Businesses and investors are factoring in their operations’ social and environmental impact to an ever-increasing degree. There is also increasing momentum behind a shift towards firms and their backers demonstrating exemplary levels of corporate governance.
This is something of a shift in direction from the ‘greed is good' years and represents a change, which all investors, big or small, need to be aware of. Identifying trends and taking positions that can capitalise on them is the secret to successful and responsible investment.
Who do the Principles for Responsible Investment apply to?
One set of measures that have been brought in to standardise processes are the UN Principles for Responsible Investment (PRI). Drawn up by the United Nations, the six Principles for Responsible Investment are aimed at investors in firms rather than the underlying firms themselves. They offer a blueprint designed to encourage those with capital to invest to take a stronger position on environmental, social and governance (ESG) issues.
As of January 2022, a total of 4,721 investment firms had already signed up to the PRI scheme. The list includes some of the world's biggest investment managers, including BlackRock , J.P. Morgan Asset Management and Goldman Sachs Asset Management (GSAM).
What are the Principles for Responsible Investment?
PRI started back in 2005 when the United Nations held a meeting that involved a 20-person investor group drawn from institutions in 12 countries and 70 experts from the investment industry, intergovernmental organisations, and civil society. The mission statement they drew up stated:
“We believe that an economically efficient, sustainable global financial system is a necessity for long-term value creation. Such a system will reward long-term, responsible investment and benefit the environment and society as a whole.”
The UN Principles for Responsible Investment put the onus on the investment firms allocating capital to big corporations' stock positions. This involves applying ESG best practices through the life of a trade, from research and analysis during the stock-picking stage to ongoing monitoring of firms in which they hold a position. There is also a requirement for the investment company to measure and report on its own effectiveness in complying with the PRI protocols.
- Principle 1: We will incorporate ESG issues into investment analysis and decision-making processes.
- Principle 2: We will be active owners and incorporate ESG issues into our ownership policies and practices.
- Principle 3: We will seek appropriate disclosure on ESG issues by the entities in which we invest.
- Principle 4: We will promote acceptance and implementation of the Principles within the investment industry.
- Principle 5: We will work together to enhance our effectiveness in implementing the Principles.
- Principle 6: We will each report on our activities and progress towards implementing the Principles.
By coming up with a clear set of rules, PRI enables investment firms to raise the bar in terms of ethical governance, and those who sign up can take comfort that rival investment firms who are also signatories have to play by the same rules.
Why are the Principles for Responsible Investment important?
PRI is designed to impact the business world by regulating the pipeline of cash that corporations need to run their businesses and support their share price.
If the PRI become the global standard by which investment decisions are measured, then another part of the global economy will move towards fairer and cleaner business practices. The intention is that firms in the ‘real’ economy will adjust their approach to court institutional investors, leading to the manufacturers of consumer goods and sellers of fast food also adopting better practices.
What do the Principles for Responsible Investment mean for retail investors?
Decisions made by the huge institutional investors in terms of PRI are likely to have significant ramifications for smaller investors.
Follow the money
For retail investors, one way in which PRI is important is in terms of the flow of money. The financial markets are littered with assets that have at some time been priced ‘incorrectly’. This incorrect pricing is largely due to the fact that taking a view on the balance sheet of a firm and carrying out extensive fundamental analysis are ultimately of secondary importance to the flow of capital into or out of a market. Asset bubbles from tulip mania in 1634-7 to the tech-stock bubble of 2000 demonstrate how money-flow is ultimately the key driver of price.
If BlackRock, J.P. Morgan Asset Management and GSAM are applying a strategy which results in them pumping money into a particular market, then retail investors can benefit from going with the flow.
Additional costs of PRI
Applying PRI principles will require considerable resources. Taking the second principle as an example, which has the following stated aim: ‘We will be active owners and incorporate ESG issues into our ownership policies and practices, the next step towards meeting that target involves the following possible actions:
- Develop and disclose an active ownership policy consistent with the Principles
- Exercise voting rights or monitor compliance with voting policy (if outsourced)
- Develop an engagement capability (either directly or through outsourcing)
- Participate in the development of policy, regulation, and standard setting (such as promoting and protecting shareholder rights).
- File shareholder resolutions consistent with long-term ESG considerations
- Engage with companies on ESG issues
- Participate in collaborative engagement initiatives
- Ask investment managers to undertake and report on ESG-related engagement
Supporting the project might be the right choice in terms of improving the well-being of billions of people around the world, but it will involve additional costs. Investment managers may take some of the hit in terms of lower profits, but a significant element of the cost is likely to be passed on to the individuals who have deposited funds with the fund manager. The costs won’t necessarily be itemised, but instead take the form of lower net returns.
What are the alternatives to Principles for Responsible Investment?
The PRI scheme is an interesting development in the move towards more ethical business practices. It appears to have established enough momentum to be seen as a ‘thought leader’ in the sector.
It does add another layer of complexity to the ethical investing environment, which is already full of buzzwords such as ESG and CSR. There is also Fairtrade, ISO standards and Impact Investing to consider.
Due to the fact that there are so many schemes in operation, each firm that is supposed to be under scrutiny by a would-be investor has a degree of flexibility in terms of which metrics to use when reporting on its own performance.
The corporate social responsibility (CSR) reports of Disney and McDonalds, for example, are both comprehensive and well thought out. However, they approach the subject from different directions, and that makes comparing the two companies difficult. While the world may be gradually becoming a fairer and greener place, the big corporations have been marking their own homework, and that makes it difficult for consumers and investors to form an opinion.
How can retail investors build their own ethical investment portfolios?
One way for smaller investors to avoid paying higher admin fees and the confusion surrounding the sector while still investing more ethically is to build their own portfolio using an online broker. The increasing popularity of ethical investments means that trustworthy, well-regulated brokers are offering more and more markets in the sector. Whether the decision is to buy ethical stocks or sustainable ETFs which cover a particular sector such as solar, online brokers offer a cost-effective way to gain exposure to the market.
One inside tip on the subject of ethical investing, passed on by Tariq Fancy, who once held the title of Head of Sustainable Investment at BlackRock, is to simplify things. He was speaking with the BBC when he explained that after spending years trying to run comparisons on different firms around the globe, he started basing decisions on a simple proposition.
“Having spent years digging through ESG data and trying to understand and disaggregate it, I would actually say that sometimes the level of work going into it is almost counterproductive. It tries to put precision onto things which are quite hard to measure.”
He continued, “The simplest thing is to run a test that if this company doubles in size, is it good or bad for the world? Well, if it’s an electric vehicle maker, it’s probably good for the world… and if ExxonMobil doubles in size, it’s probably not good for the world.”
Source: Forex Traders
Are the principles of responsible investment good for the financial markets?
It’s not hard to see how the biggest fund managers could stand to benefit from PRI practices becoming the norm despite the additional costs. This is largely thanks to additional administration costs forming a barrier to entry for smaller disruptor-style firms.
With billions of dollars under management, the biggest fund managers will find the additional costs of PRI reporting form a smaller percentage of their total book. This could then result in those looking to invest in funds choosing to deposit their cash with a handful of bigger fund managers. Any action which makes the investment sector less diverse and encourages ‘group-think’ might not generate the best outcome for retail investors.
The good that comes out of the PRI scheme may outweigh its impact on the financial markets and the returns of smaller investors. However, as illustrated in the below graphic from the UNPRI site, the long-term interests of the PRI signatories are one of the scheme’s priorities.
PRI – Uptake and future developments
It looks like PRI is here to stay. In fact, the current setup looks likely to be a first step, as the PRI site states that member firms are ready to develop the scheme further.
“We also commit to evaluating the effectiveness and improving the Principles' content over time. We believe this will improve our ability to meet commitments to beneficiaries as well as better align our investment activities with the broader interests of society.”
As the move towards responsible investment has been driven by consumers, firms, including institutional investment companies, are putting a lot of effort into changing established business practices. For smaller investors, gaining a clear understanding of the new protocols could be good for the trading bottom line and the planet.