SRI sales surprise in market downturn

Inflows into socially responsible investment funds have held up relatively well this year, while many mainstream equity funds have floundered. Despite heavier weightings in battered smallcap stocks and the technology sector, these screened funds are holding onto existing investors and attracting new ones. Alex Mathias finds out why

Sales of socially responsible investment (SRI) products have proved remarkably resilient during the recent downturn in global equities. Their relative success is largely based on mounting investor concern about corporate corruption and mismanagement, the higher degree of loyalty shown by SRI investors, and the longer-term investment outlook of SRI funds, say most market participants. But the SRI market is also maturing: in its stock selection; the mix of products it offers; and its investment philosophies. These changes are helping attract a broader range of investors, analysts say.

In the US, SRI funds have been holding their own in the current bear market, which has seen the S&P 500 stock index lose 40.9% of its value from its March 2000 peak.

While the SRI sector in the US is dwarfed by mainstream mutual funds – representing around $11.4 billion in assets compared to $3.6 trillion for mainstream equity funds – SRI inflows are increasing faster than those for unscreened funds, according to data from Lipper, a Denver-based fund analysis firm.

SRI funds attracted $1.7 billion of net inflows from January to September this year, compared to mainstream diversified funds which suffered from $9.2 billion of net outflows during the same period, according to Lipper data. In June this year – a bad month for mainstream funds – net redemptions totalled almost $13 billion, yet socially responsible mutual funds attracted net inflows of $47 million, says Lipper.

“In a year that’s been so awful, we’ve had net inflows,” says Julie Gorte, director of social research at Calvert, a Maryland-based fund management firm. Calvert’s total net sales were up 96% at the end of September, compared to the same time last year. And, while the firm admits that much of this is due to two non-screened fixed income products, net sales for its 17 SRI funds were up by 39% over the same period.

In Europe, stock markets have been almost as badly hit as in the US but the fortunes of SRI funds have been more mixed. Between January and August, the FTSE100 fell 19%. Over the same period, sales of SRI funds that invested mostly in UK equities dropped 25%, compared to a 22% drop in sales of unscreened UK equity funds, according to the London-based Investment Management Association.

In Germany, SRI funds suffered a net outflow of €16.2 million ($15.8 million) – representing 10% of total assets – between January and August this year, whereas mainstream funds had net outflows of only 1% over the 12 months to the end of August, according to Bundesverband Deutscher Investment, a Frankfurt-based investment management association.

Jupiter Asset Management, a London-based investment management firm, “continues to see steady inflows of money” into its three SRI funds, says Emma Howard Boyd, head of the company’s environmental research unit, although she declines to disclose figures. Rival UK firms Henderson Global Investors and ISIS Asset Management also report steady sales of their SRI funds. Henderson’s Ethical Fund saw outflows double to £770,000 ($1.2 million) between February and July, but sales in July alone topped £1 million, according to a Financial Times article. Mark Campanale, associate director of SRI business development at the firm, confirms that retail inflows have exceeded outflows during this period, but declines to give figures.

In Australia, SRI managed funds’ total assets were 31% higher at the end of July than a year earlier, but assets of unscreened managed funds slipped by 0.1%, for the 12 months to 30 June, according to a September report from Deni Greene Consulting Services and the Sydney-based Ethical Investment Association.

Asia’s SRI market is still relatively immature, but appears to be attracting a growing number of investors, say regional specialists. The Eco Fund, one of Asia’s first SRI funds, and the Global Sustainability Fund – both of which are managed by Nikko Asset Management – collectively have ¥522 million ($4.2 million) under management. The bank declines to disclose precise sales figures for the funds but they have suffered no more from the slump in equity prices than the firm’s mainstream mutual funds, says Yuko Takaishi, in the environmental affairs department of parent company Nikko Cordial Corporation.

Despite plunging share prices across the region, Kingsway Fund Management is so confident about attracting investors it launched what it claims is the first Asian-domiciled sustainable investment fund investing in non-Japan Asia on 7 October (see Environmental Finance, September 2002, page 9). The open-ended Hong Kong dollar-denominated fund aims to raise $50 million, and is aimed at both retail and institutional investors.

New SRI products have been launched in Europe too. Five new licences have been granted for investment products based on the Dow Jones Sustainability Index (DJSI) this year, and a sixth is imminent, says a spokeswoman for Zurich-based SAM Indexes, which researches the indexes.

This is despite the DJSI underperforming its benchmark this year – the DJSI dropped 15.5% against a fall of only 6.1% for the Dow Jones World, in the 12 months ending 15 September. The DJSI, which has attracted 40 licensees from 14 countries since its launch in 1999, has seen its licensees’ assets drop by €400 million in September, down from €2.1 billion last year.

So what factors have helped bolster SRI sales in falling markets? The recent wave of corporate scandals in the US, such as Enron, WorldCom and Tyco International, is a major reason, many market participants say. “[SRI funds] offer more protection against this chicanery,” says Calvert’s Gorte.

US investors are in “uncharted psychological territory,” adds Don Cassidy, senior research analyst at Lipper. Besides witnessingnumerous high-profile corporate scandals, they have weathered two and a half years of declining stock markets, and have a possible war on Iraq to consider. These issues have steered some towards socially responsible investing as a perceived safe haven, says Cassidy.

Another frequently offered explanation for robust sales of SRI funds is that SRI investors tend to be more ‘sticky’, meaning that they invest for reasons other than financial performance and are more willing to weather volatile markets, says Ted Scott, director of ISIS’ Stewardship funds. As they are generally longer-term in their thinking than average investors, they are less sensitive to fluctuations in the market. And, if they are truly committed to investing responsibly, they have nowhere else to turn in a down market, says Lipper’s Cassidy.

And some larger institutional investors in France have invested in SRI recently “because they have panicked” and want to diversify, rather than simply wanting to invest ethically, says Alice Audouin, a spokeswoman for Novethic, a Paris-based SRI research firm.

But, in addition to these changes on the demand side, fund managers are increasingly providing a more varied mix of SRI products that can better withstand a market downturn.“There is a flight not necessarily to quality, but to value or defensiveness,” says Henderson’s Campanale.

The firm’s SRI With Profits fund has a lower risk profile than traditional SRI equity funds, and has proven to be “quite resilient” says Campanale. With-profit funds seek to smooth out market fluctuations over the medium to long term by holding back some of their gains in years of rising stock markets and keeping them in reserve as a cushion in hard times. A growing number of SRI fund managers also offer fixed income or mixed bond and equity funds.They include US investment management firms Domini and Calvert, Canadian firm Phillips, Hager & North (PH&N) and Morley Fund Management in the UK.

Traditional SRI funds can be handicapped by the limited universe of stocks from which they select their investments, but savvy fund managers are getting around this problem too. Many SRI funds have a bias towards small and medium-cap stocks. TMT (technology, media and telecoms) stocks also tend to be favoured, because of their typically low environmental impact. TMT stocks, however, are normally growthoriented, so earnings are reinvested in the business to fund and generate future growth, and dividends tend to be smaller. Large-cap ‘value’ companies, on the other hand, which generally have more visible earnings and tend to pay higher dividends, are seen as a wiser bet in a market downturn.

To address this problem, some fund managers are bringing the sectorweightings in their SRI portfolios more into line with the broader market, while others are seeking out ‘value’ stocks in growth-dominant sectors.

The Stewardship Income and Growth funds that ISIS offers have been “good sellers,” says Scott, the funds’ director, despite a mandate that prevents them from investing in approximately 75% of the UK market for ethical reasons. Some defensive TMT stocks in the Growth fund have proven relatively resilient but technology stocks alone, which have done “appallingly badly”, account for only 3–4% of the fund, says Scott. Long-established UK educational publishing firms Reed International and Taylor & Francis were good defensive picks and stood up relatively well to market pressures, he notes. Reed International, for example, returned 5.1% from 1 January to mid-October. However, the fund also has a substantial holding in UK telecoms firm Vodafone, one of the few companies in the sector that passed its ethical screens, and which has dropped more than 40% this year.

Indiscriminate selling of small and mid-cap companies has also created an opportunity for fund managers to find well-managed but undervalued stocks, says Scott. “There was such a radical sell-off we are well positioned going forward,” agrees Brent Sutton, vice president ofleading Canadian investment management firm Phillips, Hager & North, which launched a series of four SRI funds on 1 October.

Another new trend in the market is for many SRI fund managers, like their counterparts in conventional funds, to devote more attention to corporate governance, since the wave of corporate scandals in the US has shone a spotlight on the issue. Calvert admits it “did not escape entirely unscathed”. It held Enron in one of its passive SRI funds, for example. On 21 August it announced it would expand its corporate governance guidelines to examine 51 separate issues pertaining to corporate ethics and behaviour, such as board independence and diversity, executive compensation, the quality and independence of auditors and disclosure of information to shareholders, for example.

But can this extra attention to corporate governance deliver the security investors are looking for in the wake of the well-publicised US scandals? Gorte from Calvert admits that “fraud is really hard to find”. Enron passed through both Domini’s and Calvert’s corporate governance screens, so SRI funds should not automatically be seen as a safe haven from corporate governance fears, says Shannon Zimmerman, a fund analyst at Morningstar, a Chicago-based global investment research firm.

Corporate social responsibility and socially responsible investing should not be thought of as interchangeable, stresses Henderson’s Campanale. Henderson’s approach is to invest in companies and sectors that, due to societal changes, are “driven by sustainability”. Renewable energy, healthcare and public transport are a few examples cited for the company’s Global Care fund.

The wave of the future in SRI stock selection is assessing companies by how they have internalised external costs, says Campanale. Asbestos and climate change-related risks which have not been internalised by the company could lead to substantial legal and regulatory costs, for example. Funds adopting this approach might have sectoral weightings in line with the market but, in the energy sector, for example, would be overweight in companies with larger natural gas portfolios, and perhaps zero-weighted in companies with large coal portfolios.

In one of the worst and longest stock market downturns in decades, sales of SRI funds have remained remarkably healthy. Whether it be out of fear, the urge to diversify, a longer-term outlook, investor loyalty or a twinge of conscience, the market is continuing to prove its resilience and attract investors when it needs them most.