The bottom line on SRI

Michael Jantzi is founder and president of Jantzi Research Inc., an independent investment research firm that evaluates and monitors the environmental, social and governance performance of securities. A frequent commentator and writer on social investment and related topics, he is the co-author of The 50 Best Ethical Stocks for Canadians: High Value Investing, published by MacMillan Canada. He can be reached at mjantzi@jantziresearch.com.

As a proponent of socially responsible investing (SRI), the past year was a challenging one for me. My firm's now nine-year-old Jantzi Social Index (JSI), as a proxy for social investment, provided little to combat the common view that socially responsible investing is not so good for your portfolio. In absolute terms, the JSI suffered with the overall decline of the market. This was also the first year in which the index lagged in relative terms to domestic equity benchmarks that do not screen for environmental, social and governance (ESG) criteria.

The JSI is a socially screened, market capitalization-weighted common-stock index of Canadian equities. It was created, in part, to be a benchmark against which institutional investors and retail advisors could measure the performance of socially screened portfolios.

The JSI lost 35.4% in calendar 2008, by far the worst in absolute terms in its history. That was 2.4 percentage points worse than the S&P/TSX Composite Index's 33% loss, and 4.2 percentage points behind the S&P/TSX 60 Index of large-cap issues.

Last year was a departure for the JSI in terms of its historical relative performance. More often than not during the first eight years since its inception on Jan. 1, 2000, the JSI has outpaced the S&P/TSX Composite Index. Indeed, up until the end of October 2008, the JSI remained ahead, posting a 4.1% annualized return since inception versus the Composite's 3.7% return over the same period.

But poor relative performance in the final two months of last year, primarily due to the JSI's underweighting in the volatile gold sector, left the index lagging the S&P/TSX Composite. The JSI's annualized return from inception to Dec. 31, 2008 now stands at 2.44%, trailing the S&P/TSX Composite by an annualized 30 basis points.

To return to the perennial questions about the bottom line on SRI: How does the application of social responsibility criteria affect long-term investment performance? Does an evaluation of ESG performance detract from the bottom line, or can it enhance shareholder value over the long term?

Critics cite modern portfolio theory in concluding that SRI takes a toll on returns. They argue that integrating ESG criteria into the investment decision-making process reduces the size of the investable universe, thereby resulting in lower returns.

My own view, which is shared by a growing number of pension funds and mainstream financial institutions, is that integrating ESG criteria into the investment process helps identify risks that often are not covered or well understood by traditional analysts. For example, ESG analysis can help identify best-of-sector oil and gas companies that are better positioned with respect to climate change risks or opportunities regarding carbon trading systems and alternative energies.
The JSI consists of 60 Canadian companies that pass a set of broadly based ESG rating criteria. These include aboriginal relations, community involvement, corporate governance, employee relations, environment and human rights. The JSI also incorporates several industry-specific exclusions (nuclear power, tobacco, and weapons-related contracting), which eliminate firms from contention regardless of what their record of performance may be in other areas.

Subsequent to creating the JSI's rating criteria, the Jantzi team analysed the ESG records of the S&P/TSX 60 companies, at which point 17 companies were eliminated from contention. To bring the JSI to 60 constituents, we then sought companies with superior ESG performance in sectors in which the JSI was underweighted relative to the S&P/TSX 60. We also favoured companies with larger rather than smaller market capitalizations.

This set of rules continues to guide Jantzi Research in overseeing the integrity of the JSI. Like any index, turnover is kept to a minimum. Most changes today result from corporate actions – mergers, acquisitions, privatizations, and the like. Aside from imminent bankruptcy, we do not remove a company for financial reasons, including stock valuation.

We will drop a company from the JSI when we determine the deterioration in ESG performance adversely affects the firm's best-of-sector ranking. As a first step, we place the company on the JSI Monitor List to convey that the review process is under way.

For example, we placed Goldcorp Inc. on the Monitor List in November 2006 following its acquisition of Glamis Gold, which was facing community and aboriginal relations concerns at its operations in Guatemala and Honduras.

We continued to monitor Goldcorp's ESG performance, including a February 2008 analyst visit to Latin America to meet with corporate representatives and other stakeholders. Last spring, we removed Goldcorp from the JSI on the basis of the firm's exposure to growing opposition from local communities in Guatemala and Honduras, and the company's poor environmental compliance record. These and other ESG-driven decisions are integral to our investment process.

That said, the JSI's recent performance has undoubtedly been disappointing to social investors, and critics will begin to voice the "I told you so" arguments. However, given its history and make-up, one can surmise that when the Canadian market experiences a broader recovery, the JSI will once again show a more competitive face.

Moreover, as calls for greater corporate disclosure and transparency continue to emerge out of the financial crisis, and demand for ESG leadership and performance are incorporated into economic recovery packages, many of the JSI constituent companies will be well positioned to compete in the new and changing marketplace.

Reprinted with permission of the author and Morningstar Canada, where this article was originally published.