Spread your investment risk using multiple ethical screens

One of the things that made me curious when I was doing the investigation into the Norwegian Government Pension Fund investment strategy was the use of multiple screens for ethical investments. The fund did have a bit of a problem with its investments in Burma it did present new ways of screening, while at the same time keeping a sound and diversified portfolio.

The screens that they use are:

  • International Collaboration and contribution to the development of best practice (Best in class strategy)
  • Targeted Investment programs (Positive screening)
  • Research and Investigation (Integrated analysis)
  • Active ownership (Shareholder activism)
  • Exclusion of Companies (Negative screening)

This thinking is not totally new as the Danish pension fund ATP used a similar screening system. While it is not as elaborate as the Norwegian one it shows that multiple screenings can reduce the risks that you are facing and still insure a stable high return. ATP is one of the most successful pension funds in Denmark and a market leader into ethical investments. It is not the considered a big fund in international terms but in Denmark it is one of the biggest funds around. The screenings that ATP uses are:

  • Active ownership (Shareholder activism)
  • Research and Investigation (Integrated analysis)
  • Negative screening against ATP own ethical guidelines (Negative screening)

The interesting thing is that more and more pension funds are fining out that this approach is making sense and can be managed effectively. Funds like APG in the Netherlands and others across Europe are finding out that adopting similar models can reduce risk and at the same time keep the investment returns at market level and in some case above what the market normally delivers.

So why is this? Conventional wisdom would dictate that the more screen one uses the smaller the pick of companies one can choose from increasing the risk of making lower returns. While screening might help in the way that it reduces social risk it will present a challenge in the area of fund diversification. The more screens you have the less will you be able diversify and thereby exposing one self to increased financial risks, or at least that is the theory.

So why are things not as they seem? At appears that these funds see the need for integrating social responsible investment and risk policies to become more financial and ethical robust but at the same time more agile. It would look like that they through their improved business intelligence abilities are able to react more quickly to changing market conditions. That they have been able to take advantage of new opportunities within a framework in which they have the knowledge and resources to measure, understand and manage risk exposures.

For most large funds that have the resources available to them to do multiple screenings it will within their ability to do such screenings. However, for smaller or medium size companies it might be an issue as the complexity of the portfolio management increases. The result will be that the smaller funds will have less screening criteria than large ones resulting in that they will be exposed to more social risk while unable to package their portfolio as good as the major large funds.

I think that the prospects of multiple screenings are promising and the benefits to both institutional investors and other investors interested in SRI are clearly there. Both ATP and the Norwegian pension fund are doing really good with their strategy and it is catching on with other actors in the market. There is no real research into the field of a multiple screening system as “common sense” has dictated that it is not a good investment strategy, however, it is clear that there is evidence to the contrary. If you know of anybody looking into the subject please let me know.