Socially responsible investing is not a fad – it is a trend
The integration of ecological, social and ethical criteria into the investment process holds economic promise and is beneficial to risk and return
by Thomas Kabisch *)
When glancing at the newspapers these days, one might gain the impression that climate change and the hype surrounding it are just a fad. Yet the subject is far from new. As early as 1974, Munich Re started conducting systematic research into the causes and effects of climate change – more than three decades before the issue became a matter of public interest. Today, Munich Re’s research activities are handled by its Geo Risks Research Centre of Competence.
What is now popularly referred to as sustainability has been an important component of the experts’ considerations from the very beginning – the idea of using a natural system in a way that maintains its most important characteristics in the long term. This view is currently gaining more and more adherents in the investment sector as well. It is therefore fair to say that climate protection and sustainability are both a fad and a trend in asset management.
Requirement for sustainability
When applied to investment, the term sustainability refers to using capital to generate lasting and steady returns. The concept appears perfectly tailored to the investment needs of the insurance industry. The insurance industry’s main institutional investors in terms of asset volume are the life insurers. Pension funds have a similar business model, investing their policyholders’ funds in a way that meets minimum return requirements. The promised or forecast minimum return varies depending on the insurance product. In the case of funded insurance, a minimum annual return is stipulated for all the amounts paid in. What these institutional investors all have in common is that they give very high priority to maintaining the value of the assets entrusted to them. Admittedly, this is not exactly an ambitious asset-management objective in itself, but it becomes one when linked to ambitious target returns.
Investment objectives
Achieving the highest possible return whilst preserving the capital base is probably also how foundations – an increasingly significant group of institutional investors – would describe their investment objective. And their interests are also similar to those of the insurers with regard to the ongoing returns. Insurers need this income to cover their continuous cashflow requirements from insurance contracts, which explains why they are also referred to as liability-focused investors. Foundations, by contrast, need regular income in order to accomplish their purpose, for instance to fund specific projects. And it also serves to cover running costs and establish reserves. Foundations attach great importance to generating the most constant return possible in order to prevent fluctuations in payouts. And although, strictly speaking, they do not take a liability-focused investment approach, their purpose does oblige them to provide the steadiest flow of funds possible.
Minimising risk
Sustainable investment is based on ecological, economic and social criteria, but it is not merely about giving investors a clear conscience. It seeks to minimise risk, and as such it is uncompromisingly profit-oriented. Ecologically sustainable activities minimise risks, lower costs and promote lasting performance. One example of this is the sparing use of energy and resources. The economic criteria practically speak for themselves. In a crisis, a company’s financial strength is safeguarded by a well-functioning risk management system. Social criteria help maintain employee health and performance and increase the competitiveness of companies. Sustainable investment criteria serve to identify profitable corporate strategies that take no incalculable risks and can therefore be successfully pursued on a long-term basis.
Lower volatility
Investors benefit from a lower volatility in performance and steeper growth. That is why sustainable investing is not just a fad but a long-standing trend in asset management for insurance companies and others. This insight has of course spread among companies vying for investors, as they derive two benefits: not only are sustainable business strategies more successful per se, they also make a listed company more attractive for investors. And this is doubly beneficial to the share price.
Measuring performance
A closer look at the risk-return profile of sustainable investments should make this double benefit clear. Figure 1 shows the indexed performance of the Naturaktienindex, the Dow Jones Sustainability Index ex All, the MEAG Nachhaltigkeit, and the MSCI World. The Naturaktienindex is a strict selection of international, "green" companies with predominantly low market capitalisations. The Dow Jones Sustainability Index ex All is a broad international sustainability index based on the best-in-class principle and specific exclusion criteria. The MEAG Nachhaltigkeit is an equity fund that aims to provide investors with better investment results than the Dow Jones Sustainability Index ex All. And finally, the MSCI World is a broad-market, worldwide equity index which most global investors take as a benchmark. A glimpse at the chart suggests that the Naturaktienindex has performed best over the past four years, followed by the MEAG Nachhaltigkeit, the Dow Jones Sustainability Index ex All and the MSCI World. However, the chart only reflects performance. What about the underlying risk? The Markowitz analysis shows that, compared with the broad-market MSCI World, the Dow Jones Sustainability Index ex All fares better, i.e. the investor gets a better return for less risk. MEAG Nachhaltigkeit, as the representative of an investable portfolio, surpasses it even more comprehensively with its much higher returns and lower risk. The Naturaktienindex, by contrast, offers a better return but greater rather than less risk. Furthermore, its investability for institutional investors is limited due to its low accumulated market capitalisation and low liquidity.
Double advantage
Figure 2 illustrates another finding. The curve shows a number of combination ratios between the Naturaktienindex and the MSCI World Index. Taking the triangle representing a pure Dow Jones Sustainability Index ex All portfolio as a basis, the double benefit of a higher return and less risk is achieved by successively adding the Naturaktienindex portfolio to the mix. But this is not the case everywhere, for in the area above the extreme left corner of the curve (portfolio with minimal variance) a higher return can only be achieved at the expense of risk. The fund management of MEAG Nachhaltigkeit avails itself of this analysis. Based on the Dow Jones Sustainability Index ex All, it adds an "innovator portfolio" consisting of small, particularly sustainability-focused companies that are, to some degree, similar to the stocks in the Naturaktienindex. The result is far better than the investment result of the Dow Jones Sustainability Index ex All. What we can learn from this is that to a degree sustainability is doubly advantageous as it brings a higher return and lower risk.
Focusing on innovation
What should the investor choose? Sustainability or climate protection? Figure 2 indicates that the best might be a combination of both. With respect to the risk-return profile, an investment reflecting the Dow Jones Sustainability Index ex All is probably the more conservative option. Investors prepared to accept a greater risk for a better return will add an innovator portfolio specialised in small and medium-sized securities – see MEAG Nachhaltigkeit. By comparison, a climate fund portfolio is likely to have similar features to an innovator portfolio. Investors could therefore actively exchange return for risk, depending on their risk-return preference, thereby achieving a portfolio that is better geared to their requirements.
It should be taken into account, however, that climate funds capitalise not only on long-term and sustained trends but also on innovations. In competing for innovations, winners can quickly become losers (and vice versa), at often significant risk to investors. On top of this, the beneficiaries of global warming are usually small, highly specialised companies that also bear greater risks in this regard. Climate funds are therefore less suited to investors aiming for a steady return at low risk but are rather designed for those who wish to actively invest in pioneering innovations. Although climate funds diversify risks, their emphasis is on seizing opportunities. For this reason they are particularly suitable as additions to a portfolio mix but less as portfolios in themselves.
Investment topic of the future
Sustainable investment criteria are ideal for institutional investors in the insurance industry. The Munich Re Group identified the advantages of sustainable investments early on and therefore defined sustainability as applicable to all levels of asset management. Consequently, Munich Re took part in developing the United Nations' Principles for Responsible Investment presented at the New York Stock Exchange on 27 April 2006. It was among the first signatories worldwide and the first German company to sign up. As the Munich Re Group’s asset manager, we at MEAG ensure that these principles are taken into account in all strategic and tactical investment decisions and, as a next step, in the individual acquisition and disposal decisions. At least 80% of the equity and corporate bond portfolio are invested on the basis of sustainability criteria. In the case of government bonds, we account for sustainability aspects by using a self-developed rating system.
Benefiting from opportunities
The subject of climate change also provides important signals for taking advantage of opportunities within the scope of long-term trends. Experts assume that climate change will only be able to be slowed and not stopped in the foreseeable future. Companies that take on the challenges of climate change, that is those that quickly and unerringly draw the right conclusions, will benefit from the opportunities, as will their owners.
One example of this is the company welivit new energy GmbH, a subsidiary of KarstadtQuelle Versicherungen, in which the Munich Re subsidiary ERGO holds a majority stake. Its task is to place investments from the insurance industry in projects such as solar parks, thereby combining sustainable action with an investment that meets the strict risk and return requirements of German insurance companies. So as can be seen, the overall portfolios of major insurers provide ample scope for innovative investment ideas within a strictly risk-controlled investment process. Our decision to give preference to sustainable investments over traditional ones is therefore more than just a matter of credibility. On the contrary, the integration of ecological, social and ethical criteria in the investment process also holds financial promise, as it favourably influences risk and return.
*) Dr. Thomas Kabisch is the CEO of MEAG
Munich Ergo Asset Management GmbH
The article was originally published in the German financial paper "Börsen-Zeitung" from 10.11.2007 (issue no. 217, page B16).