Mainstreaming Responsible Investment - AccountAbility

Responsible Investment
and Sell-side Analysis
In the last two decades, the development of equity analysis
has focused largely on developing financial expertise,
anticipating corporate events and establishing valuation
benchmarks. Competency revolves around the interpretation
of accounts, the analysis of structural position and the
development of discounted cash flow valuation models.
Analysis of non-financial criteria has mostly focused on “quality
of management”, particularly following the corporate abuses of
recent years. Commitment to this looks thin, however, as it
features on the official reading list of the Chartered Financial
Analyst (CFA) programme yet has failed to gain sufficient
importance to become an issue in the examination process.
Focus on other non-financial aspects is even leaner; for
example, the London component of the CFA’s continuing
development programme provides just 1.5 hours of training in
social and environmental issues during its entire 12 month
duration.
Probably the single biggest step in pushing sell-side equity
analysts into their first tentative steps toward responsible
investment has been the emergence of Socially Responsible
Investment (SRI) funds among the client base. This contact
between questioning clients and mainstream equity analysts
has helped to raise awareness of the impact of environmental,
social and ethical risk. There are a number of sectors (such as
mining, tobacco, food producers, oil and gas) where the ability
to spot the surfacing of such risks might provide an
opportunity for differential performance.
The main reason most advances toward responsible investing
by sell-side equity analysts have followed the surfacing of risks
is that most analysts (and their contacts) already operate in
this manner. And under this model, one of the few ways that
sell-side equity analysts can offer added value is by
anticipating the emergence of a new risk in the short term.
However, if responsible investment is to take a greater hold
among mainstream sell-side equity analysts, it will require a
different way of thinking and different approaches to analysis,
either by introducing a different set of competencies or a
different set of analysts.
Knowledge on social and environmental factors exists in
the sell-side analytical community but it is still thinly spread
and tenuous. Given the short lifespan of equity analysts this
means that many only become oriented to social and
environmental issues towards the end of their investment
banking careers.
Expanding existing practice for analysing equities to include
non-financial criteria demands a significant investment in
training. Mature sell-side equity analysts learn most “in situ”
by research writing. However they only aim to write
research that will be immediately consumed and acted
upon by their buy-side clients. For the current stock of sellside
equity analysts to gain sufficient knowledge to judge
companies on responsible investing criteria, it would require
a significant investment in training or in writing research that
could be too easily categorized (at least internally) as “noncommercial”.
New analysts are receiving too little training in the use of
non-financial criteria in equity valuation. As a result, an
impediment still exists on the extent to which the turnover
in the population of sell-side equity analysts might promote
a change in investment philosophy.
The prevailing culture in sell-side equity analysis remains
focused on financial criteria. Most sell-side analysts remain
focused on winning in the current system rather than
attempting to change it. Few managers in investment
banking firms, who developed in the trading floor
environment, buy-in to the notion of responsible investing.
For sell-side equity analysts to deliver a different type of
research product focusing on non-financial criteria requires a
change in culture and a refocusing of management approach,
beyond the “measurables” of call rates and short-term market
share. As we will see in the next section, there are
considerable short- term disincentives to making these
changes.
C. Incentives
The previous two sections have indicated that for sell-side
equity analysts to make the shift from financial investment
criteria to responsible investment criteria, a significant
investment in knowledge and information source is required. Is
there anything in current incentive schemes to underpin this
kind of investment Indeed, are there any real incentives for
sell-side equity analysts to help to establish responsible
investment approaches at all
Sell-side equity analysts, like most trading floor professionals,
share in an incentive structure that provides a basic salary,
potentially supplemented (substantially) by a (i.e., year-end)
bonus. This structure matches the revenue-oriented nature of
sell-side equity research and the transaction that underpins it.
For the analyst the rewards are substantially deferred, as most
investment banks pay bonuses on an annual basis and only a
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