ANALYSIS - Sovereign funds to boost ethical investing

An employee of the Korea Exchange Bank (KEB) counts 100-dollar bills in Seoul in this October 2008 file photo.

LONDON (Reuters) - Sovereign wealth funds, eager to be accepted in the West, are increasingly keen on "socially responsible" or ethical investing, which could generate big flows into a sector that has so far failed to give convincing returns.

Socially responsible investing (SRI) involves buying shares in companies that manage environmental, social and governance (ESG) risks. For example, firms which make clean technologies are favoured, while businesses which pollute environment, abuse human rights or produce nuclear arms are shunned.

Investors tend to chose SRI not because of its history of outstanding performance but in order to include "alternative" assets, which tend to have low correlation with traditional stocks and bonds, allowing them to diversify their portfolio.

And greater involvement of sovereign wealth funds (SWFs), who already own nearly 10 percent of global stock markets, might create a virtuous cycle for the SRI industry, boosting performance and encouraging other investors to follow suit.

"In the official institutions sector there's a greater interest in this sector. It's not just performance but it's the low correlation argument that has enhanced the attractiveness of SRI products," Gary Smith, head of central banks, supranationals and SWF business at BNP Paribas Investment Partners, said.

"Norway does continue to set some of the agenda. It is possible that the increased focus that Norway has had on these issues may prove to be an accelerant for other SWFs over time."

Norway's $400-billion SWF, which hold 8,000 companies, is the leading SRI force. In September French state fund FSI made a joint 5 million euro investment into Toulouse-based MECAMIDI, which makes small and average hydropower plants. Abu Dhabi's state-owned fund Mubadala is investing in renewable energy.

Assets under management in the fast-growing SRI industry stand at $2.71 trillion, over a tenth of total assets held by U.S.-based investors, according to the Social Investment Forum.

And SWFs, whose current assets of around $3 trillion are set to more than double in 10 years, are getting increasingly active in SRI as one way of getting back into markets after the crisis.

PERFORMANCE AND FLOWS

Experts say growing awareness of climate change or SRI could bring more flows into the sector, which could lead to better performance, and actions by SWFs may reinforce the trend.

Performance data on SRI is mixed. The Impax Environmental Markets fund -- run by Impax Asset management, which runs funds for BNP Paribas IP -- has returned 15 percent in January to end-August, nearly double the MSCI world equity index gains on a sterling basis.

However, the dollar-based Dow Jones Sustainability World Index has risen 22.5 percent since January, compared with 22.0 percent in the MSCI index.

G20 nations, many of which own large SWFs, agreed in September to phase out subsidies for oil and other carbon dioxide-spewing fossil fuels in the medium term, in a move analysts say could help a new U.N. climate deal in December.

Nearly 600 institutional investors representing a total of $18 billion have already signed up to the Principles for Responsible Investment, a United Nations-led framework. The New Zealand Superannuation fund is one of the founding signatories.

"We recognise that environmental, social and governance issues are long-term factors that can be highly relevant to investment performance," the fund said in the annual report published on Friday.

"ESG issues present regulatory, market, reputational, and operational risks and opportunities shareholders need to consider to fully understand the companies in which they invest."

GREEN AGENDA

Ethical investing allows SWFs to combine a multitude of objectives: seek long-term returns via non-traditional assets, meet social goals, and gain wider acceptance even among critics who suspect they operate politically.

Norway's ethical investment guidelines rule out holding firms which for instance produce nuclear arms, damage the environment or abuse human rights. It likes firms which tackle climate change or water scarcity and pushes them to be greener.

It names and shames companies the fund expels for not meeting its criteria. In September it ejected Israel's Elbit Systems for supplying surveillance equipment for the West Bank separation barrier. BAE Systems, Wal-Mart and Rio Tinto are among other expelled firms.

"They do it to provide institutional legitimacy to their process. It enables them to sell themselves to their own domestic audience. And in terms of public relations, this might help international acceptability and that may enhance investment opportunities," BNP's Smith said.

Gordon Clark and Ashby Monk, Oxford University researchers and SWF experts, say that the fund -- which only invests abroad -- seeks to give global effect to national values and commitments with its ethical investment policies.

They argue the clear guidelines and the integrity of the selection process enhances transparency and accountability. Therefore, such a process might be more important than the resulting financial performance -- or it might help explain to the wider public even if it resulted in a loss.

"It is apparent that the value attributed to ethical standards is... a moral value not a financial value... As such, these standards are not subject to a profit and loss statement," they wrote in a recently published paper.

"There is a premium on the transparency and accountability of the process whereby ethical issues are evaluated... In fact, it might be argued that the process is more important than any outcome in these circumstances."

For a graphic on SWF assets and the SRI industry, click on:

r.reuters.com/vyd59d

(Editing by Andy Bruce)