The launch of the Global Compact 100 Index, which selects its line-up according to financial performance as well as sustainability credentials, pits purists against pragmatists

There is a new kid on the block in environment, social and governance investment, and it’s one that has some answers for those who remain sceptical about “social investing”. The Global Compact 100 index offers welcome new developments in a field hungry for innovation and dogged by ideological correctness.

The GC 100 tracks the stock market performance of a representative group of Global Compact companies selected not only on their adherence to the Global Compact’s 10 principles covering human rights, labour, environmental and anti-corruption standards, but also on evidence of leadership commitment and consistent profitability.

“While many other sustainability screens focus primarily on the environment and social dimensions, we’re a little different,” says Gavin Power, deputy director of the United Nations Global Compact, which launched the index in September. The measure of pre-tax profitability included in the new index is a factor often overlooked by competing sustainability screens.

“We’ve established a baseline for every eligible company,” Power says. The GC 100 companies were selected from about 1,000 publicly traded corporations, a fraction of the more than 8,000 GC member companies.

The index is more nuanced than most of the competition, even its chief rival, the Dow Jones Sustainability Index, a key reference benchmark for investment companies since its launch in 1999. The DJSI and its various offshoots rely on annual assessments developed by RobecoSAM. They are solid products and the questionnaire they are based on is well regarded, but the indexes depend heavily on self-reporting and have no financial screens.

The GC 100 also avoids the chief pitfall of classic social investing – a reliance on squishy “social values”, focusing instead on metrics and transparency.

Green roots

The modern roots of corporate social investing can be traced to the 1970s and 1980s, marked by the confluence of the environmental movement, anti-apartheid activism and the excitement generated by entrepreneurial “socially responsible” businesses including Green & Black’s and Ben & Jerry’s.

The original wave of social funds tended to divide the corporate world into “good” and “bad” companies. But by whose definitions and with what values? Catholics got to choose the Aquinas Fund and Muslims the Islamia Fund, both of which clumsily applied religious doctrines to corporate behaviour.

Concerned about the environment? You could pick funds that over-weighted alternative energy investments or employed negative screens, refusing to invest in certain sectors, such as fossil fuels or weapons. For gay and lesbian rights? There was the Meyers Pride Fund. Against the “homosexual agenda”? Invest in the Christian fundamentalist Timothy Plan.

In the Wild West of the 1990s, hundreds of what might be called green litmus test funds were launched, from military-hating Pax World to animal-rights protector Beacon Cruelty-Free Value to Women’s Pro-Conscious Equity Fund.

It was an appealing investment strategy to many activists – invest in your personal values. But what these exciting new funds didn’t do in their early iterations was significantly change corporate behaviour.

“The early ethical funds movement was just fooling itself,” John Bishop, professor of business administration at Trent University, Ontario told me in 1995, when ethical investing was beginning to gain traction. “Investors might feel good, but capital markets are like a swimming pool.” At that time, ethical investing represented less than 1% of the market. “It was like taking a thimble full of water out of the shallow end and emptying it in the deep end,” he said.

Limits to growth

In other words, despite lofty ambitions, early versions of social investing were trapped by feel-good anti-establishment roots. That limited the potential growth of what could be a powerful tool for social change.

In fact, ethical investing has grown dramatically since the mid-1990s. A 2012 report by the US Forum for Sustainable and Responsible Investment estimated that $3.74tn is now sustainably managed. The Paris-based World Federation of Exchanges sets the global stock market capitalisation at $54.6tn.

What fuelled this boom, and its spread from a niche product to a mainstream investment tool? Much of the growth was driven by frustrated younger socially responsible investment professionals who were less interested in symbolic protests and more focused on moving the needle of corporate behaviour, particularly on environmental issues in which metrics were becoming increasingly available.

One of the early pragmatists was Toronto-based Michael Jantzi, who launched the Jantzi Social Index in the early 1990s. Reflecting the ideological spirit of the time, he kept some targeted negative screens, eliminating companies for consideration whose primary business was tobacco, nuclear weapons or military contracting. But he introduced a crucial and transformative innovation: Jantzi decided his new index would not inherently favour one sector over another – what became known as the “best in sector” approach. No longer would an organic grocer automatically be given more weight than an energy company.

Part of his motivation was practical. “You just can’t do that in Canada,” Jantzi said at the time. “Resource companies make up more than 40% of the Toronto Stock Exchange. If you eliminate these sectors, you don’t have diversification. And if your fund isn’t diversified, its performance is volatile and you will drive out investors.”

Inside the tent

Jantzi’s approach sometimes settled for corporations that others believed were less than pristine actors, such as defence contractors or mining companies. Purists were apoplectic, but there was a huge upside: by identifying the most progressive companies in the “messiest” industries, and providing a real incentive for competitors to match their sustainability innovations, the Jantzi Index spurred genuine corporate reforms.

This philosophy of pragmatism struck a chord with savvy investment professionals. While many of them were not activists in the classic mould, they recognised that corporations needed to do things differently to compete in a fast-changing international marketplace beset with risk. ESG principles made common sense.

So when the UN Global Compact sought out a partner in its new venture to extend its brand, it approached Jantzi, who by then was head of the global and highly respected responsible research giant Sustainalytics. In creating the GC 100, they moved even further away from the ideological roots of social investing, deciding to abandon negative screens altogether.

The focus on pragmatic change and a desire to work with corporations by both UNGC and Sustainalytics rankles hardliners. Some of the criticism is thoughtful. Prakash Sethi and Donald Schepers, professors at the business school at Baruch College in New York, continue to believe that the Global Compact is more a club than a forum for ESG engagement, and that the principles are “soft”. There is no real accountability for those companies that don’t walk the talk, they claim.

In fact, to its credit, the Global Compact has become increasingly aggressive as its organisation has grown in stature, demanding more accountability from its member organisations to ensure that it’s not a greenwashing exercise. Since 2005, it has expelled thousands of companies for lack of annual reporting on their progress in meeting sustainability goals.

Old-school “green” activists, still fighting the battles of the 1980s, offer a more pointed critique. The rollout of the GC 100 led to a searing piece by GreenBiz.com’s Michael Kramer, who accused the Global Compact of including in its index “companies operating in inherently problematic economy sectors”. He bemoans the inclusion of companies with military contracts and those in gas, mining, oil, automotive and airline sectors. You can almost hear his distaste when discussing the inclusion in the index of General Electric – a complex company with many challenges but also widely regarded for its sustainability initiatives.

What companies would GreenBiz substitute? Organic food and biodegradable household product makers, which Kramer calls the “cornerstones of the green economy”. That kind of thinking might play well in Vermont, but it’s almost laughable when trying to bring ESG principles to a complex global economy.

Even more bizarre, Kramer lists 16 ESG categories that “any serious assessment of environmental and social performance should address”, including “climate change risk”, “operations in oppressive political regimes”, and “hazardous or unsafe products”. In fact, all of these considerations are embedded in the Sustainalytics-GC 100 research framework.

“We didn’t start out with the premise that companies are good or bad,” says Simon McMahon, Sustainalytics global director of advisory services. “We use an overlay of the Global Compact principles to apply hundreds of complex and weighted factors, which we believe reflect the diversity of ESG performance.”

Performance questions

There are some legitimate nits to pick about the GC 100, but they are more about appearances. The news release for the launch was headlined “Companies Beat Overall Market – Return More Than 25 Percent”. It was accompanied by a quote from Georg Kell, executive director of the Global Compact. “While the performance of the GC 100 should not be seen as clear evidence of a causal relationship between a commitment to corporate sustainability practices and stock performance, there appears to be an exciting correlation,” he said. Michael Jantzi has also been quoted as touting the “particularly notable” performance of the index over the past two years.

Those claims are overstatements, and highlight the danger of promoting ethical investing funds based on claims of superior performance. The GC 100 uses the FTSE All World as its comparison index. Sustainalytics’ own figures show that the GC 100, as currently constituted, would have outperformed the FTSE All World over a one- and two-year period – time frames not considered long enough to judge long-term performance with statistical reliability – and then would have performed identically, with a compounded annual return of 12%, over a more statistically relevant three-year period. Sustainalytics’ McMahon says that based on the limited data available the firm has as yet found no correlation linking the GC 100 with over-performance.

The jury is still out as to whether ethical investing screens can help boost stock returns. There was a plethora of claims linking ESG performance and returns in the early 2000s, using stock performance data over historic 20-year bull market that began in the 1980s. Many of the outperforming stocks in the technology, banking and information sectors were over-weighted by social investors, pumping performance. But the investment climate changed sharply in the 2000s, as many old reliables, such as financial stocks, swooned while resource and basic materials stocks soared. The correlations disappeared.

Like zombies, such claims never die. Barely four years after the crash that pummelled many socially responsible favourites, particularly in the financial sector, Deutsche Bank’s climate change investment research division issued a report – Sustainable Investing: Establishing Long Term Value – touting the superior returns of social investing. ESG and “CSR” practices “correlated with superior risk-adjusted returns at a securities level,” wrote Mark Fulton, the unit’s managing director. The proof? Less than meets the eye. Deutsche Bank’s research drew heavily on studies that focused on the outperforming bull market years but had almost no data encompassing the troubled 2000s. In other words, using selected research, intentionally or not, affected the results.

In other words, ESG market performance is an empirically complex and ultimately irresolvable debate. What we do know – and there is extensive research underscoring this – is that companies that aggressively adopt what might be called “high sustainability standards” such as robust internal metrics, independently verified, across a range of outputs, are far less likely to be sideswiped by black swan (surprise) events or quick market shifts.

There is a reason why private equity heavyweights such as Carlyle and KKR vigorously integrate ESG metrics into their portfolio assessment process. A thoughtful new study drawing on data from signatories of the United Nations Principles for Responsible Investment by Dinah A Koehler and Eric J Hespenheide in Deloitte Reviewoutlines very convincingly how the diligent application of ESG principles can inform risk analysis across the supply chain, operations and in the products themselves. In other words, ESG drove profits but, most importantly, lowered risk. Gavin Power at the GC 100 and Simon McMahon at Sustainalytics both say that ethical investing might be best understood as an insurance policy that protects against unforeseen risk in the marketplace, while providing dividends along the way.

“The GC 100 Index is compelling even if we do not beat the overall market,” McMahon says. “No one is suggesting that ESG factors should be a primary investment signal. But looking at ESG allows you to identify risks that other approaches miss and it unearths hidden values. Even if you just mirror the benchmark, if you can get social value out of it, it’s a net gain. Moreover, over the last five to 10 years there has been a growing appreciation that ESG has the potential to be very valuable to asset managers, and not just socially responsible investors. We think that trend will continue.”

Jon Entine is a senior fellow at the Center for Health & Risk Communication and STATS (Statistical Assessment Service) at George Mason University.

Ethical investment  Global Compact  sustainability credentials