Can you be good and still make a lot of money? In the year 2000 the $239 billion California Public Employees’ Retirement System (CalPERS), the biggest pension fund in the US, dumped its investments in China, Colombia and the Philippines because of their poor democratic records, as well as pulling money out of the tobacco industry.
Another state fund, the $162 billion California State Teachers’ Retirement System (CalSTRS) also dropped cigarette firms. By 2008, the result was that CalPERS had made $400 million less than if it had not made these exceptions, while CalSTRS had left $1 billion on the table.
This is just the sort of story that convinces many people that, when it comes to investing, morals cost money. Others argue that business is just not the sort of thing that should be concerning itself with questions of right and wrong. As the libertarian economist Milton Friedman said: “The business of business is business”. Take Corporate Social Responsibility, or CSR, a shibboleth of those who would make capitalism good. A powerful critic is Robert Reich, an economist who served in three American administrations.
In his book Supercapitalism he says that corporations are driven by profits pure and simple. It so happens that sometimes firms’ aims coincide with those of environmentalists – such as when they reduce waste, or with those of employee-rights advocates – for example when they decide to give employees health insurance. But the firms do these things to reduce costs, or staff turnover. They are concerned only with the bottom line, and to say that these were done for “ethical” reasons is corporate spin.
Cynics try to write off the idea of ethical business, but they are increasingly out of step with the times. For years fund managers have been looking beyond the bottom line and focusing on the sorts of things that might be called ethical, or socially responsible. Since the crash more managers have been taking a fresh look at issues such as corporate governance, fiduciary duty and sustainability.
Henry Boucher, a fund manager at Sarasin & Partners, a responsible investment fund management firm in the City of London, points out that there are three separate ideas to be understood here: ethics, sustainability and responsibility. Ethical investing is where you choose not to invest in certain businesses because they clash with your beliefs. For example, the Quakers avoid investing in activities that they believe cause social harm, such as arms, tobacco, alcohol, pornography or gambling. Boucher says that if you exclude companies that were involved in these areas then that would remove about 9% of the investment universe.
It follows that an investment which excluded these sectors would not track the complete universe – and the more exceptions you make, the greater the tracking error – but it doesn’t follow that the investment return would necessarily be lower than that of the whole universe. For example, many conventional investors are moving out of tobacco stocks now, as they believe that regulation will adversely affect the industry in the future. Sometimes the outlook of the money-motivated and the ethically minded can coincide. Secondly, you might decide only to invest in firms that you think are sustainable. This encompasses three different things.
For a start, you might exclude sectors that you think have no future – oil companies if you believe that the fossil fuel industries will be regulated out of existence, or tobacco firms if you think that people will stop smoking.
This is not an ethical position, but a practical one. Next, you might take a best-in-class approach. This would look at companies’ relative social, environmental and governance performance and rank them in those terms. An investor might then choose to invest in, say, only the top 50% judged on these criteria. This means that you are excluding a lot of firms, but if you think that they are not sustainable businesses then (as long as you are right) in the long-term that doesn’t matter. The final aspect of sustainability is to invest in “sustainable themes”, such as alternative energy or water purification or supply.
The third approach, responsible investing, is a little more nuanced. This approach, says the industry, aims to manage an investment’s risk, and to identify opportunities. The key concept here is ESG – environmental, social and governance issues. Yogi Dewan, chief executive of Hassium Asset Management, which invests money for wealthy families, says that ESG issues include, but are not limited to, “climate change, alternative energy, water, waste, healthcare, human rights, child labour, executive compensation, employee relations and regulation.” He adds “It’s about creating profit for shareholders whilst protecting the environment and improving the lives of those within it.”
That might sound a bit hippy, but it isn’t. It’s important to understand that ESG is not an ethical concept, at least in the way that the Quakers would understand the term. Take, for example, a mythical coal company, CoalCorp. Some might not want to invest in it because they feel that the fossil fuel industry is unethical because it creates CO2. Others might think that it is an unsustainable business – perhaps they think that governments will make life hard for coal companies as they struggle to reach their pollution targets.
But another investor might look at it and be impressed by its carbon-capture technology, the way that it makes sure it gets the most out of its mines, and be impressed by the way it is run, with a solid pension scheme, a wise board and happy workers. You could conclude that in a world where coal will continue to provide power, then this is just the sort of firm that will flourish. CoalCorp might not be everybody’s cup of tea, ethically-speaking, but it has good ESG performance.
Clearly, ESG is not a straightforward thing, and as Sarasin’s Henry Boucher says, “Responsible investing is not mechanical, it requires judgement”. ESG is not a straightforward guide to performance. Some firms that top the league in terms of ESG are poor performers, while it is clear that others which pursue short-term gain, disrespect the environment and labour rights are massively profitable and show no signs of slowing down.
So you might argue that ESG has limited use for those interested in good returns. But there is another way to look at it – in terms of fiduciary duty. Advocates of ESG say that the publication of the FairPensions report at the end of March was a highly significant moment for the fund managment industry. The report said that fund managers should move away from what it called the “myth” that their only duty is to maximise returns.
It said: “Prevailing interpretations of fiduciary obligations have lost their way, neglecting the core duty of loyalty – including the duty to avoid conflicts of interests – in favour of a narrow focus on maximising returns. It is time to move on from an outdated view of fiduciary obligation as a straitjacket which prevents investors from behaving in an enlightened and responsible manner.” Responsible fund managers ought to consider that environmental, social and governmental issues are fundamental, argued the report. Doing business is, despite what Milton Friedman might have thought, about more than making money.
And the ESG worldview is rapidly moving into the mainstream. A body called the International Integrated Reporting Committee is trying to create a global reporting standard that integrates ESG and financial reporting. The United Nations Principles for Responsible Investment (UNPRI) is an initiative that encourages institutional investors to promote ESG issues – for example, insisting that companies report on ESG questions and pressuring them to improve.
Currently 883 institutional investors with a total of $25 trillion under management have signed, including big players like the BP and Santander pension funds and charities such as the Joseph Rowntree Foundation. The important word in the UNPRI is “responsible”.
Investors such as pension funds have liabilities over decades – far longer than those of the chief executive or the board. They are the ones with a real interest in ensuring the long- term health of the business and it would be irresponsible for them not to encourage the business to behave in their long-term interests. ESG is shorthand for responsible behaviour.
What has all this got to do with families? For a start, there is an obvious ethical element to family investing. Some people might not want the name of the business they built up over generations, or indeed the name of the family itself, to be associated with certain industries. But sustainable and responsible investing are also highly relevant to families because of their investment horizons.
One of the biggest players in sustainable investing is Generation, an asset management firm set up by Al Gore and David Blood in 2004. Its philosophy is that what is relevant to a company’s returns over the long-term are precisely its ESG factors. Generation says that a short-term perspective hinders innovation and research and development, diminishes investment in human capital, encourages what it calls financial gymnastics and discourages leadership. So firms that take ESG seriously ought to be good long-term bets. And those are exactly the investments that families ought to be looking for.
All this appears to point in exactly the opposite direction to the conventional view about responsible or sustainable investing, that it costs you returns. So what is the truth? A number of studies and meta- studies have looked into this. Typical is one by the Center for Corporate Responsibility and Sustainability at the University of Zurich, which found that “sustainability does not have a negative impact on the financial performance of share portfolios”. On the contrary, “sustainability tends to have a positive impact on share performance.” Most other studies find that a sustainable or responsible portfolio performs either as well or better than a conventional one. The “sustainability filter”, as they put it, is not a hindrance.
How can this be? For a start sustainable shares provide a large enough investment universe to give you a sufficiently diversified portfolio to at least match portfolios with other filters. Secondly, those looking for sustainable investments might also look in places that conventional fund managers do not – for example to smaller businesses which are good investments, such as renewable energy or water treatment businesses. In this sense, the sustainable universe can actually be larger than the conventional one, argue proponents of ESG.
What of the argument that ESG issues are an add-on, a nice thing to have but secondary to profit? ESG’s defenders argue that it is fundamental to profit because in some respects the line between ethical and practical is blurred. Take the example of a company that abuses human rights. This is a question not just of morals, but of the very survival of the business – a prosecution for human rights abuses would see customers and shareholders run for the hills. So should they also avoid child labour? Low wages? Polluting? Should pharma companies pay poor people to take part in trials of dangerous drugs? If not, is that because it is wrong, or because it would be bad PR? It is hard to draw a line between purely business issues and ethical ones, and between doing the right and the prudent thing.
For a long time mainstream investment professionals said that ESG issues have no bearing on performance, but the examples of bad corporate governance at Lehman Brothers and the fact that a safety incident at BP led to one of Britain’s biggest businesses losing half of its share price in a few days show that ESG can no longer be ignored. In one sense, it is totally unsurprising that sustainable or responsible businesses outperform others over the long- term. Sustainable and responsible business are designed to do just that.
Some might push ESG as an ethical issue, but that is to misunderstand the concept. As Dewan of Hassium says, though: “ESG is becoming more of a proxy for management quality”. ESG is about long-termism, fiduciary responsibility and thinking about investors’ interests, exactly the qualities that you would expect to lead a firm to outperform the market.
That’s the good news. The bad news is that as soon as companies realise that good ESG attracts investors, they will start trying to fake it.
(Pictures from Press Association)