(May 14, 2013) – The past few days have seen a plethora of sin stocks being dumped: Norway’s finance ministry excluded two tobacco companies from the Norwegian Pension Fund Global’s (NPFG) investment universe; in New Zealand Barrick Gold Corporation and its subsidiary African Barrick Gold were dropped for human rights and environmental problems, and in the US a number of high profile pension funds have divested from gun manufacturers following the Sandy Hook tragedy.
But is excluding sin stocks prudent decision for investors? And can you make the same – or even better – returns from investing more ethically?
Environmental, social and governance (ESG) investing has been around for several years. More than five years ago, a Dutch media exposé on pension investments in landmine manufactures ignited massive of public criticism.
Since then, ethical investing has covered everything from human rights abuses to carbon usage; but are investors choosing a higher ground for ethical or reputational reasons?
Ethical or Reputational?
Aled Jones, head of responsible investment in Europe for consultants Mercer, told aiCIO that while there had been a lot of ethical investment stories in the media recently, he was unconvinced of any suggestion that investors were stepping up their ESG presence.
“Having said that, recently we’ve seen a second wave of avoidance of certain stocks when investors have become concerned by reputational issues, rather than ethical ones. That’s certainly happened with some corporate pension funds,” he said.
“Is it prudent to abandon sin stocks? It’s possible to find substitutes for individual stocks but if you start excluding everything in that area; tobacco and gambling and guns etc, then it’s a much harder task. It all comes down to your investment objectives really.”
Many pension funds adhere to the UN Global Compact as a basis for their ethical investment decisions. Indeed, New Zealand Super quoted the UN standards as its reason for pulling out of investing in Barrick Gold and African Barrick Gold, saying the companies’ activities were inconsistent with the human rights and environmental standards contained in the accord.
But rather than use its firepower as a major investor, the sovereign wealth fund decided not to engage with the companies directly, with responsible investment manager Anne-Maree O’Connor claiming engagement with Barrick would be “unlikely to be successful”.
“Until it is evident that significant improvements can be made on the ground we will be excluding both companies from our portfolio,” she said in a statement.
“”It is important that we focus the fund’s efforts to influence company behaviour on situations where we believe a difference can be made.”
As at 31 December 2012, the fund held shares worth NZ$1,826,470 in Barrick Gold Corporation and NZ$78,824 in African Barrick Gold in its global equity portfolio. The stocks have now been sold.
Norway’s NPFG sold off its NOK215m (€28m) worth of holdings in China’s Huabao International Holdings and US-based Schweitzer-Mauduit after it discovered both firms produced reconstituted tobacco leaf, thought to account for as much as 15% of tobacco in cigarettes.
Explaining its decision to recommend exclusion, the Council’s report claimed Schweitzer-Mauduit produced around 75,000 tonnes of the leaves last year – around half of global production – and noted its plans to increase output by one-third through a new plant in China by 2014.
Huabao meanwhile said in a recent annual report that it produced around 20,000 tonnes of tobacco a year.
NPFG’s guidelines, introduced in 2010, state it must not invest in tobacco companies. It has excluded 17 companies from its investment universe since the rule was introduced.
Separately, it has also excluded an Israeli property company over concerns it was violating the Geneva Convention through its involvement in settlement construction.
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In the US, the Sandy Hook Elementary School massacre spurred dialogue at most major pension funds about the ethics of investing in firearm-related stocks. The California State Teachers’ Retirement System became the first to drop gun manufactures from its portfolio, following a unanimous vote after a tearful board meeting on January 9.
That month, Chicago Mayor Rahm Emmanuel also called on all of his city’s pension funds to divest from gun stocks.
Then last week the New York City Employees’ Retirement System (NYCERS) fund sold $16,260,630 worth of gun stock holdings, becoming the second New York fund to do so after the New York Teachers’ pension fund’s dropped the stocks in February.
Jane Ambachtsheer, partner and global head of responsible investment at consulting firm Mercer told aiCIO investors are becoming more vocal about their investment preferences, given the growing focus on the embedded risks in certain stocks or sectors where a number of social and political forces may impact market price.
She cited recent work on unburnable carbon as a recent example. “In this environment, fiduciaries should ensure that they have factored future risks into portfolio construction processes.
“Using fossil fuels as an example, this type of discussion might lead investors to ask whether they’re comfortable to bet that carbon will not be priced, this is certainly the implicit bet that most are currently taking.”
Once they’ve considered the risks, alternatives to divestment begin to emerge, Ambachtsheer continued, such as tilting portfolios towards lower carbon assets or introducing a sustainability themed allocation.
“The conversation is much less black and white than it was five years ago, and far more interesting as a result,” she concluded.
Does it make investment sense?
David Harris, director of ESG at FTSE, said rather than seeking to exclude entire sectors, many pension funds today are looking for a more blended approach.
“We’ve been working with Vanguard to create two pooled index tracker funds which takes an ESG approach and excludes some of the stocks – around 5% to 10% of the relevant market. We’re talking about those landmine-type weapons companies, and those which contravene the UN’s Global Compact,” he explained.
“The challenge has always been to integrate them into passive investments – and the Vanguard Global SRI fund and the Vanguard European SRI fund are among the most rapidly growing equities indexes now.”
Performance wise, the exclusion of a minor part of the regular index has resulted in a miniscule differential, according to Harris.
“Where an ethical screen is applied it’s not helpful for returns, reduces diversity, and there’s evidence of suffering a performance penalty… (but) where you take a broader approach and exclude companies with poor ESG practices, there’s no evidence of underperformance at all, and many may expect better returns in the long run,” he said.
Harris’ comments echo the findings of Deutsche Bank’s white paper on ESG investing last week, which found that solely investing in “good” companies will help improve overall returns.
The white paper also answers critics who claim ESG factors are neutralised at a portfolio level, adding diversification is improved by including them.
“As firms with good ESG ratings are associated with lower asset-specific (that is, firm-specific) variances, integrating ESG criteria in investment processes can enhance portfolio diversification.”
Setting their investment objectives will ultimately dictate how investors can and should approach ESG investment, but there is growing evidence that divesting from sin stocks won’t necessarily decimate your returns.