Pension funds are increasingly trying to do the right thing, but does morality really pay? Sara Benwell and Louise Farrand find out
When Al Gore makes an argument, the world tends to sit up and listen.
The former vice president of the United States is well known for his mission to raise awareness of the perils of climate change. Now he has turned his attention to pension funds.
As chairman of asset management firm Generation IM, Gore is seeking to convince schemes that investing sustainably does not contravene their fiduciary duty to invest in members’ best interests. In fact, if schemes fail to consider the long-term prospects of the companies in which they invest, they are breaching their fiduciary duty, he argued at a London press conference.
Why? Because if they fail to do proper due diligence on companies, schemes could be missing vital warning signs which will ultimately come back to bite corporate bottom lines. “Climate change is becoming a central issue for asset owners,” said Frédéric Hoogveld, an investment specialist who focuses on smart beta and low carbon solutions for asset manager Amundi.
Climate change is becoming a central issue for asset owners”
A case in point is carbon risk – the risk that businesses may not be able to tap into their oil or coal reserves if carbon emissions targets are tightened.
“The transition to a low carbon economy is the biggest challenge facing us today”, said Generation IM’s co-founder, David Blood. “As investors, there are significant risks to assess in every asset class. They are all affected by carbon risk.”
Many pension funds are invested in companies with exposure to oil or coal. Such companies could be hit hard by the issue of stranded assets in years to come.
“Most fossil fuel companies are valued on the basis of their reserves. But we won’t be able to burn all the reserves for a very simple reason. If we don’t want the temperature to increase by more than two degrees, the budget for CO2 emissions is 1,100 GtCO2. But if you burned all the reserves in the world, that would amount to 2,800 GtCO2. Companies with carbon-centric reserves – particularly coal – will not be able to monetise their assets,” explained Hoogveld, speaking at PensionsEurope’s conference in Brussels.
We don’t believe there is a trade-off in investment returns when incorporating sustainability”
So in fact, schemes’ moral and fiduciary duties are one and the same, according to Gore and Generation IM’s co-founder, David Blood. “We don’t believe there is a trade-off in investment returns when incorporating sustainability,” said Blood.
The proof is in the pudding
Does the research reinforce Gore’s argument? Historically, it hasn’t been easy to evaluate the financial consequences of investing responsibly.
Now, Hermes Investment Management believes it has the answer. It rates each company it invests in on a series of ESG factors and tracks performance, benchmarking it against each company’s rating. As a result, the company has been able to evaluate investment returns to establish once and for all whether you can do better by doing good.
It busts the myth that investing in those companies that behave well will harm your returns”
From an environment and social perspective, the research found that there was no strong relationship between the company’s scores and the actual returns. That is to say you do no better by considering environmental and social factors, but also, crucially you do no worse.
This is good news for those who want to invest conscientiously because it looks like it busts the myth that investing in those companies that behave well will harm your returns.
On the governance side, the results were even more interesting. The company found that the over last six years, companies with poor or worsening standards of governance have underperformed their peers by 36bps per month. This equates to around 4% a year, a sizeable shortfall.
Lewis Grant, a senior portfolio manager at Hermes Global Equities, explains: “What we haven’t proven is that good governance has led to outperformance. We’ve found that the poorly governed companies or the ones getting worse are the ones that underperform… So from a stock picker’s perspective, it’s more important to avoid bad governance that it is to find the best.”
We’ve found that the poorly governed companies or the ones getting worse are the ones that underperform”
Indeed, the governance findings were so strong that the Hermes Global Equity Fund takes them into account when stock selecting, despite not being an ESG specific fund.
So good news for pension funds: investing in good governance does pay and taking into account environmental and social considerations won’t harm you.
Unfortunately things aren’t as clear cut as they first seem.
Hermes’ research does take into account companies’ future prospects, and naturally concludes that those which have not considered issues which could hit their long-term profit lines will perform less well. But it is difficult to quantify the impact of future unknowns on valuations.
In addition, Hermes’ research only compares companies against their peers. That is to say, a tobacco company which has a better governance record will perform better than another tobacco company.
Equally, investing in an oil and gas company with a good environmental record won’t harm you, but choosing to invest in solar panels rather than oil and gas might.
Excluding specific assets from investment portfolios is a complicated area. Grant explains: “If you start excluding things, so start ruling out those sin stocks, whatever they are, I think generally speaking, it’s not that they’ll necessarily do better or do worse, but they will have different performance in different market environments.”
It is a more holistic way of looking at a business, which should pay dividends longer term”
Worse, evidence suggests those investors that exclude companies or sectors they deem to be bad will usually face greater risk across the portfolio. This is, in part, because exclusion makes a portfolio less well diversified.
Alex Connor, investor relations manager at Triodos Investment Management believes exclusion may decrease other risks. This is because taking sustainable factors into account forces investors to take more holistic view of a company rather than just looking at its short-term financials and profits.
She explains: “If the status quo is going to change, it is a more holistic way of looking at a business, which should pay dividends longer term. So you increase risks in some ways by excluding but you probably reduce risks by actually taking into account more long-term factors than a traditional strategy would do.”
Unhappily, excluding stocks altogether may actually make them more profitable, according to research produced by Elroy Dimson, Paul Marsh and Mike Staunton of London Business School.
When everyone piles into ‘good’ companies, the price is pushed higher and returns fall”
The study, which was produced for Credit Suisse, found that when sin stocks such as tobacco and alcohol are persistently excluded by investors, they tend to sell for a somewhat lower share price. Other things held constant: a company which sells at a lower price, will usually provide a higher return.
Conversely, when everyone piles into ‘good’ companies, the price is pushed higher and returns fall.
Dimson explains: “Normally when you’re thinking about whether a company is a good investment or not, you have an insight and you hope that others in the next two or three years will share your views; if you are correct, there will be a capital gain.
“For sin stocks the argument is different: that their price is somewhat lower than they would be if they were more saintly companies, but the price is expected to remain depressed. If you are a long term investor and you stick with the stock, you would expect to find that the higher income for each dollar or pound that you invest provides an extra contribution to return.”
Someone else, with presumably less commitment to responsible investing than you, will be buying them”
Furthermore, Dimson points out that when you choose to exclude these stocks they don’t magically disappear. Someone else, with presumably less commitment to responsible investing than you, will be buying them.
So by doing the right thing, investors may actually miss out on potentially good opportunities and actually make sinful companies an even better bet for less scrupulous investors.
Engaging your way to better results
Fortunately it’s not all doom and gloom. While exclusion may harm a portfolio’s performance, engagement on ESG issues can make ethical investment pay.
“Ethical screening avoids unpleasant companies and overweights companies that are thought to be good. Further forms of screening address use of child labour, environmental concerns, and other issues. If as an investor you can engage with these companies and successfully influence them to behave differently, then there’s evidence that there can be a modest contribution to superior financial performance,” explains Dimson.
This is because you are creating a change in the company which is not already priced into the market.
Connor agrees that engagement may be the best route forward: “I think one does have to be careful, when looking at listed equity funds, that you don’t necessarily screen out too much but that you use engagement to try and improve activity. That’s a way of managing that risk aspect of responsible investment.”
People who bought into ethical investment crazes like socially responsible investment got badly burnt”
The Hermes research also found that companies which improve their ESG scores do well. “When we score a company, we rank it in two dimensions, both level and change. That’s really important to us, because it’s the companies that improve - they’re the companies that can really unlock shareholder value, and for us that’s what this is all about.”
In the past, says Grant, people who bought into ethical investment crazes like socially responsible investment got badly burnt. What is different now, he argues, is that ESG is being linked much more to performance and how a company behaves, rather than what type of product a company makes.
So for schemes that want to do the right thing without harming members’ retirement prospects, the answer seems to be trying to effect change within the companies you hold stocks in, rather than excluding them.
The important thing is to engage. “If you choose to do nothing, you’ve still made an investment decision”, says Generation IM’s Blood.