Socially Responsible Mutual Funds Arrive

It's amazing what a little dose of impending doom can do to catch a banker's attention. For years Canada's biggest banks balked at the prospect of selling ethical funds to investors. Sure, they liked to be thought of as good corporate citizens.

Socially Responsible Mutual Funds Arrive

It's amazing what a little dose of impending doom can do to catch a banker's attention. For years Canada's biggest banks balked at the prospect of selling ethical funds to investors. Sure, they liked to be thought of as good corporate citizens. But actually weighing in on the ethical proclivities of other companies? No thanks. Too messy. Besides, it's not as if investors were beating down the door to buy the things.

That was before climate change and global unrest squeezed out celebrity gossip at the water cooler. Investing with a conscience is suddenly big business and the biggest financial institutions in the country are piling in. Call it what you will - ethical, socially responsible or just plain responsible investing - last year the sector accounted for more than $500 billion in assets, according to the Toronto-based Social Investment Organization, up nearly sevenfold from 2004. In the past six months alone, Royal Bank, Toronto Dominion Bank and Barclay's have all launched socially responsible investing (SRI) funds.

It's still too early to say the sector has hit the mainstream, but it's definitely never been easier for people to save on their own ethical terms. Yet those looking to plunge into the new green rush face a dizzying array of options. Not all SRI funds are built the same. Their approach to responsible investing ranges from the tenacious to the tepid. In fact, there are some surprises lurking inside even the most virtuous-sounding fund. With more than 70 SRI funds available to the public, and growing, there are a few things ethical investors need to know before diving in.

It's been 20 years since the first ethical funds hit the market, and for a long time they were easy to overlook. Most funds were tiny, and mediocre performers at best. But over the last few years SRI funds have been aided by a booming stock market and fears over the state of the planet. "A lot of people are looking at their investments, and they're upset when they see the companies they own are against everything they believe in," says Brian Pinch, a financial adviser in Victoria who specializes in SRI funds.

Two years ago, the idea of socially responsible investing wasn't even on the radar screen at TD Bank. But with so much money flowing into the sector, TD took notice. "We saw a big business opportunity," says Timothy Pinnington, the president of TD Mutual Funds. In September, TD - hot on the heels of Royal Bank, the first big Canadian bank to get into SRI - announced its foray into the sector with a mutual fund called the TD Global Sustainability Fund. Drawing from the Dow Jones Sustainability World Index, it's made up mainly of big international companies deemed to be leaders in environmental sustainability, says Pinnington.

But TD's entry, typical of many big institutions these days, is still only a cautious one, underscoring the often ambiguous nature of responsible investing. Pinnington is quick to point out that TD's fund, despite the name, is technically not an SRI fund. A quick glance at the companies that make up the DJSW index shows why. Many would keep SRI traditionalists up at night, including Big Oil and several mining giants. Even a few gambling and tobacco firms make the cut. Call the bank's initial foray into the sector "SRI-light."

One thing that's made it easier for the banks to take part is the growth of firms that already analyze companies on their environmental, social and governance performance (ESG). That infrastructure allows new entrants to set up funds without having to also hire teams of new researchers. For instance, at the heart of many new SRI funds in Canada you'll find Jantzi Research in Toronto, a firm launched by industry veteran Michael Jantzi. RBC's three new SRI funds, which cover the Canadian and global markets, draw from a list of companies that pass Jantzi's best-of-sector analysis. Meanwhile, the Jantzi Social Index forms the basis for an exchange-traded fund launched by Barclay's in May. "Institutions are sensing the same thing we see in the market, which is that Canadians are now thinking about SRI at a level they haven't been before," says Jantzi. "In 18 years, I've never seen an environment on the retail side of the market like what we're seeing now."

Though big banks are just now warming to responsible investing, the notion of distributing capital in accordance with social values dates back to 18th-century American Quakers, who avoided companies tarnished by war and slavery. And while the vast majority of SRI funds today are secular in nature, at least one has its roots in Canada's small but devout Mennonite community. Seven years ago, several organizations formed Meritas Financial in Cambridge, Ont. Today the firm manages $174 million in assets. "Most Christians would acknowledge that the ownership of the assets they have actually belongs to God," says Gary Hawton, CEO of Meritas. "On that level, Christians, Jews, whomever, need to look at how they invest those assets, because they are investing them on behalf of God, and would God be pleased with how those assets are being invested?"

While the firm was born out of a faith-based tradition, Hawton says the goal wasn't to form a religious fund. Instead its funds draw heavily on ideals of global justice, human rights, and community responsibility that he believes appeal to a wider market. For instance, Meritas' funds are the only ones in Canada to put money into microfinance investment pools, which in turn lend money to small businesses in Aboriginal communities and developing countries. The investments are a relatively small part of Meritas' overall strategy, accounting for no more than two per cent of total assets, but Hawton says they can make a big difference. "SRI is about providing competitive financial returns, but it's also an opportunity to have a positive social impact," he says. "And in seven years of microfinance investments we've never experienced a single negative return. I wish we could say the same for our equity investments."

At its most basic, responsible investing involves "screening" out companies in certain industries. The vast majority of funds exclude companies in sectors like tobacco, military hardware, and nuclear power. That's certainly the case with one of the oldest players in the field, Ethical Funds of Vancouver, which launched its first fund in 1986 and now manages $2.3 billion in assets.

But as the responsible fund sector grows more crowded, Ethical Funds has had to find ways to set itself apart. It's beefed up its research team with 11 analysts focused exclusively on SRI issues, the largest among fund companies. And it focuses on dealing with companies in its funds head-on through shareholder engagement. Each year the firm identifies a list of issues and companies it will try to nudge into making changes. Elaine McHarg, chief marketing officer at Ethical Funds, calls it "corporate coaching," and at any one time Ethical Funds works with up to 45 companies. When the firm doesn't get a good response, it files shareholder resolutions that go to a vote at annual meetings. "We're trying to affect change and make good companies better from the inside," she says. "There is a link between strong long-term financial performance and strong ESG performance."

While Ethical Funds is perhaps the best-known fund company in the sector, it doesn't manage many of its own funds. In most cases, it outsources the fund management to outside firms or hires other firms as sub-advisers. By contrast, Inhance Investment Management of Toronto does everything under one roof, says Inhance CEO Kerry Ho. Each day the researchers meet with the fund managers to hash out investment ideas. "Then we'll have debates over which are leaders in ESG, and which will perform better for unitholders," he says. That integrated approach recently caught the eye of Bank of Montreal. Last month, BMO Nesbitt Burns Investment Advisers tapped Inhance to offer its clients access to socially responsible investments.

While traditionally SRI funds started with the premise of keeping certain companies out, an approach gaining steam involves investing in companies that are seen to be doing good things for society and the environment. Sometimes called positive screening, the result tends to be funds with a tighter focus on a particular sector. For example, in November, fund giant Investors Group, which already operates the largest SRI fund in the country, launched a fund focused, in part, on companies developing technologies to target climate change and pollution. This follows on the heels of a clean energy fund launched by Criterion Investments in September.

Even as new entrants rush into SRI, questions about investment performance continue to dog the sector. Tobacco stocks have been strong stock-market performers, while war, unfortunately, will always be a booming industry. By avoiding "unethical" stocks, funds limit their options. "They certainly have underperformed in some periods and outperformed in other periods," says Eric Kirzner, a professor of finance at the University of Toronto's Rotman School of Management. "But over the long run, I'd have to say you're going to pay for being a good person."

That penalty may not be as serious as some fear, however. Last month, the United Nations issued a report that examined 20 studies on the topic. It found "there at least does not appear to be a performance penalty from taking wider factors into account in the investment management process." Hardly a ringing endorsement, but for many investors debating whether or not to invest in SRI funds, it's encouraging nonetheless.

For now, SRI funds have a lot of catching up to do before they reach the size of more traditional MUTUAL FUNDS. But it's the direction, advocates say, that matters. "Mainstream players aren't interested in stealing slices from the groups doing it now. They want to increase the size of the pie," says Jantzi. "When names like TD and RBC step in, it catches peoples' attention and gives SRI validity."

Maclean's December 10, 2007