25 May 2017
The only way is ethics
Investors with a conscience can reap additional rewards.
by Frank O’Nomics
Ethical investment has long been the cause of a dilemma for those looking to maximize their investments returns. Historically arms and cigarette manufacturers have provided attractive rewards, as companies prey on human proclivities to fight and smoke. For those wishing to generate income from a portfolio it is hard not to hold stocks like British American Tobacco, which has a history of high and rising dividend pay outs and has generated a total return of over 30% over the last year. However, for some, having an unfettered investment approach is just not acceptable. Comic Relief found themselves in hot water in 2013 when they were exposed for having invested some of their funds in companies seen as the cause of the very issues they were campaigning to resolve. They, like most charitable entities, quickly adopted an ethical investment policy and this year’s record fund-raising total of £76mn suggests that they have suffered no lasting damage. What may, however, come as a surprise is that there is growing evidence that the very act of imposing ethical rules on their investments may actually be helping charities to generate better long-term returns and there may be lessons to be learnt for all of us.
Last week, the Church of England’s £7.9 billion endowment fund reported its best investment performance for 3 decades, generating a return of 17.1% in 2016. This was not a one-off – the fund has averaged a 9.6% return for the last 30 years, which makes it one of the best performing endowment funds globally. Theywill only invest in companies which they regard as compatible with Christian values and hence have no direct investments in arms manufacturers, gambling or tobacco firms (they did have an investment in Wonga, but sold it following the Archbishop of Canterbury’s criticism of payday lenders). This may seem like divine providence, but there is both evidence and theory to support their success.
Since the 1970’s there has been a growing number of research projects searching for the relationship between environmental, social and governance (ESG) criteria and corporate financial performance (CFP) – in essence looking for the impact of ethical investment policies. Researchers at the University of Hamburg have trawled through all of these academic studies (some 2200 of them) in an effort to generate an overview, and the results are encouraging. The large majority of the studies reported positive findings, with 90% “non-negative”. Perhaps as important, the positive impact of ESG on CFP appears stable over time. The positive effects are also demonstrated across asset classes, although there does seem a greater impact for bonds and property than for equities. Interestingly, when splitting the impacts, all three of the virtues, environmental, social and governance, made a difference on their own. Overall, the biggest positive impact comes in the financial performance of those companies with good governance. Such evidence is valuable in helping to justify investor activism, giving empirical weight to those challenging executive pay, board structure and gender balance. The Church of England fund managers, for example, voted against most of the executive pay proposals of the companies that their fund has a stake in.
A negative screening process, excluding investments in those companies that do not conform to your ethical criteria, has a long been a feature of the investment policies of many funds, but what seems to be adding to performance in many cases is the benefit of positive screening. This involves looking for those companies that proactively go beyond just the legal requirements of environmental, social and governance criteria to deliver best practice, with environmental aspects providing perhaps the best opportunities. An investor such as Allianz will not only use negative screening to reject investing in a company that uses coal for more than 30% of its electricity requirements, but also takes a positive approach, currently having EUR 2.5 billion of investments in renewable energy, which it is looking to double in the medium term.
The good news is that a great many fund managers have already bought into this, adopting to some degree an ethical investment process. In 2015, around $60 trillion in assets under management (around half of the global total) were managed by Principles for Responsible Investment (PRI) signatories. The process is not straightforward, with less than a quarter of investment professionals acknowledging that they consider non-financial factors in their decision making, and only around 10% of them getting any formal training on how to include ESG criteria in investment analysis. The other difficulty is the degree to which ethical policies can ultimately be applied. Excluding those companies that do not have a proper gender balance on their board will, until the 30% Club has achieved its ends, be too prohibitive, and it is all very well excluding tobacco companies, but where should you stand on those that retail their products? A strict approach could exclude all supermarket chains, pubs and hotels from your portfolio. Nevertheless, there are many ethical funds out there to take those difficult decisions for you, and it just may be that they might generate the kind of returns that have helped to pay Church of England salaries and pension over the last 30 years.
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