Courtesy of Othar Kordsachia
Background
In 2006, the United Nations Principles for Responsible Investing (UN PRI) adopted a sustainability-based decision framework for large institutional investors that moved socially ‘responsible investments’[1] from the margins to the mainstream. Today, assets managed by signatories to the UN PRI are in excess of 80 trillion US dollars.
The mission of the UN PRI is to further economic efficiency and the sustainability of the global financial system, thereby facilitating steady long-term value creation. To this end, the international network of investor signatories pledge to incorporate environmental, social, and governance (ESG) factors into their investment and ownership decisions. These investors are encouraged to engage in active monitoring over long investment horizons. They are also required to outline their investment and monitoring strategy with regard to ESG issues in annual transparency reports.
At the EU level, legislative considerations concerning ESG related investor duties explicitly assume causal economic benefits. Institutional investors, who receive a mandate from their clients or beneficiaries to take investment decisions on their behalf, should integrate ESG considerations into their internal processes without sacrificing financial return. However, the predominant view is that not all corporate social responsibility (CSR) activities are value enhancing and that the “right amount of CSR” depends on specific firm characteristics. In view of these previous findings, the question remains: are the fiduciary duties of institutional investors, in fact, compatible with the integration of ESG factors in investment decisions?
The Impact of Socially Responsible Investors on Firm Value and Risk
In my recent paper, I argue that equity owned by socially responsible investors (SRIs) leads to interest alignment between shareholders and other stakeholders of the firm, thus reducing the need for rotating or salience-based trade-offs by managers.
The multi-attribute value function of SRIs, which values both the financial and non-financial performance of the invested firm, may lead to a level of CSR that also maximizes long-term shareholder value. SRIs may have greater expertise in determining the kind of CSR activities that also yield economic benefits. These investors have a dedicated team of analysts that pay special attention to the non-financial performance of companies. By exercising their significant voting rights,[2] SRIs can thus influence managers to invest in the type and quantity of CSR that is also most favorable for long-term shareholders.
In that sense, the long-term investment horizon and active monitoring of SRIs may curtail managerial myopia; for instance, management’s predisposition to boost short-term earnings at the expense of long-term value. Myopic management behavior is associated with underinvestment in long-term, intangible projects such as CSR, research and development, advertising, and employee training, for the sake of meeting short-term goals.
Studies find that managerial myopia is exacerbated by capital market functions that exert pressure on managers to sacrifice long-term projects. For example, frequent trading by transient (short-term) investors (Bushee, 2001, Cremers et al., 2019). Ownership by sophisticated institutional investors with long investment horizons alleviates these pressures, which then allows managers to focus on long-term value creation. Prior studies consistently find that short-term shareholders are less engaged in monitoring and exert weaker oversight over managers (e.g. Gaspar et al., 2005). The literature also provides a strong case for a direct relationship between investor monitoring and firms’ financial outcomes. For example, Ferreira and Matos (2008) differentiate between ownership by independent investors (i.e. mutual fund managers and investment advisors) and “grey” investors (i.e. banks and insurance companies) and find that better monitoring by independent investors leads to positive valuation effects.
My paper analyzes the valuation effects of ownership by different types of institutional investors by categorizing SRIs as “green” investors and analyzing their impact on firm value and firm risk. Based on a large panel of listed European companies, the results indicate that a greater percentage of SRI ownership is significantly associated with greater firm value. A one percent increase in SRI ownership is associated with an increase of the (industry adjusted) Tobin’s q of about 0.007 (p-value = 0.000).[3]
While prior studies largely focus on the association between institutional shareholdings and different measures of firm value, very little is known about the relation between institutional ownership and firm risk. This, however, is also a relevant firm outcome that is just as likely influenced by the firms’ internal and external governance mechanisms. There are two competing views on the impact of institutional investors on firm risk. The traditional view is that large shareholders can attain value maximization through the promotion of greater risk taking. According to this hypothesis, shareholders can transfer wealth from bondholders by increasing the volatility of future outcomes through asset substitution. However, due to their fiduciary duty to clients, institutional ownership could also have a negative impact on firm risk. In a UN report,[4] there is a clear focus on risk management and integration of ESG related risks of particular securities. This indicates that the duty of prudency is not limited to the portfolio level, but relates to individual companies. Using annualized stock price volatility as a measure for firm risk, I find that SRI ownership is associated with lower firm risk. Depending on the model design (i.e. random versus fixed effects regression), the annualized stock volatility is 0.002 to 0.003 lower with every percentage increase of SRI equity ownership.
The findings remain significant under a number of additional analyses. For example, using the absolute number of SRIs in the ownership structure (instead of percentage of equity owned by SRIs) as the dependent variable yields the same results. This approach mitigates the effect of especially large SRIs. This finding also suggests that investor collaboration between SRIs may lead to favorable financial outcomes. In fact, the UN PRI provides a detailed guide for such collaboration between individual signatories. While the European Union’s ‘acting in concert’ regulation may be regarded as a barrier for investor collaboration, the UN PRI clarifies that these rules are generally not designed to apply to investor collaboration on ESG issues. In that regard, the UN PRI can be regarded as an enabling organization for collective monitoring efforts and shared monitoring costs.
Conclusion
The effectiveness of institutional ownership as an oversight mechanism is already well established. In my study, I provide evidence that this also holds for the special case for SRIs. Their integration of ESG factors in monitoring activities is related with positive firm outcomes.
As part of this project, I find institutional investors prominently feature their signatory status with the UN PRI on their company website; presumably to widen the client base by marketing to environmentally conscious retail investors. The results indicate that investors do not merely misuse their signatory status as a ‘greenwashing’ and marketing tool, but are in fact actively engaged with the invested company. I find that retail investors do not sacrifice any financial return by investing via signatories of the UN PRI.
It remains an open question if the mandatory integration of ESG factors in the investment and advisory process, as proposed by the European Commission, facilitates economic growth and stability. While environmentally sustainable economic activity could further increase the economic relevance of SRIs, I believe that voluntary principles already provide guidance for institutional investors and transparency for retail investors.
References
Bushee, B. J. (2001). Do Institutional Investors Prefer Near-Term Earnings over Long-Run Value? Contemporary Accounting Research, 18(2), 207–246. https://doi.org/10.1506/J4GU-BHWH-8HME-LE0X
Cremers, M., Pareek, A., & Sautner, Z. (2019). Short-Term Investors, Long-Term Investments, and Firm Value. Management Science, Online first.
Ferreira, M. A., & Matos, P. (2008). The colors of investors’ money: The role of institutional investors around the world. Journal of Financial Economics, 88(3), 499–533. https://doi.org/10.1016/j.jfineco.2007.07.003
Hoepner, A. G. F., Majoch, A. A. A., & Zhou, X. Y. (2019). Does an Asset Owner’s Institutional Setting Influence Its Decision to Sign the Principles for Responsible Investment? Journal of Business Ethics, 28(3), 447. https://doi.org/10.1007/s10551-019-04191-y
Gaspar, J.‑M., Massa, M., & Matos, P. (2005). Shareholder investment horizons and the market for corporate control. Journal of Financial Economics, 76(1), 135–165. https://doi.org/10.1016/j.jfineco.2004.10.002
Margolis, J. D., Elfenbein, H. A., & Walsh, J. P. (2009). Does it Pay to Be Good…And Does it Matter? A Meta-Analysis of the Relationship between Corporate Social and Financial Performance. SSRN Electronic Journal. Advance online publication. https://doi.org/10.2139/ssrn.1866371
[1] According to UN PRI, “Responsible investment is an approach to managing assets that sees investors include environmental, social and governance (ESG) factors in their decisions about what to invest in and the role they play as owners and creditors.”
[2] Descriptive statistics of my study reveal that the equity owned by SRIs of listed European companies increased, on average, from 14.015% to 21.821% between 2008 and 2017.
[3] The Tobin’s Q ratio equals the market value of a company divided by its assets’ replacement cost. Thus, equilibrium is when market value equals replacement cost.
[4] Fiduciary Duty in the 21th Century, available at: https://www.unepfi.org/fileadmin/documents/fiduciary_duty_21st_century.pdf
