Introduction
Any introductory course in economics, accountancy or investment management will involve a student in examining the objectives of a business, specifically one where the capital that allows the business to function comes from external investors: shareholders and bond holders – in other words a limited company.
As companies are run by a board of directors in most national jurisdictions, the responsibilities of the board must be understood and foremost among those is to make a profit so as to be able to pay the interest due to the loan stock (bond) holders and then hopefully rising dividends to shareholders.
Most people accept that companies are nonetheless accountable to other stakeholders: their employees, customers, society at large, the national government and so on. Over time the relative priority given to profit generation as opposed to other stakeholder interests varies with the political climate and it varies between individual businesses. Some cynics might say that some companies are run for the benefit of the executive directors first and foremost!
In theory, because shareholders can replace the directors, they can influence the directors’ policies and how they are delivered by the management. That may work for someone like Sir James Dyson who own all the shares in his company, but not for people like you and me who own investment funds which have in them shares we have not chosen and which, unless very large, are themselves owning such a small part of a company’s issued shareholding that they have no influence on the directors.
So if you can’t possibly influence the selection of shares in the funds you are invested in, never mind get the directors of those companies to know your opinion, can you ever invest without just accepting that ‘capitalism is not perfect, but it’s better than the alternatives’ and you are not in any way responsible as a miniscule shareholder in global businesses?
People do want to have a say in what they are supporting.
If a charity collector approaches you in the street and tells you he is raising money for a cause you personally don’t like, you probably won’t donate any money, even though your fiver is trivial relative to the charity’s total income. You don’t want your money being used to support activity that in your judgement is bad for you, or more likely for society in general. Even if you were only likely to have given a very small sum, you would choose to exercise your personal judgment on what you want to support and what to avoid.
So, it is not surprising that people want to think that however small their stake is in a business, they are not knowingly promoting something they disapprove of. If you have a dear relative who suffers from a gambling addiction, for example, you might be upset to see that your investment fund has millions of shares in Ladbrokes or William Hill.
The earliest funds that were described as suitable for ethical investors were constructed to quite strictly exclude certain types of businesses whose activities conflicted with the religious beliefs of the investors. In the UK, the financial services company Friends Provident, founded by Quakers, offered the Stewardship fund range which would not invest in tobacco companies, gambling businesses and armament manufacturers, for example.
Over recent decades, various categories of filters have been devised to help people invest in line with their consciences. A brief look at the main categories should help you appreciate how we come to have today’s choices.
Dark green, light green, SRI, sustainable, ESG and …?
Funds that invest with ethical selection criteria were called green funds at one time for much the same reason that political parties bear that name: there is an implication that the securities in the funds will be in businesses that are generally good for the environment or society.
However, as mentioned already, some people want to invest knowing that they are avoiding certain activities that don’t have their conscientious approval. Typically, these might be producing tobacco products or alcoholic drinks, supplying armaments or maybe printing and distributing pornography. Some people have other objections, such as to certain types of banking activities (eg payday lending) or testing of pharmaceutical or cosmetic products on animals.
In time investment funds that claimed to meet ethical criteria began to be classified as ‘negative’ or ‘positive’. Negative funds refused to invest in certain type of business and positive funds sought only to invest in certain type of business. Generally, the negative funds were accountable to a clientele with stricter ethical requirements and they were for a while called ‘dark green’. The funds that looked to invest in businesses that might be good for society at large were called ‘light green’.
The light green approach has been through several further evolutionary stages and we have had funds described as ‘socially responsible investment’ or SRI, sustainable funds and more recently an attempt to actually rank all businesses according to what are called ESG criteria – Environment, social and governance. More about governance later.
Who checks all this out?
If you select an investment fund that claims to invest in such a way that you feel more comfortable with it, you need to know that in practice it really does. How can you check that out?
In many cases, you will need to read the fund manager’s periodic reports about the fund’s investment activity or hope that your adviser does that for you. Some advisers specialize in ethical investment strategies and they will be well informed – most will not.
Some funds report to an external panel with appropriate credentials whose job is to keep the fund manager on the straight and narrow. That can be re-assuring, but such panels have been criticized on occasions for not sticking strictly to their mandate – the one that acts for the Church of England is a well known example.
Others only buy holdings from lists that are pe-approved by an external service, like the EIRIS Foundation, whose web site is well who a look: www.eirisfoundation.org/ EIRIS has been around a long time and can be taken as an authoritative resource.
Corporate Governance
Some fund managers are very committed to the corporate governance element of investing. Corporate governance refers to the way a company behaves relative to legislation and its stakeholders. It is usually assumed that stakeholders include employees, customers and society at large, especially insofar as the company’s activities impact on the environment. A fund that takes the ‘G’’ part of ESG seriously will use is voting power as a shareholder and if has a large shareholding in a company, apply pressure to improve behavior on things like executive pay policy and annual reporting in detail .
A small number of fund groups report on their voting record at company meetings and at least one even does research on the general progress of shareholder involvement and corporate reaction to investors attitudes. There is a research standard in the process of refinement that gives companies and funds globally an ESG score, from the Morningstar research business. This uses a combination of assessment factors and will not be adequate for investors with strong principles, but it shows that this issue is widely debated and considered worthy of thorough research.
Some difficulties
Some businesses may themselves do things that would not upset an investor’s conscience but may assist other business that are objectional to the investor. Banks are a prime example, but transport companies and general service businesses might be others. Imagine a food services business that pays its staff well, has exemplary corporate governance, uses organic produce and contributes heavily to an anti-obesity charity. Sounds suitable? But what if its main contract is with the Ministry of Defence?
Investing in bond or loan stock funds is also complex as they are usually extremely diverse with thousands of stocks and change holdings very frequently. Holding will very often include loan stocks issued by governments, like US Treasuries. Many investors would know that the US spends a large amount of its budget on military activity and would not want to indirectly lend it money.
These issues need to be understood and they can be partly resolved by funds having sets of rules, but in practice no fund will be able to promise absolute ethical purity all the time.
One can even argue that investing is participation in the economic model as a capitalist and the reward to capital in that model is taken to be profit, so one cannot really expect any business to do anything but focus on profit making.
There is however such a thing as responsible capitalism and most democratic socialists, even the Chinese communists, accept that capitalism is often the best mechanism for sharing out most goods and services – other more directive models having generally failed. Consequently, governments and society have over the last century or so made it clear that they expect businesses to take account of their responsibilities to the wider community.
It is also virtually impossible to invest in commercial property if you have strong views on certain business activities as you will never be able to know that the tenants of all the properties in the fund are running decent accountable businesses. Indeed most property funds have British and foreign government departments as tenants as well as banks and that in itself might be objectionable to some investors.
Risk and returns
It is logical to argue that if you restrict your investment universe so that you exclude some of the businesses which make the most reliable profits at all points in the economic cycle (like tobacco and pharmaceutical companies), what you have left will be a slightly more volatile set of shareholdings.
It is also true that some companies that are doing things that look very attractive in terms of environmental benefits are new, not very profitable and burn lots of investors cash. So they are going to be higher risk.
On the other hand some experienced fund managers in several parts of the world report that when they limit their investments to companies with good corporate governance standards, they get better returns than a benchmark of similar investments that were not so filtered. In other words, well run businesses often have better standards of governance. This may not show in the short term, of course, as profit maximization may be possible with poor standards of accountability (Ryanair and Sports Direct come to mind!). The argument here is that in the end badly behaved businesses get their come-uppance.
It is important to appreciate that it is difficult to create a well-diversified asset mix of ethical investments because of the difficulty in finding suitable fixed interest and property funds. It is easy to argue as a purist that ‘shorting’ shares is unethical even though it is normal and perfectly legal in most countries, so that excludes many absolute return or volatility managed funds for some investors. Therefore, conventional portfolio construction techniques are unsuitable
Although a specialist will be able to make a decent job of creating a diversified ethical portfolio to any given risk preference, it is my view that ethical investors always have to control risk by extending their investment horizon and retaining more cash. This will sometimes suppress returns, but at times will be usefully defensive, so in the really long term. I would expect ethical investors to do as well as those with no constraints at all. Perhaps they will do even better because they tend to pay closer attention to what they are actually investing in!
Finally, it has to be said that people who want to impose specific restrictions or objectives on their investments do so for many and various reasons. It is important that any adviser can empathize with those reasons and makes the effort to select the most suitable investments on a highly bespoke basis. For this reason NotHarry, who invests ethically himself to a degree, cannot publish an example portfolio. I will however comment on ethical and ESG funds from time to time and can research specific requirements for subscribers on request.