• Does SRI underperform?
  • Will SRI increase the risk of my portfolio?
  • Is SRI consistent with fiduciary duties?
  • Why does my SRI fund include tobacco and/or oil companies?

A common misperception is that sustainable investing yields lower financial returns than traditional investment strategies. However, there is growing evidence to suggest that this is not the case. Examples include:

  • A June 2012 Deutsche Bank report that found that 89% of the 100 academic studies, 56 research papers, 2 literature reviews and 4 meta studies it reviewed showed that companies with high ESG ratings saw market-based outperformance. Strong evidence was also found that companies with high ESG ratings have a lower cost of capital, implying that they are lower risk.
  • A 2015 Oxford University and Arabesque Partners meta-study showed that 88% of over 200 sources found companies with “robust sustainability practices demonstrate better operational performance, which ultimately translates into cash flows” and 80% of studies showed “prudent sustainability practices have a positive influence on investment performance”.
  • A 2015 Morgan Stanley Institute for Sustainable Investing report that found that, on both an absolute and risk-adjusted basis, the performance of sustainable investments “usually met, and often exceeded, the performance of traditional investments”.

In South Africa, several studies have shown that the JSE SRI Index has underperformed conventional market indices. This has led to some market players arguing that “SRI will see you lose a third of your retirement fund“, as the FTSE/JSE All Share Index has outperformed the JSE SRI Index by 1.6% over the past 10 years. However, there are major concerns over the selection criteria used in constructing the JSE SRI Index. The index repeatedly includes many controversial constituents such as Sasol and BAT. As a result, it is questionable whether the JSE SRI Index should be considered a reliable benchmark against which to measure SRI returns.

Further research is needed to establish the relationship between SRI and performance in sub-Saharan African markets. However, there are some indications that sustainable investing does not lead to underperformance. Old Mutual Investment Group’s South African responsible investment equity index fund, for example, showed “cumulative returns of 71.13% between October 2012 and December 2016, compared with returns on the JSE all share index/shareholder weighted index of 62.85%.

A common view of SRI is that it increases the risk of a portfolio as it restricts the “universe” of companies available for investment and therefore limits diversification. This argument is often used to discourage negative screening of certain sectors or exclusion of particular companies, especially in emerging markets where the universe of listed companies is already somewhat restricted.

However, others argue that all fund managers have a restricted universe of companies in which they can invest, that a smaller universe can assist in-depth understanding, and that incorporating ESG issues into an investment decision will also allow for potential outperformance. Companies that perform well on ESG criteria have also been shown to have a lower cost of capital, which implies that they are lower risk.

Pension fund trustees are obliged to act prudently in the best interests of the beneficiaries. Some argue that this means only maximising financial returns. Under this understanding, early concerns that SRI would lead to underperformance meant SRI was perceived to be contrary to fiduciary duties. However, over the past decade various studies have suggested that incorporating ESG factors into investment decisions is in fact consistent with fiduciary duties. Notably, in 2005, global law firm Freshfields Bruckhaus Deringer found that “integrating ESG considerations into an investment analysis so as to more reliably predict financial performance is clearly permissible and is arguably required in all jurisdictions.”

In South Africa, amendments to Regulation 28 have in fact made consideration of ESG factors a fiduciary responsibility by finding that “prudent investing should give appropriate consideration to any factor which may materially affect the sustainable long-term performance of a fund’s assets, including factors of an environmental, social and governance character.” Other sub-Saharan markets, many of which are considering Stewardship Codes, are likely to follow suite.

The fact that funds marketed as being “responsible” or “green” nevertheless include tobacco companies or oil companies often comes as a surprise. There are a number of reasons why such companies form part of these funds. Some funds might not be using a negative screen for certain sectors, but rather integrating ESG data into their investment decisions. This means that they will invest in XYZ dirty company as long as the fund manager feels that the company’s share price adequately discounts the potential clean-up costs or future liabilities that might result from its current unsustainable practices.

Another reason is that in markets such as South Africa, mining or resource stocks constitute such a significant part of the total market that excluding them is seen as potentially undermining returns. A concern for fund managers is that by not holding ABC dirty sector, they won’t be able to meet the returns of their benchmark index, particularly if they aren’t exposed to that sector when it performs well.

Proponents for including controversial companies often maintain that remaining invested in them is the best approach as this provides the opportunity to engage with the management of these companies and change behaviours. But this requires action.

Ethical investors may find these explanations unsatisfactory, and this is one of the reasons why there is a need for investors to become far more involved in scrutinising the investments made by their asset managers.