Like solar powered cars and communism SRI is a well meaning but ultimately unworkable and fatally flawed ideology. The commonly held mindset is that allowing a moral code or environmental concerns to be the determining factor behind a business model is mutually exclusive to recording a profit.   

However, as we enter the final years of the 21st century’s first decade the collective thoughts of the financial world seem to be turning towards SRI. There can be no doubt that there is a huge shift towards SRI in Europe which can be seen in the massive increase in Core SRI, funds that use ethical exclusions and positive screening criteria before selecting what to invest in. The total of Core SRI funds under management in Europe totalled €105m as of December 2005 according to the 2006 European SRI study carried out by Eurosif.

Broad SRI, funds that use even stricter selection criteria, including engagement (investors influencing and encouraging ethical business practices), norms-based screening (judging companies against their compliance to international standards, set by UNICEF, OCED etc) and simple exclusions (broader exclusion of whole sectors i.e. gaming, arms and tobacco) totalled €1.033trn in December 2005.

A reflection of this is the growth of the Dow Jones Sustainability Indexes (DJSI) which was created in 1999 in response to the number of investors who were diversifying their portfolio with SRIt. The family of DJSI indexes is used by financial companies in 16 countries and more than $5.5Bn of assets are managed against the index series. For a number of companies being listed on the DJSI index is now a corporate goal and in January 2008 the indexes were licensed to Barclays Capital. The establishment of an index such as the DJSI shows how SRI can now be seen as a mainstay and an ever increasingly important feature of financial activity and will only continue to grow in the future.     

Alongside this can also been seen the rise of Shariah compliant investment, a form of SRI that is governed by Islamic law and as such has a strict selection criteria. Investment in businesses related to, among others, gambling, alcohol and tobacco is prohibited. It also enforces a ban on securities that receive revenue made from financial interest, referred to as Riba. Shariah compliant products provide investment opportunities to people of the Islamic faith but are now increasingly attractive to investors outside the Muslim world.

Transparency and accountability
Shariah investment meets the growing consensus that investment needs to be morally guided and the strict rules governing Shariah investment lead to much higher levels of transparency and accountability, something investors relish in the wake of scandals such as the Soc Gen case in recent months.

However a clear conscience and social responsibility alone are not the only reasons behind the rise of Shariah compliant investment. It is a booming market which is predicted to only continue growing and the collective amount of assets in this type of fund is more than $250bn. The market continues to grow at an estimated rate of 15 percent annually and there is further $200bn of assets housed in Islamic windows or divisions of conventional banks.

The variety and ingenuity of Shariah compliant investments make them attractive to investors. A clear example of this can be seen an investment process adopted by FWU, a long time leader in the field.

 Their Selection and Allocation Model (SAM) uses a reactionary process rather than a predictive one and benefits from the discipline of being Shariah compliant. As a result of being a fund that is strictly and ethically regulated the scrutiny of investment selection extends to ensuring that that best possible investments from a financial point of view are made as well. In the SAM mode a strict set of criteria must be met during the construction of the fund universe. The result of this is a carefully screened, constantly monitored portfolio that as well as constantly being evaluated on ethical grounds is also continually evolving to maximise return.

While there has been a growth of Shariah compliant SRI which is driven by ethical and religious considerations there has also been a massive growth of sustainable SRI driven by ecological factors. A number of reports and studies by respected figures and bodies have shown up the ecological and economic folly of carrying on with a ‘business as usual’ attitude and as a result there has been a sea change in the attitudes of investors.

One major reason behind the emergence of sustainable SRI is the growing realisation and acceptance of the widespread and far reaching problems that climate change will cause on an economic as well as an ecological level. It could be said that the financial community is learning that what happens to the physical world will have a bearing on the economic world as well.

Concerning conclusions
A major report into the impact of climate change on the economy commissioned by the UK treasury and carried out by Sir Nicholas Stern threw up some concerning conclusions. The report states that the impact on the economy of statistically likely events such as mass migration and desertification caused by a 2-3 degree rise in global temperature would be devastating for the global economy. Sir Nicholas himself in February of this year commented that if the current consumption of fossil fuels continues it would constitute the “most colossal market failure in history” due to the ecological fallout that would result.

It follows then that continuing to record the same level of investment in industries that contribute to climate change is not only irresponsible but dangerous. If these industries continue to be provided the means to act as they have been, the consequences of their actions will in turn cause a financial meltdown. Put simply encouraging activities that are ecologically unsustainable through investment will actually result in the collapse of the global economy. Therefore the move to sustainable investment is part self preservation.

Another reason behind the growth of sustainable investment is the impact of political pressure and policy changes. In the future studies and investigations into climate change such as the Stern Report are only going to paint an even more worrying or depressing picture. As a result climate change or rather attempts to combat it, will have political importance attached to it and as such policy will punish the involvement in activities that are seen to contribute to it.

Some examples of investors turning to or exploring sustainable alternatives because it is believed that involvement in carbon heavy industries to be costly as a result of current or anticipated policy changes have already been seen. During the buyout of the Texan energy utility TXU, the private equity consortium behind the purchase pulled the company out of plans to build eight coal fired power stations. The threat of costly regulation being introduced for ecologically damaging processes makes them a less profitable, and therefore less attractive, option for investors.

Conversely this makes ecologically sound activities a far more attractive option as demand is likely to be high and government aid, subsidies and tax benefits is sure to be supplied, boosting the likelihood of investors becoming involved in them. In the next few years as the threat of climate change becomes more tangible sustainable products and solutions will only become more popular in the and it is an economically sound strategy to invest in them early and watch a high return on your investment. For example FWU sustainable SRI products have performed consistently above the benchmark performance, over three years it performed better by a factor of 11 percent.  

Economic principles
While it would be nice to think that a collective growth of a conscience is the major factor behind the increase in sustainable SRI, the simple truth is that it’s the most basic economic principles that are driving it. If carbon heavy activities were likely to remain profitable in the long term investment in them would remain the same. However due to the ecological consequences and possible government intervention they are not and as such alternatives which are free of these limitations grow in popularity.

In short, the move to SRI, including the rise of Shariah compliant investment is actually caused by traditional market forces and ultimately due to the biggest motivating factor, profit. While greater transparency and ethical behaviour are important considerations if the performance of SRI was poor it would not be as popular as it is now. If investment in carbon heavy, ecologically dangerous markets was to remain as profitable as it has been for most of this century and the last they would continue to dominate.

If sustainable markets remained niche and unprofitable then they would still be largely ignored by investors. Additionally if Shariah investment hadn’t introduced a new methodology that yielded better results it would remain a religious based form of investment only suitable for those of that faith. But as it stands SRI funds continue to perform well and it is the return on investment not a clear conscience that is the driving force behind their growth.

For further information:
Email: s.jaffer@fwugroup.com
Website: www.fwugroup.com