ESG, CSR, SRI — it seems as if acronyms are on everyone’s lips this year as a growing trend of Socially Responsible Investing gathers momentum across the global financial markets. Investors seeking instruments that match ethical as well as investment criteria are being increasingly met by issuers and practitioners who recognize the enormous potential of the market. With an enticingly appropriate crossover to Shariah principles, the SRI sector represents one of the most exciting financial trends in decades. But, asks LAUREN MCAUGHTRY, is the Islamic industry doing enough to leverage this new opportunity?
Crossover potential
With the SRI industry currently accounting for an estimated US$6 trillion in assets under management, while the Islamic finance industry holds around US$1.6 trillion, both have demonstrated an exceptional growth trend over the past 10 years and represent two of the most exciting niches in financial market development. Michael Bennett, the head of derivatives and structured finance for the World Bank, speaking at the Global Islamic Finance Forum in Kuala Lumpur this month, noted that: “Islamic finance and socially responsible investing follow similar trajectories. The two phenomena have a tremendous overlap, which offers potential for further growth for each.”
SRI assets under management have grown by an estimated 26% a year in Europe since the financial crisis, compared to only 0.4% for all assets under management, while global Islamic AUM have risen by a reported 20.2% from 2012. Dr Zeti Akhtar Aziz, the governor of Bank Negara Malaysia (BNM), recently highlighted the SRI market as “fast growing”. The sector is predicted to become a mainstream asset class by 2015, reaching a projected total of more than US$26 trillion in AUM and accounting for 15-20% of the global market. “SRI investing provides a massive opportunity for Islamic banking to reach a much wider investor market and to capitalize on attractive co-investment opportunities,” said Ayman Khaleq, a managing partner of Morgan, Lewis & Bockius in Dubai.
Islamic appeal
Hasan Al-Jabri, CEO of SEDCO Capital, one of the few SRI-focused fund managers in the Islamic space, affirmed that: “A new relationship is emerging that marries the industry’s definition of what makes a responsible investor with what Shariah scholars have always seen as principled investment.” A growing number of asset managers and practitioners are starting to agree with this, and while the total offering remains small it is clear that momentum is gathering as new entrants move in to take advantage of the potentially wide investor base.
“While technically speaking, Islamic investors need to rely on a Fatwa that declares a product to be compliant with Shariah, a well-structured Islamic investment product that highlights ethical and social responsibility components is likely to attract non-Islamic investors who are interested in the sector,” said Ayman. “The form is addressed (in the Fatwa), and the substance is robust enough to attract Islamic as well as conventional investors.”
Raising awareness
Over the past few decades, this recognition has gathered pace on a global scale. In 2000 the United Nations introduced the UN Global Compact, a leadership platform for responsible and sustainable corporate policies aiming to align businesses with a voluntary code of 10 principles relating to human rights, labor, environment and anti-corruption which has grown to become the largest voluntary corporate responsibility initiative in the world.
Andreas Feiner, the head of values-based research at Arabesque Partners, explained to IFN that: “These principles are universally appealing and built on multilateral contracts. It has grown to now more than 12,000 participants, of which a great part are unlisted. This strong growth is testament that common sense principles can help to run companies in a better and more efficient way.“
Building on the UN Global Compact, in 2005 Kofi Annan, then UN secretary-general, invited a group of the world’s largest investors to establish the UN Principles for Responsible Investment (UN-PRI): a set of six principles (ESG integration, active ownership, seeking disclosure, promoting acceptance, collaboration and reporting).
Speaking at GIFF William Truscott, chief investment officer for US investment giant Ameriprise Financial, highlighted its increasing global reach: “In 2006 there were 100 signatories of the UN-PRIs managing US$6.5 trillion assets. In 2014 there are over 1,260 with assets under management topping US$45 trillion.” Of these, Feiner points out that the majority of signatories are asset management companies and service providers. “One of the reasons for this is that asset owners — in line with Principle Four of the PRI — demand information on sustainability when they are looking for new asset management companies or service providers.”
Lagging behind
However, up until now the Islamic finance industry has been slow to take advantage of these opportunities, whether in the equity or debt capital markets. No fully-fledged Islamic bank has signed up to the Equator Principles, a credit risk management framework adopted by financial institutions to determine, assess and manage environmental and social risk. Hussam Sultan, Shariah manager at HSBC, also noted in a GIFF ‘Green Dialogue’ that there is currently weak representation from OIC countries on the list of UN-PRI signatories. “Just because a chicken is Halal, doesn’t mean it’s healthy. In the same way, just because a bank is Shariah compliant, doesn’t mean it is actively doing good,” he suggested.
Although the World Bank has been issuing bonds to support sustainable development since 1945, Sukuk activity has been minimal, with its first social Sukuk (as treasurer for the International Finance Facility for Immunization (IFFIm)) only announced this month.
“[Although] Islamic finance has grown at a very impressive rate over the last two decades, the Islamic fixed income market remains under-developed. SRI has become an increasingly common investment strategy during that same time period, but there is still insufficient supply of SRI fixed income instruments,” noted Bennett and Zamir Iqbal of the World Bank Treasury in a recent report. “The convergence of these two facts creates the opportunity for a fixed income product to be developed that could appeal to both SRI and Shariah compliant investors, and thereby serve as a bridge between the Islamic and conventional financial markets.”
However, the ‘Green Sukuk’ trend appears to be gradually developing, with institutions such as the International Bank for Reconstruction and Development (IBRD) looking into opportunities: including advising the government of Dubai on a funding strategy for its green investment program that is likely to include an Islamic tranche.
Affirmative action
This is being driven by a number of regional leaders, with Malaysia at the forefront. Dr Zeti has noted that: “Beyond financial returns, SRI also accords primary consideration to the impact on economic activity and on the broader society, thereby incorporating the important dimensions of environmental sustainability, social responsibility and governance.” She also highlighted its crossover potential: “Islamic finance presents significant appeal to the growing SRI [movement], sustainable investments and ethical finance. It has brought to the forefront the need for the financial system to be linked to the economy and for the need for greater and improved levels of transparency, fairness, ethics and social responsibility in modern finance.”
The Malaysian government last year announced an Environmental, Social and Governance (ESG) Index in its 2014 budget. During his budget speech, Malaysian prime minister Najib Razak announced that Valuecap (a state-owned investment holding company) would allocate RM1 billion (US$312.76 million) to an SRI fund that would invest in companies placing a priority on ESG principles, noting that: “I trust this will encourage more companies to show high commitment towards social responsibility.”
The Securities Commission Malaysia has also announced plans to introduce a framework of SRI Sukuk to finance green and socially responsible initiatives: which given its current stature in the global Sukuk market, should go some way towards establishing a precedent.
An economic argument
While developments are taking place on the fixed income side, there is also interesting activity occurring in the Islamic equity markets, as both investors and fund managers begin to recognize that social responsibility can actually provide a financial advantage rather than coming at a cost.
“An important way that this trend will sustain momentum is its appeal to new investors. However, many investors still think that doing the right thing has to cost performance,” agreed Feiner. However, he emphazied: “Sustainability and performance are wholly complementary and can go hand in hand.”
There is clear evidence that social responsibility improves corporate performance. A recent study by Arabesque in collaboration with the University of Oxford to measure the financial importance of ESG information found that: “Companies with superior ESG risk management are likely to have lower cost of capital and a better overall operational performance,” while according to Professor Gordon Clark and Dr Michael Viehs, collaborators on the report from the University of Oxford: “Case studies on corporate fines and settlements as well as ESG innovation demonstrate a positive influence on cash flows.”
Reviewing over 160 sources, the survey found that 87% of studies correlated superior ESG scores with better operations performance; while 86% correlated high ESG performance with lower cost of capital. “The impact of material ESG on sales, costs and long-term return on capital can be used to enhance investment decisions,” said a 2013 UN-PRI report. A 2012 risklab report on ‘ESG risk factors in a portfolio context’ also found that: “An ESG-optimized equity allocation offers a portfolio risk reduction (CVaR 95%) of around 30% at the same levels of expected return.”
A 2011 report by Eccles, Ionnaou and Serafeim on ‘The Impact of a Corporate Culture of Sustainability on Corporate Behavior and Performance’ found that: “High sustainability companies outperform their counterparts over the longer-term, both in terms of stock market and accounting performance.” In fact even over the short-term the results are demonstrable, with a 2012 report from Dimson and Karakas on ‘Active Ownership’ finding that: “Successful engagements on ESG issues are followed by a one-year outperformance averaging 4.4%.”
“A very important thing is to think about the timeframe we are looking at,” explained Feiner. “Obviously, if you have to implement an environmental protection regulation, for example, then yes on day one you might have a cash outflow. But at the same time, normally what companies then do is to innovate and make the production process more efficient — and over the medium to longer-term, what they save much over-compensates what they initially outlaid.”
And on the flipside, there is clear evidence of the financial implications of corruption and poor corporate responsibility. In 2013 J.P. Morgan was fined US$13 billion for misleading investors, while in 2012 BP was fined US$4.5 billion for environmental crime, while HSBC was fined US$1.9 billion for money laundering. Firms that have adopted ESG and sustainability drives have seen clear results: the waste management program implemented by General Motors has saved the firm an average US$1 billion annually, while the Marks & Spencer sustainability initiative has saved it US$200 million per year and the Unilever long-term sustainability program US$100 million.
Impact investors
These trends have led to the newly popular buzzword of ‘impact investing’, which follows a positive selection approach rather than a negative exclusionary screening. “While negative screening ensures Shariah compliant investors that their money will not support activities or structures prohibited by their religion, these investors have not been given many opportunities to affirmatively support activities they believe in through their investments,” said Bennett; while Truscott agreed that: “We could see more Middle East and Asian investors invest if we shift from exclusionary to impact.”
From an ethical perspective this impetus is likely to come from the retail side, and Feiner believes we are approaching a crunch point: “We expect to see interest from the retail investor increase. As with other major trends that have built up there is always some kind of a tipping point, and I think with regards to sustainability we are getting close to it.”
However, the demonstrable financial appeal is also attracting institutional players, which could give the sector the critical mass it needs. “This recent growth has largely been driven by the demand from institutional investors which are increasingly prioritizing the consideration of sustainability and social responsibility in their business conduct and institutional value system,” confirmed Zeti.
“We expect it to be driven by both sides,” predicts Feiner. “The retail investor wants companies to start acting more sustainably – because what is the point of money if you have no world to spend it in? The institutional investors will also recognize that it is actually good for their performance — and therefore they have a fiduciary duty to implement that. And they will want it for themselves, because better performance means they can attract more business.”
Spreading the word
As the movement gathers speed, the few players who entered early are starting to reap the benefits, and seeing a substantial increase in investor appeal, especially given the inclusive aspect of the ethical principles. “Those of us who have been active in the area of structuring Islamic funds and investment vehicles, realize that the investment guidelines of a number of international organizations (like the International Financial Corporation), US and European pension and sovereign wealth funds, and even savings plans for non-Islamic religious institution tend to even be more rigorous and/or detailed than Shariah sector prohibitions — they cover aspects like child labor, environmental sustainability, certain mining practices, etc.,” pointed out Ayman.
It is not just Islamic funds that are moving into this space. Thrivent Financial is a Fortune 500 investment manager originally set up for Lutherans and investing along Christian principles. Run under a Fraternal Benefit Society structure (like a mutually owned insurance company) the firm has around US$90 billion AUM, with US$58 billion in annual revenue. It wants to make money, but for people who want to do more with their money. “How far is Thrivent, as an ethical, faith-based firm, from Islamic asset management?” asked Truscott.
Threadneedle, a subsidiary of Ameriprise Financial, has launched a UK pooled vehicle that seeks both social and financial returns and turns the money it makes over to charity. The fund is now seeking to launch a similar product in the US, where the Investment Company Act of 1940 allows for 10% of a fund’s net income to be donated to charity.
Market leaders
And a number of major players are now redefining the entire approach to SRI investing. Asset manager Arabesque defines its approach as: “A quantitative approach to values-based investing,” and has developed a unique process that combines positive screening with active management to achieve out-performance.
The firm takes an investible universe of 77,000 stocks and applies a comprehensive series of screens including the UN-PRIs in order to reduce it to a prime index of just 1,200, with a market capitalization of US$9.2 trillion; which it then utilizes to run a number of actively managed funds including the Arabesque Prime Global Equity Fund, which has outperformed its benchmark by 0.85% per year over the last 10 years.
“We believe that if you combine balance sheet screening, screening for impermissible industries, and the values of the global compact and the PRI, we can achieve something that is even closer to what a Muslim investor wants — and what every other investor wants too,” explained Feiner.
Moving forward
SEDCO Capital is another firm that has focused on the ESG field. “At SEDCO Capital we conducted extensive research to establish what we instinctively thought would be a symbiotic relationship between two sets of principles: socially responsible investment (SRI) and Shariah,” said Hasan. “We were delighted to find that companies which are Shariah compliant are over 90% aligned with the companies which an asset manager applying UN-PRI principles can invest in.”
The move was driven by financial as well as ethical consideraions. “We recognized that by satisfying the SRI criteria in our funds the universe of investors we could serve would quadruple — opening up a market of over US$7 trillion globally.” The SEDCO Capital US Equities Fundamental Indexing Fund and SEDCO Capital Global Higher Dividend Yield Fund added ESG certification in 2013, and are screened for compliance with international conventions and guidelines on environment, human rights and business ethics such as UN Global Compact, OECD Guidelines for Multinational Enterprises, ILO Core Labor Conventions, Environmental Conventions and Weapons-related Conventions; while non-compliance is dealt with through a process of engagement and exclusion.
“This upgrade of the funds is a direct response to the significant and growing demand SCGF is seeing in the market for socially responsible investment solutions,” said Hasan. The company aims to expand its range of Islamic funds to more than 15, raising AUM on its Luxembourg fund platform to US$1.6 billion by the end of the year.
Altering attitudes
But the key to sustaining the SRI movement and ensuring that the Islamic finance industry can leverage and take advantage of the opportunities it offers, is to attract and appeal to new investors, rather than simply meeting existing demand. “The only way that this trend will sustain momentum is if it can access new investors… And I think this is about education,” said Feiner. “Unfortunately, many people still have the impression that if you do the right thing it has to cost something.”
According to Musa Hitam, the chairman of the World Islamic Economic Forum: “When people get together for business, they forget their political, religious and ideological differences because there is one compelling commonality that matters most before them — and that is the impetus to be peaceful and prosperous.” In 1997, the World Business Council agreed that: “Sustainability should be a criterion of financial markets decisions, as not only do societies need it, but civilization requires it.” The Islamic finance industry has not only the financial motivation, but a moral and religious responsibility, to do all it can to advance this goal.