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The question of scale
The contemporary fiduciary cannot easily factor such issues into his/ her decision-making, due in part to the very scale of modern financial institutions and their role in global capital markets. Consider the following items, which evidence the staggering growth of financial institutions and capital markets:
Private pension fund assets in the United States grew from about $250 billion in 1975 to $2.5 trillion in 1994.
The State of California's public employee pension fund grew from $13.3 billion in 1979 to $80 billion in 1994.
In 1990, nearly a hundred portfolio management organizations managed more than $10 billion, and the ten largest managed $800 billion of financial assets of the roughly $5 trillion in stocks, bonds and real estate owned by institutions.
Volume on the New York Stock Exchange increased from 767 million shares in 1960 to almost 36 billion shares in 1986 and to the 70 billion range in 1993. From 1982 to 1992, trading increased tenfold in Tokyo, twelve-fold in Frankfurt and thirty-fold in London.
In 1960, annual turnover (shares traded as a percentage of total traceable shares outstanding) on the New York Stock Exchange was 12 percent. Turnover rose to 64 percent in 1986, but when the activity which now occurs on regional exchanges, in the over-the-counter market and in foreign markets is taken into account, the consolidated trading in Exchange-listed stocks in the U.S. and abroad produced a turnover of 87 percent.
Derivatives and synthetics - futures, warrants, swaps and scores of newly engineered financial products - have created multi-trillion-dollar markets, many of which have doubled in a single year. In 1992, the value of swap contracts equaled the combined worth of the New York and Tokyo stock markets. Annual international volume of equity index derivatives in 1992 exceeded $10 trillion.
Pre-tax profits of U.S. brokers and investment banks reached a record $8.9 billion in 1993.
As financial markets explode, intermediaries and transaction-based incentives increasingly influence corporate decision-making and the flow of capital. Increasing complexity of financial instruments and global markets drives increasing specialization of financial managers. Fiduciaries seem more removed than ever from the social and environment consequences of their decisions. "Most of the time," writes leading investment banker Felix Rohatyn, "the product being bought or sold only exists on a computer screen or as an electronic impulse on a magnetic tape.... The movements of capital and the paper economy related to it used to be the result of industrial and commercial activity; now they are the cause."
When transactions come first, the consequences on individuals and community can be devastating. Commentator Adam Smith describes how most financiers never see the effects of their decision-making:
A worker may work for the same company for twenty years. A manager may live in the community, support its schools, and work to integrate the company and the community. But the owner reigns supreme; it is up to him whether the plant is shut down, the worker laid off, the manager sent somewhere else. Yet the owner these days is seldom the founder with the big house up on the hill. Technically, the owner (or at least one of the owners) is probably a pension fund or mutual fund, represented by a young portfolio manager who shares neither history nor loyalty with the company and who will sell out in five minutes if that will improve his track record. Or the owner may even be a group of arbitrageurs seeking the fastest return possible on a very swift turnover - measured in hours, not in months or years.
The implications for those concerned with the social and environmental impact of business are daunting. Whither, amidst the torrent of financial activity and the divorce of portfolio managers from people and places affected by their decisions, the concept of sustainability?
Asset management and the behavior of business
So long as assets are viewed as passive pools of income-generating securities, fiduciary responsibility ends with a diversified asset allocation plan and the selection and monitoring of money managers. Yet some institutional investors have taken in recent years a first step towards a more proactive definition of fiduciary responsibility, one which recognizes that their investment expectations can and do impact corporate behavior.
The Council of Institutional Investors, whose membership includes roughly eighty of the nation's largest public employee and union pension funds, focuses attention on corporate governance and the problem of boards of directors failing to adequately represent the financial interests of shareholders. In particular, the Council has vigorously attacked distorted compensation packages for senior management of many corporations: "High pay is not the same as pay for performance and may not, in fact, improve performance," noted the Council's April, 1994 newsletter. "Compensation can be tied to performance without giving away the store. And giving away the store pursuant to a formula still leaves one without a store."
The California Public Employees Retirement System (CALPERS), one of the nation's largest institutional investors and an active Council member, has been a leader on issues of corporate governance. Most recently CALPERS has included issues of workplace conditions and employment practices in their annual governance reviews as "one of many other considerations ... in our investment decisions."
Such initiatives mark the beginning of a process of integrating into investment decision-making factors that have previously been considered beyond the purview of financial analysis. How does a $10 million CEO compensation package affect employee morale? How does a CEO's "independent wealth" affect his/her attitude toward and loyalty to the corporation? Will directors who are paid $40,000 per annum in fees act with sufficient independence to effectively oversee senior management? Will corporations with broader employee participation in ownership or decision-making enjoy a competitive advantage? These are questions about compensation and governance, specifically, and, more generally, about corporate culture.
Assistant Secretary of Labor Olena Berg, the former Chief Deputy Treasurer of California who currently oversees the regulation of the U.S. pension industry, believes that a broader view of investor responsibility is inevitable for pension funds. "We will be asking pension funds to change their thinking," Berg says. "Instead of thinking only about beating the market by another increment, we want them to think about how their investments are contributing to the long-run health of the economy ... Given the size of the funds, it doesn't make sense to try to beat the market for a quarter. When you are the market, as the funds are, you can't beat it. The goal should be an overall lifting of the economic boats by investing in ways that are economically productive and create more and better jobs." (New York Times, August 10, 1993.)
The role of financial institutions in steering business toward sustainability begins with such steps. Concerns about corporate governance and the creations of long-term benefits to the economy as a whole mark evolving concepts of "prudence" towards broader investor responsibility and the inclusion in investment decision-making of factors previously beyond the purview of financial analysis.
Nevertheless, the connection between the long-term health of the economy and the social and environmental costs of economic growth remains problematic for fiduciaries. Institutional investors have been very slow to embrace "social investing," or strategies which explicitly seek to address this connection.
Social investing, or "ethical investing" as it is called in England, is the term that has come to be used to describe investment strategies which take into account social and environmental impact alongside financial performance. It is not a precise term. As a result it is difficult to be certain of the scale of the endeavor. The Economist (September 3, 1994) suggests that there is "an estimated $650 billion now managed according to some ethical guidelines," but that figure is probably an overestimate.
UNITED STATES TRUST COMPANY BOSTON
WE SEEK COMPANIES WHICH HAVE:
+ CONSISTENTLY GOOD
WE AVOID COMPANIES THAT:
- PARTICIPATE IN THE NUCLEAR POWER INDUSTRY, MANUFACTURE PESTICIDES OR OTHER AGRICULTURAL CHEMICALS, ENGAGE IN AGRICULTURAL BIOTECHNOLOGY
- SHOW PATTERNS OF ENVIRONMENTAL VIOLATIONS, UNLESS COMPANY HAS MADE A MAJOR COMMITMENT TO SOLVING COMPLIANCE PROBLEMS
- HAVE BEEN NEGLIGENT IN HANDLING ENVIRONMENTAL PROBLEMS, UNLESS COMPANY IS SUFFICIENTLY INVOLVED IN CORRECTING PROBLEMS
- ARE RESPONSIBLE FOR MAJOR ENVIRONMENTAL DISASTERS, UNLESS COMPANY IS SUFFICIENTLY INVOLVED IN CORRECTING UNDERLYING CAUSES
- ARE UNCOOPERATIVE IN DISCLOSING ENVIRONMENTAL INFORMATION
- ARE IN "DIRTY" INDUSTRIES WITH BELOW-AVERAGE RECORDS OF PERFORMANCE
- USE UNNECESSARILY DAMAGING INPUTS WHERE OTHERS IN INDUSTRY ARE USING ALTERNATIVES
What is clear is that there has been significant growth in the field since 1981 when the Social Investment Forum, the trade association for social managers, was formed. It should be noted that individual investors are driving the growth of mutual funds with social investment strategies. There are an estimated 33 such funds (one-third of which were established during the last year), with total assets of $2.5 billion, reflecting a trebling since 1990.
While emphasis and specialization vary between investors and firms, a number of broad screens are illustrative of the types of criteria by which companies are evaluated by many social investment advisors:
Environmental impact and performance
Employee benefits or ownership
Community involvement and charitable giving
Racial and gender diversity of directors and management
Limited or no weapons component manufacture
Limited or no tobacco or alcohol production
One of the variables of social investing is how such screens are applied. An example of a general environmental screen, shown in Figure 1, indicates some of the complexity involved in screening. Some screens are '`negative" avoiding whole sectors or companies whose practices are not consistent with stated criteria. Others are "positive" - seeking companies demonstrating leadership in responsible business practices. Some are "relative," recognizing the best in class in industry sectors which as a whole remain problematic for social investors.
More often than not the investment program is passive: buying and selling stock, without companies having any awareness of the views of social investors except through their proxy voting.
Increasingly, however, initiating or actively supporting shareholder resolutions has afforded concerned investors a means by which their voice can be registered with corporate management. Organizations such as the Interfaith Center on Corporate Responsibility (ICCR) work actively with church pension funds to sponsor shareholder resolutions on a range of social investment concerns. Since 1971, ICCR has sponsored more than 5,000 resolutions, on matters ranging from the environment to South Africa, from infant formula abuses to equal employment opportunity, from wage levels in the maquiladoras of Mexico to economic conversion of weapons manufacturers.
The financial performance of social investment funds is a topic of continuing debate. Most institutional investors eschew social investment based upon two almost axiomatic premises:
That the extra layer of "non-financial" factors will reduce the opportunity set, increase risk, and reduce return,
That any investment that yields a financial return also produces social benefits, in terms of jobs and products or services that meet a need.
As evidence of the first premise, the underperformance of social investment portfolios over various periods is often cited by analysts; however, comparable periods of underperformance can be found in virtually every sector of the money management industry.
Discussions of social investment returns are muddied by the fact that there is significant evidence that most money managers - including, of course, those that employ no social or environmental screens - underperform market indices over time. For example, one study of 769 all-equity pension fund accounts with assets of more than $120 billion "found that on average the funds' annualized returns over each three-year interval ... lagged behind the S&P 500-stock index by 1 percentage point and by 2.1 percentage points when the funds' returns are weighted by size ... And that's not counting management fees or lower returns on cash holdings." (Business Week, July 13, 1992.) For this reason, index funds grew in popularity among institutional investors during the 1980s, with the percentage of institutional equities invested in index funds rising from less than 5 percent to approximately 25 percent. (The Economist, April 30, 1994.)
In 1990, the Domini Social Index became the first index fund to incorporate social and environmental screens. Since its inception, the Domini Index is up 71%, vs. a 60.5% increase for the S&P 500. For the nine years ending in 1993, the institutional equity accounts at Franklin Research and Development, an early leader in the field, yielded an annualized rate of return of 16.75, before fees, against an annualized S&P return of 15.35 over the same period. In the 13 years ending in December 1993, U.S. Trust yielded an annualized return of 15.1% before fees. In the three years ending on June 30, 1994, Win-slow Management, a balanced manager focussing on environmental impact and innovation, achieved an annualized return of 10.17% before fees, against a balanced index weighted 65 percent S&P 500 and 35 percent in Lehman/Government Indexes, which for the 36 months was at 8.97 percent.
Economically targeted investing
While most financial institutions have been reluctant to pursue social investing through stock and fixed-income portfolios, some have, however, pursued "economically targeted investments" (ETIs) in their private or alternative investments. While lacking a single, standardized definition, ETIs have been defined by the Center for Policy Alternatives as "any prudent investment that fills a capital gap in an underfinanced area of the economy and earns a risk-adjusted market rate of return." Aiming to produce competitive returns and targeted social benefits, ETIs have included small business loans, venture funds dedicated to minority-owned businesses, and mortgage pools for low-cost housing.
The Colorado Public Employees' Retirement Association (PERA) targets more than $850 million, or about six percent of its total assets, to economic development investments in Colorado. PERA invests $75 million through Colorado Housing and Finance Agency bonds to finance fixed-rate, long-term small business loans in Colorado. Since 1992, the California Public Employee Retirement System has committed $375 million for single-family housing construction when traditional financing sources withdrew from the market. By the end of FY 1992, CALPERS had invested $5.6 billion, or over seven percent of total assets of $77 billion, in investments classified as ETIs.
As of September, 1993, the twenty largest U.S. public pension funds had invested more than $23 billion in ETIs, with roughly 85 percent going to mortgage-related investments and the remainder in venture capital, private placements, or other direct investments.
Despite these initiatives, however, nine out of ten pension funds responding to a 1994 survey conducted by Institutional Investor magazine indicated that they felt ETIs were not consistent with their fiduciary responsibility to secure the greatest financial returns for their beneficiaries. Nearly three-quarters of survey respondents were corporate pension funds.
For those who have pursued ETIs, various financial and social measurements have been used to evaluate performance. Massachusetts measures its small-business-loan securities against 90-day Treasuries. The GE pension fund expects an economically targeted mezzanine fund to beat the S&P 500 by 300 basis points. As for social benefits, yardsticks include number of new homes under a certain price level or jobs created within a defined geographical area or within a particular population.
But questions regarding rate of return, performance benchmarks, measurement of social benefits, and possible trade-offs between financial and social returns continue to prevent many institutional investors from pursuing either ETIs or from choosing money managers who pursue social investment strategies.
The Jessie Smith Noyes Foundation
The Jessie Smith Noyes Foundation, with assets of approximately $60 million and grant allocations of about $3.5 million per year, has two goals:
Preventing irreversible damage to the natural systems upon which all life depends.
Strengthening individuals and institutions committed to protecting natural systems and ensuring a sustainable society.
Involved with social investing since the 1980s, during the last two years the Foundation has redefined its investment policy as part of a process of redefining "fiduciary responsibility" for itself.
Our premises may be summarized informally as follows:
What good are good returns if you cannot drink the water or breathe the air?
Fiduciary responsibility must be subsumed by institutional or corporate responsibility, not the other way around.
We believe that it is our responsibility to view our assets, as well as our income, as tools for social change. Repercussions with respect to the behavior of the companies in which we invest are, however indirectly, our responsibility. The full scope of this responsibility can be summarized in a simple question: How does the commercial activity that our investments finance affect stake holders or damage the environment, now and in coming years?
Stakeholders include employees, customers, suppliers, and communities in which companies do business. Recognized, here, is our fiduciary responsibility to understand the use of our assets not only in terms of the financial needs of our beneficiaries (in this case, grantees), but also in terms of impact on the environment, the economy, and democracy as a whole.
Such an approach stands in contrast to that of the foundation sector as a whole. Paradoxically, the bifurcation between profit-maximizing and social purpose is nowhere more pronounced than within foundations, where the iron curtain between endowment management and the grant-making program is virtually inviolable in the name of "making as much as possible so we will have more to give away." Program officers focus on their obligations to foundations' primary constituency, grantees. Treasurers, finance committees and money managers focus on what they know best. For the most part, the two sides of the house share neither training, temperament, nor professional goals, and their interaction is minimal.
"Compared to other components of foundation philanthropy, endowment has little natural appeal," suggests one observer. "It projects none of the excitement of bold program initiatives, diversity among trustees or strategic, proactive grantmaking." Irene Diamond of the Diamond Foundation takes the case one step further. "Most foundations spend very little of their money. They're in the investment business." Seeing the choice between either "profit-maximizing" or "giving it all away," the Diamond Foundation has chosen the latter course, proceeding on a pace of giving that will spend the foundation out of existence in a few years.
In response to a similar recognition of the "dissonance" between philanthropic initiatives and investment management, the Jessie Smith Noyes Foundation has chosen a different course. Our investment policy appears in Figure 2. We have chosen to align our asset management with our mission.
What has this meant in practical terms? First, we have placed all of our public equities with three managers - US Trust, Franklin Research, and Winslow Management, all in Boston - who evaluate social and environmental impact along with financial performance and who are willing to work with us interactively as we refine our strategies and screens. We are also working similarly with our fixed-income portfolio manager, Bear Stearns. Second, we have allocated five percent of our assets to direct venture capital investments in private companies whose business is consistent with our mission. By the end of 1994, we will have invested roughly $1,000,000 in several early-stage companies, including an energy services company, a developer and marketer of enzyme-based cleaning products, and a manufacturer of leak detection systems for underground storage tanks.
Third, we are exploring the efficacy of communicating our concerns directly to management of companies whose stock we hold. For example, as a sizable supporter of sustainable agriculture with our philanthropic dollars, we are cautious about agribusiness companies even when they pass the general social screens of our money managers. In the case of a large food distributor, we have initiated correspondence to further probe corporate positions with regard to farming practices of suppliers, corporate involvement at the community level, and a number of other concerns. We are also currently working with a number of our sustainable agriculture grantees to identify areas of strategic opportunity, in order to effectively target investment initiatives in this area. We became engaged with management of another portfolio company, Intel, when we discovered that one of our grantees, the Southwest Organizing Project (SWOP), was challenging the company.
The Jessie Smith Noyes Foundation Investment Policy
Statement of Responsibility
We begin the endowment management process recognizing that our responsibility does not end with maximizing return and minimizing risk. We recognize that economic growth can come at considerable cost to community and environment. We believe that efforts to mitigate environmental degradation, address issues of social justice and promote community development will be successful to the extent that these concerns are brought from the margins to the center of business and investment decisionmaking.
We recognize that addressing such concerns while pursuing financial objectives is an imperfect process. However, we believe that the development of healthier corporate cultures, and through them a healthier, sustainable economy, depends upon the recognition of these concerns by management, directors, employees and investors. Within foundations, this means reducing the dissonance between charitable mission and endowment management.
We believe that in light of the social, environmental and economic challenges of our time, fiduciary responsibility in the coming decades will dictate the integration of prudent financial management practices with principles of environmental stewardship and corporate citizenship. Foundations have a particular role to play in this process, by coming to understand their mission not only in terms of the uses of income to fund programs, but also in terms of the ends toward which endowment assets are managed.
Investment Goals and Guidelines
The Jessie Smith Noyes Foundation seeks to preserve its real purchasing power over time through a diversified portfolio of stocks, bonds, and alternative investments, utilizing to the extent possible investment managers who achieve competitive financial returns through the application of social and environmental screens. In concert with the Foundation's mission to preserve the environment, promote sustainable community development, and support innovative individuals and organizations, we seek to invest our endowment assets in companies that:
The environmental impact of a business is tied to the throughput of materials as well as to the long-term value of the goods or services it produces. Equity within a corporation derives from participatory management, employee ownership, salary structures, workforce diversity, employee benefit programs, or other demonstrated commitments to the well-being of all individuals involved in an enterprise. A corporation can promote sustainable community development through local job creation for the economically disadvantaged, corporate giving to and active involvement with community organizations, or other initiatives that provide net benefits to the local economy. In evaluating the environmental impact of a company, we look for:
We will not invest in companies that:
In industries that do not meet our screens, companies that have signed the CERES Principles or demonstrated particular leadership within their industry with respect to social responsibility and environmental impact may be considered on a case by case basis
Intel, SWOP, and the process of engagement
The Southwest Organizing Project is a respected grassroots group based in Albuquerque that focuses on issues of economic and environmental justice and voter registration in New Mexico. In response to what they perceived as a giveaway by the state of New Mexico to Intel, as part of the company's expansion into the state of its microchip production, SWOP prepared an in-depth report. Issues addressed included state permits for excessive air pollution and water use in the desert, and financial inducements in the form of loans and tax breaks amounting to more than $250,000 per job promised by Intel. We decided, in conjunction with SWOP, that it would be useful for the Foundation to attend Intel's 1994 annual shareholders' meeting in Albuquerque and ask that the company respond to the issues SWOP had raised in its report.
At the meeting, in response to our request, Intel management stated that it was the company's policy to deal with responsible elected officials, rather than with "vocal minorities." They avoided our request for a written reply.
Subsequently, one of our money managers, Winslow Management, became involved, ultimately visiting SWOP and Intel, in turn, and reporting the situation in its newsletter. Another of our managers, Franklin Research, also researched the situation, publicizing it in their newsletter. A number of articles appeared in newspapers and financial publications calling attention to the effort, which got responses from other investors, who also contacted Intel. In November 1994, a shareholder resolution was initiated by the Noyes Foundation, in cooperation with ICCR and others, addressing issues of corporate accountability and transparency to the community.
It now appears that a meeting between Intel and SWOP may occur. Whatever the outcome, we will be assessing on an ongoing basis the efficacy of this type of shareholder involvement by the Foundation.
Corporate culture and sustainability
Our involvement with SWOP and Intel vividly underscores the challenges and opportunities created when one takes an alternative approach to what has traditionally been perceived as a dichotomy between asset management and social purpose. In such alternatives may lie powerful tools for addressing the social and environmental challenges of our time.
Given the magnitude of these challenges, not only must the left hand know what the right hand is doing, but new strategies must be developed and implemented to effectively bring all means at our disposal to bear, not just to enhance our well-being, but, quite possibly, to ensure our survival. Assets must be deployed strategically towards solving large and small problems, not only because problems sometimes translate into new markets, but also because philanthropy and the public sector cannot, by themselves, do what has to be done.
The benefits of growth in assets are illusory to the extent that they compromise or destroy the environment, which is the basis of all life and all production. Or, as Wendell Berry observes, "An economy that sees the life of a community or a place as expendable, and reckons its value only in terms of money, is not acceptable because it is not realistic."
Incorporating what we have come to know about the realities of industrial pollution and the potential for large scale, irreversible damage to natural systems, fiduciaries in the late twentieth century must reckon with the new realities of money management. They must develop a new realism. What was prudent at the inception of the industrial revolution and through various stages of ensuing economic growth is no longer prudent at the threshold of a ten-billion-person globe with a hole in its ozone layer.
Through their investment programs, financial institutions can send critical signals to corporate management and capital markets, encouraging or discouraging integration of concerns about social and environmental impact into decision-making and playing a fundamental role in the process of steering business toward or away from sustainability. By viewing financial assets as resources that can be employed in the service of our goals, rather than as pools of passive income-generating securities, financial institutions can begin the long process of "healing" the bifurcation between social purpose and making money, and so help reinvent corporate cultures, both their own and those of the companies in which they are investing.
Through a new, more realistic understanding of prudence and fiduciary responsibility, institutional investors can nurture a new generation of healthier, more humane, more sustainable companies and, through them, an environment within which healthier communities and a more humane, more sustainable economy can emerge.
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