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March 30, 2005
To Screen Or Not To Screen?: That May Not Be The Question For Fiduciaries
    by William Baue

Part two of this two-part article examines the opportunities and limitations that social and environmental sustainability screens present to pension funds and other institutional investors.

Fiduciaries with legal responsibilities to their beneficiaries may be as conflicted as Shakespeare's Hamlet when it comes to the question of environmental and social sustainability screening. A defining component of socially responsible investment (SRI), screening shows preference to companies and/or excludes companies from portfolios based on certain criteria. How sustainability screening fits into the fiduciary equation is a complex question; part two of this two-part article examines some of the answers that are starting to emerge.

An historical survey reveals that US pension funds and other institutional investors with fiduciary duties have employed several different kinds of screens. For example, the Sullivan Principles were developed in 1977 by General Motors (ticker: GM) board member Reverend Leon Sullivan to address problems of corporate involvement in apartheid South Africa.

"The Sullivan Principles very elegantly, perhaps even accidentally, laid out a series of possibilities for pension funds to participate, allowing them to take graded positions along three levels of screening--from a very dramatic to a very mild version," said Steve Lydenberg, chief investment officer of Domini Social Investments.

Similarly, pension funds such as those administered by New York City and Connecticut State screen for compliance with the MacBride Principles, which address labor standards in Northern Ireland. The California Public Employees Retirement System (CalPERS), the largest US public pension fund at $183 billion, screens entire emerging market economies such as Indonesia, Malaysia, and Thailand on corporate governance. And tobacco screens proliferated in the 1990s, with some continuing to this day.

However, looking to the past offers only limited guidance as to what the future holds for social and environmental sustainability screening.

"If you're talking about screening out, that's not the way public pension funds are going to go, and in my view, it's not the way they should go," said Jim Hawley, co-director with Andrew Williams of the Center for the Study of Fiduciary Capitalism at St. Mary's College of California. Profs. Hawley and Williams also co-authored the influential 2000 book, The Rise of Fiduciary Capitalism: How Institutional Investors Can Make Corporations More Democratic. "It really depends on what you mean by screening."

"Tilting" strategies such as the KLD Select Social Index or the US Core Environmental portfolio from State Street Global Advisors (SSgA) and Innovest Strategic Value Advisors overweight sustainability leaders and underweight sustainability laggards, forms of positive screening.

"These kinds of weighted indexes take the form of positive reinforcement instead of exclusionary screens, and will mostly fall under the so-called alternative investment strategies category, so relative to the size of the assets of the fund, they are going to be small," Prof. Hawley told "And they are certainly going to be experimental, so funds are tiptoeing very carefully that way."

"I think this kind of strategy is likely to take hold if returns on those types of funds over a three or five year time period begin to be competitive with their benchmarks," said Prof. Hawley. "To me, however, the more significant issue is the degree to which we are going to see forms of engagement to reinforce baby steps such as positive weighted indexes on a small scale."

Forms of fiduciary engagement include behind-the-scenes negotiations, development of policy statements, and the filing of shareowner resolutions on issues such as climate change--in other words, shareowner action strategies pioneered by social investors. Fiduciaries are adopting these tactics due to "the increasing use by SRI and sustainability shareholder groups of corporate governance means to focus increasingly on the long-term economic implications of their orientations," according to Profs. Hawley and Andrews in a 2003 paper.
However, the scale of institutional portfolios effectively prevent fiduciaries from adopting the earliest defining feature of SRI, exclusionary screening.

"If you took the Domini Index or the Calvert Index, how would you invest $80 billion?" Prof. Hawley asks. "If you invest $80 billion in 200 firms, you end up being the controlling interest in each and every one of those firms, and that has legal implications, political problems, and managerial hassles."

"I have no problem with SRI funds, but you can't, in my view, run a large, highly-diversified, fiduciary fund on a SRI basis," Prof. Hawley said. "You can do it on an engagement basis, since the fiduciary duty is to monitor and engage on those issues where you see problems--that's the approach that has been gathering steam."

Mr. Lydenberg agrees.

"There is a presumption sometimes that activism is a milder step than screening, and in certain circumstances that's true, but on the other hand when you're looking at institutional investors the size of the pension funds, that's not necessarily so," said Mr. Lydenberg. "Whether you're doing screening or activism on a big issue like South Africa or global warming, the ability to raise the issue for broad public debate is significant whichever of these two approaches you take."

Mr. Lydenberg also points out that the implicit final step of engagement, if compromise proves impossible, is divestment, the ultimate form of exclusionary screening.

In the end, the question of whether fiduciaries are screening may be a misdirected focus.

"From the big pension fund fiduciary point of view, SRI has a number of things that can be learned from, not so much about screening but the standards for screening," Prof. Hawley said. "SRI is a canary in the mine to them--if something's not in an SRI fund, why isn't it there, and what should they be looking at?"

"Even though they own it and they're not going to get out of it, screening might point to an engagement strategy," concluded Prof. Hawley. "Not that it's a silver bullet, but it's a good place to begin."

Part one of this two-part article surveys the current landscape of US public pension fund screening of corporate social and environmental sustainability.


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