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Taking the Long View

Some 30 institutional investors, led by former Goldman Sachs Asset Management chief David Blood,have banded together to push sell-side researchers to ditch their quarter-to-quarter obsession. They're making progress, but it's a slow go.

Plenty of people grumble about the stock market being too focused on short-term results. David Blood is doing something about it.

As founding chairman of the Enhanced Analytics Initiative, the former Goldman, Sachs & Co. executive has spent much of the past three years pushing brokerage houses to change their approach to investment research so that it is less obsessed with quarterly results and more concerned with long-term performance. Blood and his partners in the EAI promise to divert 5 percent of their institutions' brokerage commissions to pay for research that tackles what it calls extrafinancial issues. These include everything from how companies treat their employees and govern themselves to their exposure to political and environmental risks. About 30 pension plan sponsors and money managers representing $2.5 trillion in assets are now members, up from just five institutions when the group started in October 2004.

"Of course you can make money trading," says Blood. "But extra-financial issues will make a difference over the long term and should be a focus of people trying to make the best investment decisions."

During 18 years with Goldman, including a stint as head of its asset management unit from 1999 to 2003, Blood became convinced that companies can best succeed over the long haul by deftly managing not just their finances but also less-tangible factors such as employee morale, government regulation and the impact their operations have on society and the environment. He also took note of how Wall Street, influenced by the billions flowing into fast-trading hedge funds, increasingly judged companies by whether they met quarter-to-quarter earnings expectations.

Blood left Goldman in 2003 to form Generation Investment Management, a London-based firm chaired by former U.S. vice president Al Gore that is dedicated to long-term investing. One year later he helped found the EAI.

"The more that investment research has evolved to focus on quarterly earnings and price targets, the less helpful it becomes to long-term investors," explains Blood, who last month stepped down from his post at the EAI, making way for the organization's first full-time chairman, ex­London Pension Fund Authority CEO Peter Scales. "Our aim is to change all that."

So far the group has enjoyed moderate success. Some longtime members report that, since they joined, they've seen as much as a tenfold increase in the number of research reports they receive that focus on extrafinancial issues. The brokerage houses that the EAI regularly recognizes for their work in this area range from small European firms such as France's CA Cheuvreux and Oddo Securities to global powerhouses like Citigroup, Goldman, Morgan Stanley and Sanford C. Bernstein & Co. Goldman has formed a separate division, called GS Sustain, to produce this kind of research.

That's a far cry from when the EAI got started three years ago. The group's founding members -- BNP Paribas Asset Management of France, Generation, Dutch pension fund PGGM and Universities Superannuation Scheme, a U.K. pension plan for college employees -- were frustrated by the tendency of sell-side research to all but ignore issues that, they believed, significantly affected long-term stock performance. Chief among these at the time was the potential impact of Europe's fledgling carbon-emissions-trading program on businesses. Raj Thamotheram, then a portfolio manager for USS, vividly remembers the response he received when he complained about the oversight to a friend at one big brokerage-house research department. "He told me, 'You don't ask us for this, pay us for this or hold us accountable for this kind of research, so why do you expect us to deliver it?'"

To be sure, some boutique researchers were doing good work focusing on extrafinancial matters, but most didn't bring the analytical firepower and financial acumen of elite investment banks like Citigroup, Goldman, Morgan Stanley and UBS.

"Specialist research agencies were looking at some of these issues," says Eric Borremans, head of sustainable and responsible investments at BNP Paribas, "but it was a pity that sell-side analysts weren't being formally asked to put their brains to work, given their level of expertise and knowledge of companies and sectors, and their access to company management." Other firms found boutique research unreliable. "There's a different level of rigor in the analysis from the investment banking side -- a level that we found was kind of missing" from the research done by firms devoted to niches such as encouraging socially responsible investing, says Janice Hester Amey, portfolio manager in charge of corporate governance at the California State Teachers' Retirement System, which joined the EAI in December 2006.

The initiative's founders concluded that collective action was necessary. The more members they could recruit, the harder it would be for research firms to ignore demands for a new approach. Once they started reaching out to other institutions, they sensed they were on to something big. In November 2004, staff at USS had prepared the pension scheme's London boardroom for what they expected would be a low-key, midmorning presentation to about two dozen invited guests regarding the EAI's aims, with keynote speeches by Neil Dwane, chief investment officer of U.K. money manager RCM, and USS investment chief Peter Moon. But the scene was soon crammed with more than 70 money managers and brokerage-house executives, some of whom had flown in from New York for the day.

"It was standing room only, and we had to send someone out to order up more food and drinks," recalls Thamotheram, who last year left USS to become director of responsible investment at AXA Investment Managers. "We knew that we were doing something important, that we were trying to shake up the way investment research was handled and conceived, but we had underestimated the degree of interest in the new model we were proposing."

Of course, this being the investment business, the EAI members also needed to provide a financial incentive to research firms. Some members suggested allocating 2 percent of trading commissions to the firms that best incorporated extrafinancial factors into their research. Others favored as much as 10 percent, so the group compromised at 5 percent, figuring that sum would be enough to get Wall Street and City of London brokerage houses to sit up and take notice. Based on the EAI's current membership, it now pays out E20 million ($28.4 million) to E40 million in such commissions annually. Institutions in the U.S. and Europe pay a total of about $13 billion in annual commissions, according to Greenwich Associates.

"It's not a huge amount of money," acknowledges David Russell, co-head of responsible investment at USS. "But it's enough to signal that we're serious." As an added carrot for the big firms that might not be impressed with a share of that pot, the EAI offers public recognition. Every six months the top half dozen or so research providers that will share in the monetary rewards are identified in a press release that includes plaudits from some of their largest clients.

Recruiting members has been more difficult in the U.S. than in Europe, where institutions such as the U.K.'s Hermes Pensions Management, Sweden's Mistra and the French post office's asset management division have recently joined the EAI. "Here the whole issue of sustainability is seen as part of the socially responsible investing 'agenda' and has become very political," says Blood. "Even people sympathetic to the objectives have a hard time getting past their reluctance to get involved in what they see as a non-business-related initiative."

CalSTRS and the New York City Employees' Retirement System have helped Blood line up a series of meetings with U.S. plan sponsors and money managers for this fall. "Once I've shown them the long-term investment case," he proclaims, "I would be very surprised if we didn't have three or four more organizations sign on the line. And with every new member, our voice gets louder when it comes to shaping research."

Even without that larger presence, the group's efforts are bearing fruit. When the EAI was first formed, members received maybe a handful of reports on extrafinancial issues each year, says BNP Paribas's Borremans. "Now I see perhaps 120 or 130 decent-quality reports every six months, and each period there are more brokerage firms participating," he adds.

Among the standouts on the sell side is GS Sustain, which looks solely at how environmental, social and governmental issues affect companies. The group grew out of work produced on an ad hoc basis by Goldman analysts. One early request, back in 2004, came from investors who wanted to figure out how extrafinancial issues would affect the oil and gas sector. Clients liked the work, and Goldman decided to formalize its efforts. This year, the group has grown from three dedicated analysts to eight.

"Our goal is to be more comprehensive in our coverage of the issues that affect stocks," says Sarah Forrest, the Goldman executive director who heads GS Sustain. "We look at the spectrum of things ranging from demographics, resource constraints and human capital issues that would give a business a sustained competitive advantage."

It's hard to tell how much of this flood of new research owes directly to the EAI as opposed to other factors. The three years since the group's launch have seen increasing public awareness of climate change issues as well as an influx of new capital into companies in related businesses, such as alternative energy providers and businesses aimed at minimizing carbon emissions from coal-fueled power plants. And other clients had already begun to prod research firms to provide more of this kind of analysis.

Now that Wall Street is responding, the EAI is raising the bar. No longer do thematic pieces on climate change or corporate governance earn research providers a shot at members' commission dollars. "That's become mainstream," says Russell of USS, "so we have changed our criteria." To receive a share of the commission pool now, a research firm must produce at least one report that relates an extra-financial issue directly to an investment decision, such as buying or selling individual stocks. "We need to see more of that kind of effort to integrate the topic with the question we face: How can we make money or avoid losses?"

EAI members are also prodding the sell side to think creatively about extra-financial issues and go beyond the obvious ones like global warming. "There's not much work done on corporate governance issues and how they affect financial issues like a company's cost of capital," notes Russell. "And human capital issues are very important -- what would happen to Google if half of its development team left to form their own start-up?" He also craves analysis of which mergers and acquisitions stand the best chance of long-term success. "I see a lot of analysis around the pricing of deals. That would help arbitrageurs," he says. "But when only about 30 percent of M&A deals add value in the long term, we want to know which ones offer the best real synergies, where savings would come from and how successful companies might be in integrating operations." Only then, he says, can USS's managers make informed long-term investment calls.

In addition to challenging research firms to improve their analysis, the EAI is still trying to broaden its influence, particularly in the U.S., where it has just three members -- one of which is Calvert Group, a firm dedicated to socially conscious investing. The group hopes to woo more mainstream institutions to join CalSTRS and the New York City fund. The EAI is launching a campaign this fall aimed at U.S. institutions, with the goal of increasing the assets it represents by 20 percent, to $3 trillion, according to Blood.

Joining him in that drive will be new EAI chairman Scales. Expanding membership, says Scales, will allow the group to convince brokerage houses that aren't doing extrafinancial research that it's worth their effort. "If we could bring in another six large and significant pension funds," he says, "that would give us some critical mass."

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