February 2010 I Nº 2

February 2010 I Nº 2

INVESTINGIN VALUESSOCIALLY RESPONSIBLEINVESTMENT(SRI) is one of the main pillarswhich relies on the rise andprofessionalization of socialresponsibility.

PUBLICATION ON CSR FACTS AND TRENDS 1

Socially Responsible Investing (SRI) isone of the main pillars on which thegrowth and professionalization of SocialResponsibility is founded. A growingnumber of investors, in absolute termsand by volume of managed resources,have begun to pressure corporateagendas to analyse and differentiatebetween investments not just accordingto traditional financial parameters butthrough ethical, social, environmentaland good corporate governance (ESG)screens.

An enormous variety of investmentstrategies have flourished since the daysof the first SRI investors who werecommitted to ethical ideologies basedon religious doctrines. Today investmentstrategies involve exploiting risks andopportunities that stem from seculartrends in our socioeconomic environment

such as climate change, water shortageand changing demographics. There aretwo reasons for this. On the one hand,SRI is a formula that makes it possibleto bring investment portfolios into linewith individual and stakeholder´sconcerns and idiosyncrasies. On theother, ESG criteria improve financialanalyses by including risks imperceptibleto traditional assessment models.

Do productivity disputes with workerssubtract value from a company? Whatorganisations could survive in anenvironment that is economicallyrestrictive to carbon? How does anincreasingly virulent season of hurricanesaffect a hotel chain in the Caribbean?The answers to these questions are someof the improvements that SRI brings totraditional financial analysis.

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PhilosophySRI: An Investment


One source of innovation in the field ofinvesting which has stood out the mostin the past ten years has been SRI. Itsimportance and sophistication has grownin quantitative and qualitative termsalike. Some industry professionals havecompared the challenge of incorporatingsocially responsible criteria intoinvestments with the revolution of thewidespread use of derivatives oralternative investment products in the1980s and 1990s.

Responsible investment means takingethical, social, environmental and goodcorporate governance criteria intoconsideration in investment managementprocesses . The ac ronym ESG(Environmental, Social and Governance)is frequently used to refer to sociallyresponsible investing criteria

SRI in the InvestmentProcess.

The first thing we would emphasize isthat SRI is an investment philosophy, nota product family. It is the result ofincorporating ESG criteria into some orall phases of the investment process.

It is not a product family because SRIfunds are not necessarily publicised orlabelled as such. For example, aresponsible pension fund may applyethical or environmental screens to itsinvestments; however, it can still continueto compete with other general pensionfunds.

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Determination of an investment policy that establishes aspects such as profitabilityand risk objectives, geographic markets in which to invest or type of asset in whichto invest

The allocation of assets establishes in which assets classes to invest and to whatproportion of the portfolio. The main asset classes are: fixed income, equities,currencies, commodities, property market, alternative investment, etc. Each assetclass can be subdivided, i.e., public or private fixed income, global or emergingequities

Security selection consists of choosing particular assets to incorporate in theinvestment portfolio, i.e., assets of company A, sovereign bonds of country B, sharesin venture capital firm C

Execution consists of entering and executing asset buy and sell orders, as well asportfolio coverage and rebalancing operations

Assessment consists of analysing investment behaviour over time. The followingvariables are generally measured: absolute profitability and risk performance(profitability and volatility) and relative profitability and risk spreads(deviations withrespect to the reference index, alpha, beta, tracking error), among others.

THE INVESTMENT PROCESS

Investmentpolicy

Assetallocation

Securityselection

Execution

Reballancing& Assessment


Socially ResponsibleInvesting StrategiesAlthough the degree of determinationof ESG variables when it comes to takinginvestment and disinvestment decisionson assets can vary enormously, we candesign a tree that summarises the mainresponsible investing strategies:

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Socially Responsible Investing

Focus:Influence

Focus: Selectionof Companies

Focus:Social Impact

Engagement NegativeApproach

PositiveApproach Social Action

ThematicInvest-ment

Bestin Class

PORTFOLIO MANAGEMENT

In this document we will focus exclusivelyon the sphere of investment portfoliomanagement and exclude any analysisof investments that seek a direct socialreturn, such as corporate philantrhropy,community investment initiatives or‘bottom of the pyramid’ projects.

SRI strategies have two main formulas,

although they are not mutually exclusive.On the one hand is the idea of influencingbusiness decisions. On the other is theidea of distinguishing betweeninvestments in accordance with ESGcriteria.


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SRI strategies

POSITIVE SCREEN APPROACH:

For its part, a negative approach establishesethical screens that exclude particular businesses,industries or sectors of the investment universe . The most commonly used ethical screens coverarms, tobacco, alcohol, nuclear energy, gamingand pornography.

Beyond generic SRI strategies, there are a numberof socially responsible benchmarks on the market.Major ones in terms of reputation and globalscope, respectively, include the FTSE4Good andthe Dow Jones Sustainability Indexes. Each indexprovider establishes a series of socially responsiblecriteria used in order to be granted permissionto join the index.

** The evolution of these indexes and theircomparison with general indexes can be consultedin the section on RESEARCH indicators.

this attempts to incorporate actions with aparticular profile or set of ESG practices.

NEGATIVE SCREEN APPROACH:

these types of strategies incorporateESG criteria into the selection of thecompanies or assets in which toinvest. This is the most frequentpractice, especially in Spain, wherethere is little involvement on thepart of fund managers in variablesthat are not purely financial(dividend policies, capital increases,acquisitions). There are twoapproaches within the selection ofcompanies:

Focus on Influence: with a focus oninfluence, investors incorporate ESGcriteria through the active exerciseof shares’ political rights. Thisinvolves embarking on a dialoguewith corporate management. Thematerialization of this shareholderengagement can range from theoccasional requirement ofaccountability at general meetingsof shareholders through to theestablishment and negotiation ofmanagement goals in terms of CSRwith management. For furtherinformation, see: VII CuadernoForética - El activismo accionarialen Europa. Manual europeo 2006

BEST IN CLASS: through a Best in Classapproach, the investment manager selectsonly the best companies with respect to oneor more objective variables.

EXAMPLE 1: Businesses with fewer CO2emissions per produced unit produced areselected. Example 2: Only companies with aCSR rating above 3, on a scale of 1-5, areselected.

THEMATIC INVESTMENT: this type ofinvestment involves capturing a particularthematic opportunity. For some of the more‘purist’ sectors, these types of funds are notnecessarily SRI if they are simply invested inan activity with social or environmentalattributes but do not incorporate ESG criteriain the investment process in an across-the-board fashion. A fund that invests in cleanenergies but does not take social or goodgovernance aspects into account would notbe considered SRI.

EXAMPLE 1: Clean energy funds. Example 2:Water funds. Example 3: Funds that invest ininnovation. Example 4: Microcredit funds.

FOCUS ON SELECTION OFCOMPANIES:

FOCUS ON INFLUENCE:

http://www.foretica.es/es/index.asp?TR=A&IDR=28&MP=33&MS=85&MN=2&id=13

http://www.foretica.es/es/index.asp?TR=A&IDR=28&MP=33&MS=85&MN=2&id=13

The Size of the SRIMarket

Socially Responsible Investing has beenone of the biggest growth areas in theworld of asset management for a numberof years. According to Eurosif (theEuropean Sustainable Investment Forum),SRI grew by 46 % per year over the lastexpansion cycle (between 2002 and2007) in Europe alone. Here, SRI alreadyrepresents over 17.6 % of assetsmanaged, which suggests that sociallyresponsible investing may be movingout of a niche market to become ageneral practice.

The world market for responsibleinvesting reached 5 billion euros at itspeak, prior to the economic downturnof 2008. This figure is big enough forlisted companies to sit up and take noticeof this growing niche of investors. So, ifwe compare the present volume of SRIwith the capitalisation of leading Spanishbusinesses we can see that theseresources are the equivalent to buyingthe IBEX 35 twelve times over, or 55companies like Telefónica. (See graph)

Roll-out in Spain has deviated significantlyfrom the European trend, however. Spainhas an under-developed market that

accounts for less than 1 % of totalinvestment, according to the EurosifReport which uses figures from the closeof 2007.


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2007 World SRI Market€4.9 billion

USA 38%

Canada 7%

Australia 1%

JAPAN 0,1%

Europa 53%

Source: Eurosif

Demand in the investment marketcomprises two clearly differentiatedsegments. The institutional market isbasically formed of pension plans,insurance companies and private financialentities. The retail section comprisesprivate investors, within which we findeverything from large fortunes ( HighNet Worth Individuals [1] ) to small savers.

Supply is structured around assetmanagement companies that receive amanagement ‘mandate’ (see graph). Amandate is basically a ‘commission’ tomanage financial resources for a thirdparty, which establishes the type ofinvestments that can be made in relationto a number of profitability goals anddesired risks. Managers attempt to satisfyboth segements of demand, i.e.,institutional and retail. Sometimes theyoffer specific products for each.Otherwise they can create investment

vehicles that feature the participation ofboth wholesalers and retailers in a singleinvestment portfolio, although withdifferent prices and conditions. Anexample of the former would be thecreation and marketing of an investmentfund on the Spanish stock exchangeearmarked at private investors. Anexample of the latter would be thecreation of a fund that invests in Chineseequities. The portfolio would be marketedvia two types of shares: class A forinstitutional investors and class B forprivate investors.


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[1] HNWI (High Net Worth Individual) refers to private investors who have over a million dollars in financial assets.

SRI Market and Relative Importance

0 10 20 30 40 50 60

Coca Cola

Telefónica

Microsoft

Exxon Mobile

Ibex 35

SRI market versus value of large companies (no. of times)

SRI Supply andDemand: Who ManagesIt? Who Purchases It?


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It is a good idea to analyse the twosections, i.e., institutional and retail,separately, as they have significantlydifferent competitive dynamics.

The Retail Market inSpain. A Market ofSupply

A Market of Supply. Spain has twoimportant peculiarities that make the

retail investment market one in whichsupply prevails over demand. This is dueto the fact that financial entities haveenormous power when it comes toprescribing saving and investmentproducts. This phenomenon is known inacademic circles as a problem ofasymmetric information, in which oneparty (supply) has a lot more informationand knowledge than the other party(demand) and therefore a great deal ofinfluence. The fundamental reasons forthis include the following:

Mandate

Supply

Retailers

Institutional

Demand Manager

Retail fund

Multichannel Fund

Institutional Fund

A. Dependence on prescription: Spanish savers demonstrate alower level of financial sophistication with respect to neighbouring countries.This generates a natural preference for investment in property, deposits andsovereign fixed income (goverment bonds). 45.7 % of family savings is foundin bank deposits, compared to a small 9.1 % in mutual funds. This lack offinancial sophistication goes hand in hand with a need for prescription ininvesting in other, more complex assets such as equities, raw materials,structured products or thematic funds.


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Family Financial Savings in 2008

Direct Investment: 27%

Créditos: 1%

Insurance: 9%

Others: 2%Pension Funds: 6%

CollectiveInvestmentInstitutions: 9%

Bank Deposits: 45.70 %

Source: Directorate-General of Insurance and Pensions Funds. Ministry of Economy

B.A great many banks. Spain has more bank branches per inhabitantthan anywhere else in the world. Before the financial downturn, Spain had95.87 branches per 100,000 [2] inhabitants, compared to Germany with49.41 or the US with 30.86. This figure reveals an important interactionbetween physical branches and customers. At the same time, this structureof banking networks – oversized, in the opinion of many experts – can onlyturn a profit by generating commissions on products. Own trademark productsusually generate the highest commissions for bank branches. This createsa dynamic favourable to proprietary-product prescription, reducing the visibilityof other, possibly more competitive, products.

Taking these two elements into consideration, we see a two-speed bankingsystem. While Spain has had an enormously competitive banking market interms of mortgage activity and deposit capture in recent years, saving andinvestment products face a series of conditions that greatly limit theircompetition and sophistication. This forms an unavoidable barrier to thedevelopment of SRI, because it is necessary to previously understand conceptssuch as equities, the geographic markets where investments are made,whether or not there is a currency risk, and so on, in order to be able to makeinformed decisions about purchasing these types of products. Here we shouldpoint out that the problem is not a lack of transparency or shortage ofinformation on investment products. Abundant and complete information isavailable. The main barriers are a deficient financial education on the partof the pubic and de-facto reduced competition in retail (the marketing ofsaving and investment products).


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The institutional market is a professionalone with an extremely high concurrencebetween supply and demand. Indeed itis in this segment where most progresshas been made in recent years,particularly in terms of pension plans,where companies that promote pensionplans for employees are beginning torequire ESG criteria from their fundmanagers.

However, the institutional market in Spainis one of the least-developed in Europe

in terms of volume of investments. InEurope, the institutional sectionrepresents 66 % of the total market,compared with 28 % in Spain. Within theSpanish market, the most active side ofSRI, i.e., employment pension plans,represents just one-third of the total.

[2] Cajas de Ahorros Foundation, FUNCAS

The InstitutionalMarket in Spain: AMarket of Demand.


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We should point out that the success ofSRI in Spain, as in other countries,involves the development of thesepractices in the institutional market. Thisrequires two profound structuraladjustments.

Firstly: expanding the institutional marketin volume and importance. This marketrequirement is due to the foreseeabledeficit in the public pension system andchanging demographics, which make itnecessary to shore up and boost thesecond and third pillars of the pensionsystem. Consequently, increasing theweight of employer-contribution pensionplans (second pillar) and individual plans(third pillar) would ensure pensions forthe public and bring the weight of Spain’sinstitutional market into line with theE u r o p e a n a v e r a g e , w h i c h i sproportionately 2.35 times bigger.

Secondly, enhanced integration of ESGcriteria in pension plans involves greateramplitude in the supply of plans, as wellas enhanced transparency in theirmanagement. Although regulatorychanges were recently introduced in thisarea, they are being rolled out very slowly.

In this regard, better development of theinstitutional market would generateeconomies of scale and greaterprofessionalization among the industry(supply) in Spain. This would be anecessary condition for the developmentof the retail market, although it does notgo far enough. The retail market alsorequires structural changes with regardto the financial education of savers andmore de-facto competition in themarketing of saving and investmentproducts.

Source: EFAMA

0%10%20%30%40%50%60%70%80%90%

100%

UK EU

Fran

ce

Ger

man

y

Hungar

y

Port

ugal

Aust

ria

Gre

ece

Ital

y

Belg

ium

Spai

n

Institutional Retail

Distribution of the Retail versus Institutional Markets in Europe

PUBLICATION ON CSR FACTS AND TRENDS

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Initiatives to Boost SRI

The two most important developmentinitiatives in Socially ResponsibleInvesting also appear to respond to thissupply/demand structure. Theseinitiatives are principally SIFs (SocialInvestment Forums) and PRIs (Principlesfor Responsible Investment). As a generalrule, they can be linked respectively withsupply or demand. SIFs are more closelyrelated to SRI supply (managers andanalysis suppliers), while PRIs are moreoften related to demand (mainlyinstitutional investors).

SIFs: Social Investment Forumsconstitute the first organisation of theSRI market and include the collaborationof managers, NGOs, rating agencies,research providers and academicinstitutions. The SIF agenda has stronglinks with providing support to the workof fund managers via the developmentof market surveys, reports on economicsector sustainability and the creation oftransparency guides regarding theanalysis process of ESG criteria. Althoughthere is no standardised SIF structureand it responds to local agendas thatdiffer between countries, at the Europeanlevel there is a meeting point betweenthem. Eurosif is the European SIFassociation where national initiativescome together to achieve general goalsat the European level, such as improvingreporting standards and promoting SRI.The first SIFs in Europe appeared in theNetherlands (1995) and the UnitedKingdom (1998). SpainSif is of recentcreation (June 2009), following variousyears of work on the part of itspromoters. Other SIFs around the worldinclude the US, Australia, Canada andAsia.

UNPRI: L: Principles for ResponsibleInvestment were the response to a 2005

United Nations call to institutionalinvestors to develop a number of SRIprinciples. The six Principles ofResponsible Investment arose from thework of institutional investors togetherwith the UN and other stakeholdergroups. The PRI agenda is more closelylinked to providing promotion and actionmechanisms on the part of institutionalinvestors (pension plans, insurancepolicies and financial institutions) sothey develop dialogue platforms betweeninvestors and businesses that are objectsof investment and other tools. 650entities around the world presently workwith PRIs, a third promoting pensionplans.

The Investment Case:Profitability-Risk

One of the controversial principles of SRIrevolves around the empir icaldemonstration of whether ESG criteriaadd value to or subtract it frominvestment portfolios.

From a scientific viewpoint, profitabilityin itself is not a good indicator formeasuring value creation. An investmentis only understood to add value whenthe profitability obtained by each unitof risk undertaken is maximun incomparison with other investmentalternatives. That means that a veryprofitable investment does notnecessarily have to be efficient if higher-than-‘normal’ risks are assumed to obtainit.

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Do Ethics Subtract from Profitability?

Conventional wisdom holds that theintegration of ESG criteria in investmentsis commendable from a humanisticviewpoint but less profitable from thepractical side. Investing in pollutingsectors or activities that do not offerguarantees with respect to human rights- the argument goes - will provide above-average profit.

A more scientific view in this regardwould be that when applying ESG criteriayou are first and foremost limiting theinvestment universe, which thereforecould exclude assets within the optimalinvestment frontier by reducingdiversification alternatives.

Or Do They Improve theAnalysis of CompaniesOffering Investment andDisinvestmentOpportunities?

This is not borne out by the reality. Arecent report from consultancy groupMercer[3] which reviewed 36 academicstudies in this regard, some of whichcovered the period between 1984 andthe present day, found that only 10 %would support this popular theory. Bycomparison, 60 % of the studiesestablished a positive relationshipbetween the application of ESG criteriaand financial profitability.

Profitability-Risk Relationship of SRI: Empirical Studies

[3] Shedding Light on Responsible Investment: Approaches, Returns and Impacts. Mercer, November 2009.

20

2

8

3

Positive relationship

Neutral-negative relationship

Neutral-positive relationship

Negative relationship


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Perhaps, As Always, ItDepends on the Qualityof the ManagerIn the last analysis, the quality of themanager is the truly differential point inportfolio management. Forética has spentthree years following the five-yearevolution of the ten best-performing SRIfunds versus the ten best-performingtraditional funds in the MorningstarGlobal Large-Cap Blend Equity category.

The three observations that follow weretaken at the last stock exchange peakof 2007, right in the middle of the 2008downturn and during recovery in 2009.The results show that prior to thedownturn, the two best-performing funds(of the 20 considered) were SRI ones,taking their profitability/risk ratio into

account. This pattern continued duringthe downturn of late 2008. Subsequently,now in the recovery of 2009, four of thetop five funds were SRI ones and onceagain the top two were as well.

Source: Morningstar, Avanzi, Forética

Volatility

Acc

um

ula

ted

pro

fita

bil

ity

SRI 12/07/2007 Traditional 12/07/2007 ISR 31/12/2008Traditional 31/12/2008 SRI 26/08/2009 Traditional 28/08/2009Linear (SRI 12/07/2007) Linear (Tradicional 12/07/2007) Linear (SRI 31/12/2008)Linear (Tradicional 31/12/2008) Linear (Tradicional 31/12/2008) Linear(SRI 26/08/2009)Linear (SRI 26/08/2009) Linear (Tradicional 28/08/2009) Linear (Tradicional 28/08/2009)

SRI Profitability and Risk Versus Traditional Managementl

120.0 %

100.0 %

80.0 %

60.0 %

40.0 %

20.0 %

0.0 %

-20.0 %

Traditional

PUBLICATION ON CSR FACTS AND TRENDS

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Conclusion

Socially Responsible Investing is a realityon the international assets-managementlandscape. The immense majority ofinvestment fund managers have beenrolling out teams and launchinginvestment products related to aspectsof sustainability, while a whole relatedindustry has flourished. ESG ratingagencies, investment consultancies,NGOs and research centres have madeSRI more than a niche market.

Spain, as we have seen, is laggingseriously behind in the development ofSRI because of characteristics typical toSpanish savers (generally removed fromfinancial investment circuits) and the

limited development of the institutionalmarket. However, a changing trend hasappeared in recent years, brought aboutthe incorporation of a growing numberof employment pension plans in SRIactivity.

Once SRI has reached its maximumpenetration in this segment of theinstitutional market, future growth willslow down unless end consumers changetheir savings preferences. We should notforget that from the marketingperspective SRI is a hyper-segmentationof saving and investment products andas such requires a series of previousnotions with regard to capital markets,analysis methodologies and assetmanagement.

14

5-Year Profitability – Top 10 SRIs vs. Top 10 Traditional

56%

8.9%

57.5%

8.7%

Profitability

2007

Risk Profitability

2008

Risk Profitability2009

Risk

ISRI Traditional

-1.8% 2.8%

16.2%15.0% 9.6%

4.8%

17.3% 17.2%

The samples tested at three securities cycle show efficient relationship between profitabilityand risk of SRI products.

PUBLICATION ON CSR FACTS AND TRENDSRSEARCH 15

When this first barrier has beenovercome, savers will have to matureand match their variable aversion to riskwith an appreciation of the social andenvironmental attributes of theirinvestments. Here at Forética we areoptimistic that growing public awarenessof sustainability (see the different InformeForética (see the different InformeForética reports) will reach the world ofsavings. Sociological changes are slow.It is a matter of waiting.

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http://www.foretica.es/es/index.asp?MP=33&MS=85&MN=1&TR=A&IDR=28&idCat=5

http://www.foretica.es/es/index.asp?MP=33&MS=85&MN=1&TR=A&IDR=28&idCat=5

PROJECT DIRECTOR:Jaime Silos

EDITORS:Germán GrandaAna HerreroLaura MaureNatalia MonteroJaime SilosRicardo TrujilloÍñigo Luis

DESIGN: 21 Gramos, Marketing de peso.

TRANSLATION: CELER Soluciones

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February 2010 I Nº 2