Read this article and learn about:
- Why firms develop SRI strategies
- The importance of establishing a formal SRI strategy
- Using environmental, social, and governance (ESG) data to drive good decision-making
- Ensuring compliance of SRI strategy
- Optimizing transparency and reporting
About the author:
Hugo Ludbrook is a Co-Editor at the Journal of Applied IT in Investment Management
Hugo Ludbrook is a communications specialist and a Co-Editor at the Journal of Applied IT in Investment Management. With a keen interest in the financial services industry, Hugo studies and writes about mega trends in the industry, and how they impact investment management firms. He has previously worked in the insurance software industry, and completed his BA(Hons) in International Relations at Victoria University, New Zealand.
Socially responsible investing (SRI) represents a growing client-driven industry trend with an increasing number of investment management firms developing formal SRI strategies to satisfy the corresponding demand.
The untraditional nature of these strategies compared with traditional investment approaches, often adds a new layer of complexity to a firm’s operating model. This article looks at how IT lies at the core of successful implementation of SRI strategies in terms of data, compliance, transparency, and execution.
The rise and rise of socially responsible investments
Responsible investing represents a strategy that considers both financial return and social good at the same time. It represents a growing market trend and is often narrowed down to cover environmental, social justice, and corporate governance (ESG) issues, all of which come under the broader umbrella of socially responsible investing (SRI).
With an SRI strategy, the investment-picking process by asset managers is essentially the same as always, just with an extra step in which quantitative research, such as debt-to-equity ratios or price-earnings ratios, is reinforced by qualitative analysis, such as a company’s commitment to sustainability or labor relations.
At a global level, SRI investing continues to expand rapidly. The PRI, a group of signatories of six Principles for Responsible Investment, has grown since its inception in 2006 to include over 1260 organizations, accounting for more than USD 45 trillion in assets under management.1 While SRI strategies have been popular for quite some time in Western Europe, in the US, according to a survey by The Forum for Sustainable and Responsible Investment (US SIF), SRI assets grew 76% between 2012 and 2014, while assets managed by investment firms considering ESG issues increased more than three-fold. As a result, approximately USD 1 of every USD 6 under professional management in the US can be classified as an SRI investment.2
But to succeed in SRI, firms need to have the technological capability that supports a multi-asset class strategy. Many SRI clients are interested in non-traditional asset classes, such as non-fossil fuel and energy, private equities, real estate, and infrastructure. Alternative investments, however, differ markedly from traditional investments in fixed income, equities, and derivatives. Among other demands, managing a book of alternative investments requires a system which is sufficiently flexible to enable monitoring of the special data forms.
Why firms develop SRI strategies
Asset management firms develop SRI strategies for different reasons. Some firms believe it helps them manage their long-term risk better by investing in companies with sustainability in mind. In a report titled, From the Stockholder to the Stakeholder,3 which is based on more than 190 academic studies, industry reports, newspaper articles, and books, the researchers found that:
- 88% of their results showed that solid ESG practices result in better operational performance of firms
- 80% of the studies show that stock price performance of companies is positively influenced by good sustainability practices
Interestingly, a survey by PwC among institutional investors showed that while 74% stated they wanted to quantify their private equity manager’s environmental, social and governance (ESG) stances, only 19% had made any attempts to do so.4 Other firms see SRI as part of a wider PR strategy to both promote themselves and protect their reputation. No one likes to be associated with negative news stories, especially when they have potential investments in an associated party. According to McKinsey, the “most widely known way that ESG programs create value is by enhancing the reputations of companies – their stakeholders’ attitudes about their tangible actions – and respondents to a recent McKinsey survey agree.”5
Table 16 shows the gains companies can achieve from having ESG programs.
Table 1: Value in environmental, social, and governance (ESG) programs. Source: McKinsey
In general, investment managers are listening to louder client calls for SRI and the issue now is using technology in their everyday application of SRI criteria to satisfy client investor demand and ensure they have the technological capability to meet related risk management and compliance requirements.
...investment managers are listening to louder client calls for SRI and the issue now is using technology in their everyday application of SRI criteria to satisfy client investor demand...
Establishing a formal SRI strategy
A survey7> published in December 2014 by French research group Novethic polled 185 long-term investors in 13 European countries with over EUR 6 trillion in assets and found that 72% of those surveyed had drawn up formal SRI policies, an increase of 7% on 2013. More than half of those surveyed now integrate SRI criteria across all their asset classes. The number of customers requesting SRI reporting capabilities is also on the increase, rising 15% from 2013 to 46%, representing the growing importance in the sector. Malcolm Preston, PwC’s lead of global sustainability has said that, “To many, such initiatives may feel idealistic or like an onerous layer of administration, but to an industry where there is a growing belief responsible investment is a driver of value, they are not to be taken lightly.”8
In an industry facing growing amounts of regulation, SRI-related issues is yet another aspect to consider for the operating models of investment management firms. The technology-related SRI issues for the front-and-back-office are becoming more relevant for portfolio managers. Translating these issues into action with clearly defined policies, processes, products, and services that help fulfill SRI demands and achieve tangible goals cannot be achieved without IT involvement.
A formal strategy can help attract new customers, ensure that employees understand their responsibilities when making investment decisions, and brand an investment management firm as a responsible investor. Dominique Blanc, Director of Research at Novethic, claims that such strategies “help investors identify megatrends such as climate change, talent retention, and efficient use of resources - information that is not captured by traditional financial analysis, yet no doubt impacts investment portfolios over the long term.”
Companies can develop their own ‘personalized’ SRI criteria, or sign up to local or international initiatives that provide them with a set of guidelines they agree to uphold. A strategy may employ negative screening, divestment, shareholder engagement, and impact investing in their method of execution. Dominique Blanc explains that “the first step is to define the objective pursued by such a strategy: for example, is it an ethical or reputational consideration, or a wish to invest sustainably?” Based on these possible objectives, the strategy could lead to some kind of exclusion from the portfolio, integrate ESG research into asset valuations, or lead to green investing (green bonds).
Once an investment firm has a formal strategy in place, they need to think about how it can be implemented in a compliant, transparent, and effective way. That’s where IT systems play a vital role.
Applying IT to enable SRI strategies
As soon as firms make the decision to support ESG issues, the goal is to integrate such criteria into asset valuation. The challenge, Dominique Blanc explains, is that “the output of the resulting analysis needs to be integrated into the mainstream investment decision tools, for instance the front and back office platforms.”
Using data to drive good decision-making
Responsible investing requires a different set of data compared with traditional investing in order to support the implementation of an SRI strategy. One common method is the use of ESG indicators to support risk calculation. They offer objective, transparent, and rules-based benchmarking solutions for measuring ESG performance and then rate companies based on that information.
Data integrity is currently a big topic within SRI. Compared with traditional investment data, ESG indicators can be a little less complete or reliable. Because companies use various forms of data from different sources covering different issues, such as employee turnover or NOx emissions, the IT platform needs to be able to integrate these disparate forms of data, and structure them in a useable manner.
Data integrity is currently a big topic within SRI.
It is important to be able to process this data and make good use of it in order to meet the SRI strategic goals. This could be to create and modify rules in the compliance module or incorporate the data into risk analytics activities. Currently, one of the most common methods of implementing SRI is via exclusion – for example, exclusion of sin stocks or exclusion of stocks with a low ESG rating.
Table 29 shows examples of data points and KPIs relating to ESG issues.
Table 2: Examples of ESG data points. Source: ThomsonReuters
Ensuring strategy compliance
To execute an SRI strategy, firms need a robust compliance solution capable of creating, modifying, and classifying compliance rules so that trades can be implemented freely while still complying with their SRI strategy. Feeding in the data and risk analytics mentioned previously, should be automatically incorporated into the compliance solution in order to allow pre- and post-trade as well as end-of-day compliance checks.
Whether companies want to block investments in tobacco companies for example or make sure they aren’t breaching any UN resolutions, the compliance solution should be capable of supporting pre-set metrics and actively sending alerts if compliance parameters breach the terms set. A strong compliance management system ensures smooth day-to-day execution of SRI so that portfolio managers can focus on investing, responsibly.
Transparency and reporting
SRI requires firms to be able to prove they are walking-the-walk and not just talking-the-talk. Having a strategy is one thing, implementing it another, and being able to prove it to the outside world yet another important aspect. Dominique Blanc agrees, “SRI is not a standard approach, it is a promise, and being able to report on its outcome is crucial. It shows how the strategy is actually implemented according to the promise, while at the same time educates investors on issues that are still largely misunderstood from a financial perspective.” Whether it is for shareholders or regulators, firms need the ability to produce reports proving that they are following through on their SRI strategy. In the report, From the Stockholder to the Stakeholder, researchers also found that “72% of S&P500 companies are reporting on sustainability, demonstrating a growing recognition of the strong interest expressed by investors.”10
SRI is often a client-driven initiative, meaning that aspects of SRI need to be incorporated into client reporting so that they know their money is being used in the way they signed up for. In Novethic’s 2014 Profile of Responsible Investors in Europe survey,11 they found that “four out of five investors monitor the ESG quality of their portfolio, requesting reports from their asset manager…” showing just how important this data is, as well as the ability to pass the information and insight onto clients. In her article, 6 Sustainability Investing Trends for 2015, Maureen Kline writes that “investors are demanding transparency from companies on ESG issues, and more and more, investors are setting an example with their own transparency. More than 780 Transparency Reports by Principles for Responsible Investment signatories are viewable on the PRI website.”12
When executing thousands of trades every day, it is important to be able to trawl through that data and ensure no breaches to SRI strategy. This gives asset managers peace-of-mind and signals to the market that SRI is taken seriously.
Optimize SRI and get started today
The growing access to information means that investment management firms are coming under increasing scrutiny for their investment decisions. It is not always that the market will only accept financial returns as the sole arbiter of performance, as seen by the growing popularity of SRI.
Many firms are beginning to develop formal SRI strategies to satisfy this demand, and this article has looked at how their IT platforms can support them. Implementing such strategies can be complex due to the untraditional nature of data being used. SRI strategies are therefore heavily reliant on IT platforms to play an integral role in terms of ensuring strategy compliance, structuring and making proper use out of the relevant ESG data, and being able to produce audit trails to prove correct implementation of the SRI strategy.
3. From the Stockholder to the Stakeholder, September 2014, by Gordon L Clark, Andreas Feiner and Michael Viehs.
10. From the Stockholder to the Stakeholder, September 2014, by Gordon L Clark, Andreas Feiner and Michael Viehs