Originally appeared in the Journal of Applied Corporate Finance (Vol. 25, No. 3, Summer 2013) from the Simon School of Business at University of Rochester
Responsible investors in increasing numbers are asking corporations to disclose data on their environmental, social, and governance policies and practices. These investors put this data to use in analyzing companies' financial prospects, assessing stakeholder relations (and the potential risks and rewards associated with them), making buy-sell decisions, and, when necessary, engaging with management as owners. Such investors also seek to identify companies where management has invested in credible and effective environmental, social and governance (ESG) initiatives that, broadly speaking, aim to create environmental and societal value.
Who are these investors? What types of ESG initiatives to they expect corporate managers to create, monitor, and report on? Will companies whose managers invest in such initiatives be rewarded in the marketplace? These are the kinds of questions this paper seeks to answer...
Originally appeared in Green Living Journal (Fall 2013)
Rian Fried, one of a handful of people who shaped what is now called “socially responsible investing,” passed away on July 3. A passionate and disciplined man, Rian sought to return capitalism to its initial purpose of helping to create a good life, and he was boundless in his enthusiasm for sustainable investing.
Along with Doug Fleer, Rian founded Clean Yield in 1984. In addition to managing assets, they also began publishing a newsletter by the same name. I have received it ever since and have never ceased to be amazed by the bold voice with which it presents groundbreaking new ideas. Whether seeking alternatives to fossil-fuels or finding ways to capitalize a local organic seed farm, Clean Yield has brought all of us along into its cozy Vermont way of doing things.
During the 1980s, Rian Fried traveled to Boston many times, as a small group of us met to discuss our shared vision of investing and to learn from each other. From these meetings grew a shared commitment to the values of responsible investing that endure today. We determined that we must select investments carefully, with environmental and social standards considered. We determined that we must take our Wall Street voice to another level by directly contacting companies and government agencies to raise issues and to mitigate injustices and harms that ordinary business can create. We determined that we must be ready to support grassroots efforts to expand the economic well-being of more people, through innovative financial institutions and from non-traditional companies alike. I will always be grateful to Rian for his quiet insistence that values come first.
Not every passing of a giant is recorded in the headlines, but we in the field of socially responsible investing know full well that Rian Fried was a cornerstone to our thinking and our work. Our hearts are heavy at his passing.
Originally Appeared in Domini Funds' 2013 Annual Report
On March 25, 1911, a fire swept through the 8th-10th floors of the Asch Building in lower Manhattan, occupied by the Triangle Waist Company garment factory. This tragic event, which killed 146 young immigrant workers, helped spur the growth of unions and set in motion a series of legal reforms to protect U.S. garment workers from such preventable disasters.
More than 100 years later, however, garment workers around the world still face the same risks that led to that tragedy. The recent collapse of the Rana Plaza factory complex in Bangladesh was the worst disaster in the history of the apparel industry. The owners of the eight-story complex had illegally added three floors to the building, and although cracks had been seen in the walls the day before the collapse, the factory owner chose to ignore warnings and protests, and ordered workers into the building.
Unfortunately, Rana Plaza was no anomaly. Factory disasters claim the lives of countless workers around the world every year. In Bangladesh, more than 1,800 workers have been killed during the past eight years, and in the past eight months alone, approximately 130 Bangladeshi workers have lost their lives in factory fires.
Globally we have seen a continuous search for the lowest-cost facilities, but nowhere has this issue become as critical as it is in Bangladesh, where the apparel sector employs more than four million people, mostly women. The minimum wage in the country is $38.50 per month, less than half the wage paid in Cambodia and a quarter of the wage paid in China. According to the World Bank, as of 2010, Bangladesh ranked last in terms of minimum wages for factory workers. This race to the bottom has made Bangladesh the second-largest global apparel exporter, behind China. Adding to the problem is a history of weak labor unions and strong representation of factory owners in government. Roughly ten percent Bangladesh’s parliamentary seats are currently held by garment industry leader. The sector’s political influence has been, predictably, an obstacle to meaningful reform.
In the same way that the Triangle Shirtwaist fire brought attention to these issues in the United States a century ago, Rana Plaza has now brought attention to these issues globally. Below, we discuss several paths that companies have taken to improve worker health and safety, particularly in Bangladesh, where the issue has become most critical.
Factory Monitoring Efforts
When we began reaching out to companies to discuss supply-chain sweatshop issues in the mid-1990s, we heard a common refrain: “we don’t own these factories.” However, as responsible investors, consumer activists, students and other labor rights groups engaged with companies to discuss the advantages of taking on greater accountability, things began to change. Companies in a wide range of industries have since adopted codes of conduct for their suppliers and have instituted factory monitoring programs. Many have supplemented these efforts with training programs to educate workers and managers on factory safety and labor rights. Some companies, like Gap, have recognized that a degree of responsibility also lies back at corporate headquarters, where cost-cutting initiatives and last-minute changes to orders can trigger overtime violations and increased pressures on factory managers to cut corners on safety.
It is clear, however, that these efforts have been insufficient to address systemic problems that persist in factories around the world, including excessive hours, forced labor, child labor and safety problems. Many multinational corporations report that they are serving a regulatory function with factory owners that should be played by government. While several leading companies have partnered with civil society organizations to find more lasting solutions, Rana Plaza has made it abundantly clear that more drastic and immediate action is needed.
Banning Production in Bangladesh
Global brands cannot police factory working conditions if they do not know where their clothes are being made. When a company places an order with a factory that meets its standards, it is not uncommon for that factory to ship the order to another factory without the buyer’s knowledge. This practice of unauthorized subcontracting is endemic in Bangladesh, where it is estimated that half of the nation’s roughly 5,000 factories are subcontractors. Even companies with rigorous monitoring programs risk finding their orders being produced at factories not on their approved list. Such was the case when several boxes of Disney sweatshirts were found at the Tazreen factory after a November fire that killed 112 workers.
Our relationship with the Walt Disney Company dates back to 1996, when we first encouraged the company to take greater responsibility over its supply chain. Since then, we have seen a dramatic evolution in its approach to these issues. In addition to providing feedback over the years on Disney’s code of conduct and audit program, we have also visited factories and participated in a hands-on project with Disney and McDonald’s to find a better path towards sustained factory compliance with labor standards.
Two months before Rana Plaza, Disney executives reached out to obtain our feedback on their plans to withdraw from Bangladesh. Disney permits licensing of its name and characters for production in more than 170 countries. While Bangladesh represented only a very small portion of its global sourcing, Disney believed it presented significant risks. Leaving Bangladesh could help the company reduce risk to its brand and allow it to focus efforts where it could most improve working conditions. Therefore, in March, Disney announced that Bangladesh had been removed from its “Permitted Sourcing Countries” list.
Some have accused Disney of “cutting and running,” a tactic that companies use to avoid accountability for sweatshop conditions, but we disagree with those accusations. Disney’s limited economic activity in Bangladesh would have afforded it little leverage with factory management, but by publicly withdrawing, it was able to exercise its leverage as a global brand to send a clear message. The Bangladeshi government needs to understand that substandard working conditions will have economic consequences if it does not take immediate action.
A Shift in Worker Safety Initiatives
For many companies, however, leaving Bangladesh is not a viable option. These companies instead must take a hands-on approach to reform.
In the wake of the collapse, several significant initiatives have arisen to improve worker safety issues. Most notable is the Accord on Fire and Building Safety (the Accord)—a five-year, multi-stakeholder agreement between retailers, non-governmental organizations, and labor unions to maintain minimum safety standards in the Bangladesh textile industry. We believe that this initiative is the best hope for meaningful reform. As a legally-binding agreement, the Accord represents a significant shift from past practice. Its board of directors, which is chaired by the International Labor Organization (ILO), is split evenly between corporations and labor unions. We believe that this equal representation of trade unions is critical. Domini’s Global Investment Standards have always recognized that:
“Healthy and vital unions play a crucial role in addressing the imbalances in power that often arise between corporate management and workers in their struggle for fair working conditions. Without unions, the possibilities for long-term equal partnerships between management and labor would be vastly diminished.”
One Rana Plaza survivor told Time: “The managers forced us to return to work, and just one hour after we entered the factory the building collapsed…" It was not simply lax regulations, political corruption and greed that led to these deaths—it was also fear. In order for desperately poor workers to stand up for themselves, they need strong labor unions.
To date, the Accord has been signed by more than 80 companies, primarily based in Europe. One of the first to sign was Hennes and Mauritz (H&M, Sweden). Over the past three years, we have seen impressive improvements in H&M’s approach to labor conditions in its supply chain. The company has advocated for increases to the minimum wage and for the adoption of a “living wage” standard, and has pledged to remain in Bangladesh even if wages rise.
Some of the other major global brands that have signed the Accord include Fast Retailing (Uniqlo, Theory), PUMA, Carrefour, Tesco, Next and Marks & Spencer. The decision to sign the Accord by Japan’s Fast Retailing, one of the world’s largest retailers, supplements an already impressive social profile, including its practice of publicly reporting the results of its factory audits and the remedial measures its takes. To date, only a handful of American companies, including PVH (Calvin Klein, Tommy Hilfiger) and American Eagle Outfitters, have signed the Accord.
Domini Helps Lead Investor Response to Rana Plaza
In May, Domini worked with other investors affiliated with the Interfaith Center on Corporate Responsibility (ICCR) to draft a public statement urging global companies sourcing from Bangladesh to sign the Accord on Fire and Building Safety and to strengthen local trade unions, disclose suppliers, and ensure appropriate grievance and remedy mechanisms for workers.
More than 200 institutional investors from around the world, representing more than $3.1 trillion, signed our statement. The first 120 signatories came together in only 48 hours, a strong testament to the seriousness of this issue and the need for systemic reform (Read the investor statement).
Citing legal concerns with the Accord, a group of 20 North American retail companies, including Gap, Wal-Mart, Target, Macy’s, Nordstrom and Costco, announced another initiative—The Alliance for Bangladesh Worker Safety (“the Alliance”). While we favor the Accord over the Alliance because of its legally-binding nature and the role of labor unions in its governance structure, both initiatives represent an important shift in approach to worker safety issues. Both the Accord and the Alliance focus on bottom-line, critical reforms to address urgent fire and safety issues; both recognize the need for competitors to work together toward common solutions, to share the results of their factory inspections with each other, and to enforce common standards; both are committed to a level of public transparency; and both recognize the need for workers to have a voice.
Domini is currently helping to coordinate a global investor coalition focused on factory safety in Bangladesh. In the coming months, as we follow developments with the Accord and the Alliance, we will turn careful attention to those apparel companies that have not signed up for either initiative.
Here are a few additional changes we will continue to push for, both in Bangladesh and around the world:
- A global dialogue is needed about the definition and achievement of a sustainable living wage—sufficient for a worker to support a family and save for the future.
- A social safety net should be provided for the families of workers who are injured or killed in the line of work.
- The New York Times reports that children in Bangladesh can tell the latest fashion trend based on the color of the water in the canal that runs past their schoolhouse. The environmental consequences of global supply chains are significant and must be addressed.
- We would like to see the Accord model, which incorporates cross-company information sharing, an active partnership with unions and a commitment to public transparency, become the norm for global supply chains everywhere.
- While Bangladesh may be the flash point today, similar problems persist in other countries around the globe. It is our hope that the reforms sparked by Rana Plaza will reach beyond Bangladesh.
Rozina Akter, a 21-year-old survivor of the Rana Plaza collapse, told the Wall Street Journal: "I'll go back to work as soon as I get better. Not all buildings will collapse." What other choice does she have?
Like the Triangle Shirtwaist fire of another era, we hope to look back on Rana Plaza as a turning point for Bangladesh, and an end to the global “race to the bottom” that this poor country has come to symbolize. We hope that it will catalyze a new era of labor reforms that will provide young women like Ms. Akter with more acceptable and dignified choices. As investors, we will continue to do our part to bring that hope to fruition.
Fiduciaries are the only class of investor legally obligated to care for other human beings. In recent decades, however, the fiduciary duty of loyalty has been turned on its head and converted into a duty to ignore other human beings. Financial returns are now considered more important than the interests of beneficiaries. This misstatement of the law in the quest for alpha is at the heart of the so-called “mainstream” rejection of social investing, and the opposition to divestment from gun makers in the wake of the horrific shooting in Newtown, Conn.
The opposition to divestment, including a Pensions & Investments editorial on Jan. 21, “Misdirected furor,” is based on several well-worn misconceptions about social investing and fiduciary duty. The foundational myth is the notion that “social” issues are unrelated to financial return and must therefore be ignored by fiduciaries. This myth was put to rest ages ago by the performance of the MSCI KLD 400 Social index, and numerous academic studies, including excellent reports on fiduciary duty from Freshfields Bruckhaus Deringer LLP, a London-based international law firm, and FairPensions, a London-based group that campaigns for responsible investing in the pension industry.
The individual performance of a gun investment is largely beside the point, however. There are many lucrative investment opportunities — a fiduciary must exercise prudence in selecting the most appropriate ones. There are only three small-cap publicly traded gun manufacturers in the United States, and a handful of gun-related private equity investments. Can a diversified portfolio be managed for the long term without these investments, which “externalize” unacceptable harm to participants and beneficiaries? This question is neither asked nor answered byP&I's editors.
First and foremost, fiduciaries must be dedicated to their beneficiaries' financial goals. This requires a deep understanding of risk and opportunity, including those relating to “social issues” that affect consumer demand and the broader economy, or impose legal risks and operational costs (e.g., cleanup costs). The debate has moved on from the artificial, bifurcated view of reality that views the investment portfolio in isolation from the real world. A modern fiduciary must understand how the corporation affects the health of the systems upon which it depends for its long-term survival.
P&I urges pension funds to ignore calls for divestment and to “step up and communicate the value of investments to their portfolios. ... They must stay focused on securing the highest risk-adjusted returns possible for their funds.”
This is roughly half right. As Justice Benjamin N. Cardozo famously wrote, the courts have kept “the level of conduct for fiduciaries ... at a level higher than that trodden by the crowd.” Fiduciaries should not respond to every demand — they need to set a higher standard and stay focused on long-term goals. But where P&I and other critics of divestment would ask fiduciaries to ignore these demands in favor of an exclusive pursuit of profit maximization, Mr. Cardozo had something else in mind: “A trustee is held to something stricter than the morals of the marketplace.”
In the marketplace, everything has a price. The market has no use for irreplaceable things of infinite value. As a result, finance lacks clear imperatives to maximize life and the priceless things that sustain it, such as clean air and water. Finance knows no imperative to safeguard children.
Fiduciaries, however, can check the more damaging aspects of finance through the process of prudent decision-making in conformance with a duty of loyalty — another priceless thing. “Price” is not a fiduciary's sole concern. If fiduciary duty meant “maximize returns,” we'd have no need for fiduciary duty at all. We would merely need to set the incentives right and guard against embezzlement.
Newtown presents a very concrete example of what a violation of the duty of loyalty looks like. If you use my money to make a weapon that kills my child, don't tell me that in 20 years I'll retire with more money as a result. If you claim that decision was made in my best interest, you have no right to call yourself a fiduciary.
On the question of divestment as a tactic, the P&I editors have the question exactly backwards — we should be asking about the impact of the investments, not about the tactic of divestment. Investors are not seeking to enter this debate on guns. They are already knee-deep in it, have been on the wrong side and are now looking for an exit.
Semiautomatic weapons are now widely available, not solely as a function of consumer demand, but also due to the ready availability of investor capital and investor demand for expanding markets. Is there any limit to these demands? The New York Times reports that industry strategies to increase market share now include an aggressive push to get guns into the hands of children. The editor of Junior Shooters magazine noted that if the industry is to survive, gun enthusiasts must embrace all youth shooting activities, including “semiautomatic firearms with magazines holding 30 to 100 rounds.”
This is your return on investment: Children toting semiautomatic weapons. Whether communicated through private or public equity ownership, the message, no doubt, has been the same — make more, and get these weapons into as many hands as possible.
Whether they like it or not, pension funds are, in fact, agents of social change. Freedom Group has used pension fund capital to change the retail gun landscape, with clear social consequences.
When we allocate billions of capital, we are also sketching out the parameters of future societal possibilities. The long-term growth of these companies depends upon Washington's inability to enact meaningful gun control. Trustees should consider whether that outcome is in their participants' best interests.
Divestment can be effective. The mere suggestion of divestment prompted Cerberus Capital Management LP to announce it would sell Freedom Group. For public equities, divestment sends a signal to management about what is and what is not acceptable. If it is done on a wide enough scale, it can certainly have an impact on a company's finances. But on the most basic level, it is an expression of the duty of loyalty.
P&I's editors noted that these divestment activities “reveal shortcomings as fiduciaries in portfolio oversight.” Here, I wholly agree. These funds should never have been invested in gun makers in the first place. But that is a very poor argument for taking no action now.
The concept of fiduciary duty sits at the confluence of two powerful streams of Western intellectual thought, the legal and the economic: the legal because fiduciaries are managing the assets of others whose interests the law seeks to protect; the economic because fiduciaries assume the role of investors in the marketplace in managing these assets...
Mutual funds, according to a recent Vanguard statement responding to the mass-shooting in Newtown, Connecticut, are not “optimal agents to address social change.” I agree. But while a mutual fund may not be the best way to promote sound social policy, when trillions of dollars in mutual fund assets are managed without any social or environmental considerations, they can be a very effective way of promoting broad social harm.
Unlike other national tragedies fueled in part by investment decisions – the BP disaster immediately comes to mind – the Newtown massacre has prompted an important and overdue debate about the role of investment in our society. Your IRA is at the heart of that debate.
We’ve read about how the retirement funds of teachers and other public servants were used by Cerberus, a private equity fund, to create Freedom Group, the largest gun maker in the country. Freedom Group makes the assault weapon that was used to kill children and teachers. Unless you are a participant in a public pension fund, or a very wealthy individual, however, you are probably not invested in any of the private equity firms that own gun makers. But you are most likely invested in a mutual fund, and your fund may own gun stocks.
Vanguard’s statement was issued in response to the revelation that it is one of the largest owners of Smith & Wesson and Sturm, Ruger, the largest publicly traded gun manufacturers. Vanguard holds these stocks in passively managed index funds. This, of course, is no real revelation – it is the status quo, the result of a philosophy that treats investments as abstractions, divorced from real world impacts. But it should serve as a wake-up call for the millions of Americans invested in so-called ‘low cost’ index funds. What are the true costs of these investments? 
Vanguard’s statement contains two of the most common excuses offered for failing to address the social implications of investment decisions. Let’s take each in turn.
The first statement involves benchmarks. Vanguard is the inventor and largest manager of index funds – ‘passive’ funds designed to replicate benchmark indices. Smith & Wesson, Sturm, Ruger and ammunition maker Olin are members of the Russell 2000 and Russell 3000 indices. In essence, Vanguard claims that its hands are tied – to track an index, it must invest in all the stocks in that index. But is this true? Is it possible for an index manager to track a 3000 stock index with 2997 stocks?
Does a passive investment strategy relieve an asset manager of all moral responsibility? Do managers have an obligation to choose appropriate benchmarks that do not contain inherently destructive companies?
If an index strategy requires automatic investment in destructive companies – landmine manufacturers, human rights violators, gun-makers – then safeguards need to be put in place to allow passive investment while also protecting innocent third parties. Ultimately, this responsibility should rest with the firms that manage the benchmarks themselves. Generally, companies are selected for major market indices without any consideration of their social or environmental impacts. But what if Russell decided to assess the true value these companies contribute to society? What if Russell identified a set of corporate practices that pose unacceptable risks, and then chose to remove those companies from their indices? Every index manager in the world would divest overnight.
If there’s anything we’ve learned from the financial crisis, it is that even the most arcane financial decisions can have real-world impacts. Such is the case when you allocate billions of dollars to companies that make military-style assault weapons. We can no longer pretend that these decisions are morally neutral – they are not.
Standard-setting is not foreign to index management. Both the index managers and the stock exchanges set all sorts of financial and governance standards. The OMX Nordic Exchange actually has a standard to “investigate”, and presumably to ultimately delist, companies that have committed “serious or systematic violation of human rights or other ethical international norms” including those that manufacture chemical weapons or land mines. They placed these standards under the heading “marketplaces with integrity.” After OMX’s acquisition by NASDAQ, it is unclear where those standards now stand. Some exchanges, including the Johannesburg Stock Exchange, require listed companies to produce sustainability reports. Dow Jones, MSCI and FTSE all maintain indices that include social and environmental standards.
Should investors be able to choose between both responsible and irresponsible indices? That depends on whether you believe there are real-world consequences for allocating capital to firms that are hurting people.
Vanguard’s second claim, drawn from its longstanding statement on social issues, is that “as a fiduciary” it is required to manage its funds in the best interest of shareholders and is obligated to “maximize returns” in order to help shareholders meet their financial goals. Whenever you hear the phrase "maximize returns," add three simple words: “at any cost.” Pure profit seeking should never be conflated with fiduciary duty. Fiduciaries are held to a higher standard.
The 19th century ‘prudent man standard,’ for example, directs trustees to “observe how men of prudence, discretion and intelligence manage their own affairs.” When fiduciaries manage money for parents, they need to think like parents. It is self-evident that a prudent person would not use her own money to harm her children. It is both callous and misguided to suggest that fiduciaries are compelled to do so.
The long-term rationale for investing in gun manufacturers is the belief that society will not act to rein in the costs these companies impose on others. The largest asset managers in the world are backing a future that fails to address broad social harm. They have placed many billions of dollars of other people’s money on the laissez faire side of the scale, and they have done this despite a clear legal obligation to put their investors’ best interests first. We should therefore not be surprised to see our children inherit a passive democracy that is unable or unwilling to protect them.
I believe divestment of stocks in gun manufacturers is appropriate, but there is more that can be done. Beyond divestment, institutional investors – including mutual fund managers – should be using their clout to place this issue on the agenda of every board in the country. Directors should be asking whether their company’s products, services and political activities are contributing to this epidemic of violence, or standing in the way of reform. Many companies, including those that manage theme parks, operate stores in large shopping centers, or are closely associated with children, could benefit from strict gun control. These companies should stand up and say so. Video game companies that partner with gun makers to help market assault weapons should be asked to review these practices. Every retailer that sells semiautomatic weapons should be asked to take them off the shelves. In addition, as we wait for stricter gun control laws, there is no reason why companies that sell guns cannot impose strict rules of their own. I believe that when trillions of dollars of capital unite against gun violence, companies and policymakers will listen.
Money managers, unlike individual investors, have a legal obligation to think about the welfare of others. Institutional investors are not prevented by fiduciary duty from taking these actions; rather, fiduciary duty compels them to do so.
Let’s apply a little common sense. We don’t need to finance violence in our communities in order to provide for our retirements. Now is the time for individuals to speak up and demand an approach to investment that is appropriate for children.
 Passively managed index funds invest in portfolios designed to match the composition of a public benchmark, such as the S&P 500. They are generally offered at significantly lower cost to investors than actively managed funds, and may offer certain tax advantages. Over time, mutual fund operating expenses can negatively impact returns. All mutual funds are subject to expenses and risks, including loss of principal. You should always read the fund's current prospectus before investing.
The Initiative for Responsible Investment, a project of the Hauser Center for Nonprofit Corporations at Harvard University, has prepared this report On Materiality and Sustainability: The Value of Disclosure in the Capital Markets for the Sustainability Accounting Standards Board (SASB). Steve Lydenberg is the report’s author. this report builds on the report From Transparency to Performance: Industry-Based Sustainability Reporting on Key Issues published by the Initiative for Responsible Investment in June 2010.
Looking forward ten, even twenty years, what will Socially Responsible Investing (SRI) have become? What will it have accomplished? What will the field look like? Today, I build a case for a good future. In a word, it will largely be marvelous.
Roughly 15 years ago, I spoke in Jackson Hole, Wyoming. It is a spectacular setting, one that makes a person proud to be in a great nation like ours, one that protects such places. Yet, as I reminded the audience that day, it had not been the public that had kept the Grand Tetons pristine. It was one man, John D. Rockefeller, who had purchased the land and given it to the nation.
This is the classic dilemma we in SRI struggle with every day. It is great that the Grand Tetons are a public treasure, but they became so on the backs of crushed labor forces, pollution and selfishness. One man made his money and then gave it away, but he set in motion the international oil industry, an industry that is robbing us of a climate, a future.
That day I challenged SRI to become relevant. Today, I can see clearly that it has. Over the next twenty years, the positions we have taken and the battles we have fought will lead to a universal understanding that what we have been saying, the way you invest matters, is absolutely correct. We will see our guiding principles integrated into the mainstream. We will be astonished at the acceptance and the impact that we have had.
How We Became Relevant – Performance Matters
Perhaps the most devastating argument we faced early on was the Modern Portfolio Theory (MPT). It argues that the previous “prudent man” idea of buying good stocks alone, created risk. Introduced in 1952 by Harry Markowitz, the original premise was simple: investors should focus on overall portfolio risk. Simply put, even if you love software, you still shouldn’t build an entire portfolio of software stocks. Astonishingly, this revelation won Mr. Markowitz a Nobel Prize in Economics and caused the entire financial services industry to argue that the individual risk characteristics of a company mattered little.
Against this backdrop, SRI seemed hopelessly old fashioned. We argue that each company, by virtue of the industry within which it operates, faces a series of risks that we label as risks to people or the planet. We then argue that taking too large a risk is not necessary and further, that it perpetuates an acceptance of these risks. Wall Street pundits stated with great authority, but with no basis, that our form of analysis flew in the face of Modern Portfolio Theory and so would fail. Our largest barrier was that, to use the vernacular, every smart person knew SRI was stupid.
The evidence proved otherwise. The MSCI KLD 400 Social Index has not only debunked the premise of MPT, but also shown that risk avoidance works. The index has outperformed — and has done so with a lower standard deviation. Clearly, examining the risk of corporate behavior tells us something about a company that is useful to investors.
Why We Are Relevant – An Increase in Reporting
SRI practitioners have pushed for “extra-financial” data and have gotten it. At first, true comparative data on companies was extremely scarce in some areas of keen interest to the concerned investor. Any good researcher understands that the newspapers are a lousy place to start. The fact that we know that Apple sourced from Foxconn does not tell us what Hewlett Packard does. What is needed is data that is universally ascertainable, without the company answering a questionnaire (which allows them to self-define), and the data must be quantitative in nature, e.g. I don’t care as much about a statement that a company seeks diversity as I do about how many minorities have been hired.
Today, thousands of companies self-report. Whereas the one or two companies that issued Social Responsibility reports thirty years ago were real outliers, today it is so mainstream that Forbes magazine maintains a blog to follow them. Accounting giant PWC makes available the 2010 survey of CSR reporting on their website. The highlights: 81 percent of all companies have CSR information on their websites; 31 percent have these assured (or verified) by a third party. Their 2012 update contains examples of what to look for when writing (or reading) them.
Who was pushing for this disclosure? It wasn’t civil society, it wasn’t Wall Street; it wasn’t government. It was a loose confederation of concerned investors who consistently pushed for greater and more standardized “non-financial” information.
Why We Are Relevant – An Increase in Regulation to Disclose
Regulators are beginning to expand on the data corporations are required to disclose. Remember, there was no God-given definition of the right way to report financials to investors. In 1932, when reforms to protect investors began, regulators looked at some of the pre-existing methods and evaluated them. This led to audited annual reports on income statements and balance sheets. It led to quarterly unaudited reports. These had, in the past, come to be viewed as important in judging the financial soundness of a corporation.
However, the regulators did not stop with accounting issues. Given that the 1930s were a period of high unemployment, the number of company employees was considered important, and so its disclosure became mandated. There is no reason that more robust social and environmental reporting shouldn’t be in the financial reports. We already disclose a company’s hometown, without companies complaining of the inappropriateness and burden of so doing.
The Initiative for Responsible Investment at Harvard University maintains a database of Global CSR Disclosure requirements. In it we find 34 nations are taking steps. In 2009, Denmark, required companies to disclose CSR activities and use of environmental resources. In 2010, the United Kingdom required companies that use more than 6,000MWh per year to report on all emissions related to energy use. Malaysia, in 2007, required companies to publish CSR information on a “comply or explain” basis. Regulators, recognizing the societal costs of less than full cost accounting, are moving in to mandate disclosure.
Mainstreaming – With this solid base, here come the “big boys”
Conventional asset managers and the academic community have brought SRI to the mainstream. I began by saying the future for SRI is marvelous. Consider a world in which every major financial asset management firm demands that its staff study the social and environmental implications of the investments they make and bases recommendations upon it.
But this has already begun. Consider MEAG, the American portfolio management branch of Munich Re. Their team buys only publicly traded bonds which then back the insurance the firm issues. They use ESG criteria to give their research the edge and to avoid risk. When I met with their research team, I found that they use several of Domini’s Key Indicators. No, we don’t publish the indicators. It also was not a coincidence. The two firms independently discovered the same indicators to be telling because they both use the same logic in approaching the issues. Or there is UBS Investment Bank, where analysts specifically address the social, environmental or governance risks of a company they are recommending.
Finally, look at the all-important realm of academia, where MPT began. Just three recent examples are telling:
The Impact of a Corporate Culture of Sustainability on Corporate Behavior and Performance by Professors Robert Eccles and George Serafeim, Harvard Business School. “… we provide evidence that High Sustainability companies significantly outperform their counterparts over the long-term, both in terms of stock market and accounting performance. The outperformance is stronger in sectors where the customers are individual consumers, companies compete on the basis of brands and reputation, and in sectors where companies’ products significantly depend upon extracting large amounts of natural resources.”
Corporate Social Responsibility and Access to Finance by Beiting Cheng, Harvard Business School, Ioannis Ioannou, London Business School, and George Serafeim, Harvard Business School. “Using a large cross-section of firms, we show that firms with better CSR performance face significantly lower capital constraints. The results are confirmed using an instrumental variables and a simultaneous equations approach. Finally, we find that the relation is primarily driven by social and environmental performance, rather than corporate governance.”
An FDA (Food and Drug Administration) for Financial Innovation: Applying the Insurable Interest Doctrine to Twenty-FirstCentury Financial Markets, by Eric A. Posner and E. Glen Weyl, Law School, University of Chicago. “We propose that when firms invent new financial products, they be forbidden to sell them until they receive approval from a government agency designed along the lines of the FDA, which screens pharmaceutical innovations. The agency would approve financial products if they satisfy a test for social utility …”
The Next Twenty Years
This article limits its scope to only one leg of the SRI stool. It does not discuss the growth of shareholder activism, which is vibrant. Nor does it address the mainstreaming of selling products with narrow and specific social purpose, also a burgeoning field. Rather, by looking at the application of social criteria to an investable universe alone, we see that barriers have been removed, and that now both a mountain of money, and the force of government and academia, will work with us and introduce our goals into mainstream investment thinking.
We know we can make money, government is increasingly with us, and academia is swinging our way. Now, the rapid acceptance of more robust and integrated accounting has done away with the last barriers. This brings us the assets to have impact. As society sees the full cost of traditional business behavior, SRI will be embraced as the single most important lever towards building a better world than the planet has ever seen.
Domini Social Investments’ Managing Director and General Counsel, Adam Kanzer, has been selected to join the Securities and Exchange Commission’s Investor Advisory Committee (IAC), created under the Dodd-Frank financial reform Act. He served on the SEC’s inaugural Investor Advisory Committee, which was disbanded in 2010 after passage of the Act. The 21-member committee was established to provide the SEC with the views of a broad spectrum of investors on the SEC’s regulatory agenda. Mr. Kanzer participated in the IAC’s first meeting on June 12.
Prior to the IAC appointment, Domini met with SEC Commissioner Luis Aguilar and SEC Chairman Mary Schapiro to discuss the priorities of the social investment community, including swift passage of Dodd-Frank provisions addressing excessive executive compensation, and two provisions relating to peace and government corruption – a provision requiring companies to disclose the sourcing of ‘conflict minerals’ from the war-torn Congo, and disclosure of corporate payments to foreign governments in connection with the extraction of natural resources.
During our meetings, we also asked the Commission to act on a pending rulemaking petition seeking disclosure of the use of corporate resources for political purposes. The petition has broken the record for public comments, with more than 250,000 people writing in support. Domini also reached out to shareholders of the Domini Funds, with an Action Alert.
As a stockbroker in the early 1980’s, Amy Domini got her first glimpse of the potential of socially responsible investing. She realized that many of her clients cared about more than just the bottom line. They cared about where their money was being invested and how profit could be coupled with a vision for sustainability.
Little did she know how big this discovery would be.
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