costs and benefits of an agent’s action are affected by the actions of other (external) agents in the economy. Jensen (2001) gives a simple example of externalities, where a fishery’s catch is impaired by the pollution of an upstream chemical plant.1 When the chemical plant maximizes its profit by increasing pollution (as the costs of pollution are not borne by the chemical plant), the fishery downstream suffers through catching fewer fish and social welfare—which in this case is equal to the sum of the profits of the two stakeholders—is not maximized.

In practice, the maximization of stockholder value often conflicts with the social welfare criterion represented by the interests of all stakeholders of a firm, including employees, customers, local communities, the environment, and so forth. By maximizing stockholder value, firms may not take care of the interests of other stakeholders. Economic solutions to the externality problem are based on the principle of internalizing externalities, for example, by imposing regulations (such as quotas, or taxes on pollution) and creating a market for externalities (such as the trading of pollution permits). Furthermore, in continental European corporate governance regimes, a stakeholder approach is more common than in Anglo-Saxon countries.

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Further reading

Book:

  • UNEP Finance Initiative. Values to Value: A Global Dialogue on Sustainable Finance. United Nations Environment Programme, 2004.

Article:

  • Renneboog, Luc, Jenke Ter Horst, and Chendi Zhang. “Socially responsible investments: Institutional aspects, performance, and investor behavior.” Journal of Banking and Finance 32:9 (September 2008): 1723–1742. Online at: dx.doi.org/10.1016/j.jbankfin.2007.12.039

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