An Ethical Investment Policy reflects your or your organisation’s values, but can we be sure this leads to our desired consequences?

I chair an investment committee for an organisation with an ethical investment policy which is similar to many found around the world. We prohibit the owning of shares in companies whose businesses operate in the following sectors: weapons, tobacco, gambling and pornography. The question has arisen about whether the ethical investment policy should extend to prohibiting the burning of fossil fuels. This raises a number of questions, some of which are directly the problem for the investment committee and some are not.

Let’s take a look at what’s going on.

What is investing in shares anyway?

First off, back to basics. Investing in shares means putting money into a company, yes? Well, no, actually. Unless this is a new share issue, shares will be bought in the secondary market (i.e. traded on a stock exchange in most cases) from an existing shareholder. The company does not benefit one iota.

In fact investing into shares in a company really means investing into the income stream from dividends paid by the company as well as the right to vote on any resolutions at general meetings. It also entitles the shareholder to any liquidation proceeds, however that’s unlikely to be the reason why you will be investing.

It’s tempting to think that if a company is not benefiting from your investment then why have an ethical investment policy at all? Well, some will argue that and it might be something you are comfortable with. If not, read on.

Toxic shares

For ethical investors, some companies are beyond the pale. They operate in industries or services which are simply too toxic for the ethical investor. There is no way the investor wants their portfolio tainted with the presence of these companies.

Recall that it’s not the companies themselves that you are investing into, but the income stream of those companies. So the implication is that the monies arriving from these companies’ activities are ill-gotten gains. Just as we might not lend money (with interest) to a neighbour to buy a gun to shoot another neighbour, we might not want our share dividends coming from the profits of arms manufacturing. For example.

There is nothing much that’s controversial about any of this. We all have our values, and this is a way we overlay our values onto how we want our money to work for us. But this isn’t the only weapon in the ethical investor’s armoury.

Shareholder activism

As I mentioned earlier, owning shares provides an investment into the income stream from a company’s profits and it gives a right of voting on resolutions at company general meetings. Activist shareholders are concerned in part or in whole on the second part. Shareholder activism loosely takes one of two forms

Value investors

Some investors such as hedge funds and “corporate raiders” acquires stakes in companies to try and force through changes, which typically involves selling off part or all of the company. These investors believe the company should be worth more than they paid for their shares. They might try to remove board members, replacing them with their own. And they will embark on a strategy to extract as much value as they can, believing that the company is worth more as a sum of its parts than in its current structure. They might even force the company into liquidation, especially if they also own company debt which entitles them to a larger share of the proceeds.

Generally speaking, ethical investors are not so interested in this type of activism although it’s possible they will be faced with choices from time to time on whether to vote with or against an activist’s resolution.

Resolutions for change

Ethical investors are likely to have an eye on resolutions that attempt to change company policies in line with the investor’s values. Such resolutions might be about the level of boardroom pay and bonuses. Or they might be about something more socially responsible, like sustainability policies or diverting funds towards good causes.

Although each ethical investor is likely to own only a very small number of a company’s shares, groups of investors ensure that whole blocs of shares can be corralled to greater effect and companies do take notice. The last thing they want is to lose a vote at a general meeting, so shareholder groups get the chance to meet senior executives during the year with the aim of influencing company policy.

Arguably, an ethical investor can effect change more readily through becoming an activist than by avoiding holding any shares at all. However keep in mind that if a company exists to run casinos then it’s unlikely to be amenable to a proposal to close down its only businesses and if it did the shareholders might find their shares are worth little or nothing. So ethical shareholder activism has its limitations, assuming of course that the investor doesn’t want to lose money.

Positive Ethical Investment Policy

So far we’ve talked about what to do about companies we don’t like. The flip side is to consider the companies we do like. We might like to positively direct our investments into companies operating in certain sectors or companies which have certain corporate governance policies. But an ethical investment policy like this requires some courage.

It’s all too easy to let our idealism get the better of us, and to invest into startups operating in fashionable areas, perhaps sustainable energy, fresh water delivery or affordable housing. We might take our eyes off our investment goal and avoid looking at the fundamentals. In other words, will these companies succeed? Clearly some will and some will not. But risks are very high in comparison to investing in companies with a broader business portfolio and without the constraints of these specialist companies. It’s one thing to direct our personal investments into companies we want to support but if we’re looking after an organisation’s money, we have a duty to invest safely and prudently. If an organisation asks us to implement an ethical investment policy like this, make sure they are clear as to the risks they are asking us to take on.

The cost of Ethical Investing

As a basic rule, the more complicated the ethical investment policy, the more expensive it will be to implement. The cost arises through the workload required to screen companies before considering buying their shares. Whereas this is unlikely to be onerous for simple exclusions as with the investments I have responsibility for (weapons, tobacco, gambling and pornography) because companies involved in these activities can be identified very quickly. But what about companies involved “in the burning of fossil fuels”? These might include oil and gas producers, refiners and retailers. They might include motor manufacturers, power generation companies and transport companies like airlines and ship operators. In fact once we start thinking about it, the list mushrooms rather quickly. So those setting the ethical investment policy need to be unambiguously clear about what types of companies are in and which are out.

Another consideration when talking about cost is the opportunity cost resulting from the limiting of investment opportunities. Many organisations will an investment objective which is typically related to a benchmark index. Unless some kind of custom benchmark is created (for a cost) the benchmark is going to include the returns of companies which don’t conform to the ethical investment policy in their calculation. There will be times when beating the index is next to impossible, when excluded stocks do very well. The more stringent the ethical investment policy, the less the portfolio returns will look like the benchmark index. This is the risk of ethical investing.

Undesirable consequences

The campaign to disinvest from fossil fuels has been very successful. For my part, there are many companies I would rather avoid than those burning fossil fuels (companies dealing with oppressive regimes, or companies manufacturing harmful agrichemicals for example). But the anti-climate change campaign is well organised and a number of funds have already disinvested. Other than publicity, what does this achieve?

I like to stress-test scenarios. If most existing shareholders were to sell their shares in fossil fuel companies, who would be the buyers? Well, clearly those who have no problems with fossil fuels. And they will be pleased they have bought shares on the cheap, with prices depressed by all this ethical selling. In fact the buyers are ultimately likely to be either activist value investors, buying shares on the cheap and hoping to sell the assets to a third party at a profit. Or they might be large investors from overseas such as a sovereign wealth fund (e.g. China, Kuwait) or an entrepreneur like Warren Buffett. Either way, the company continues burning fossil fuels but without any pesky activist shareholders to worry about.

Ethical shareholders can’t change the world by disinvesting. In the case of fossil fuels, the best you can do is to nudge companies towards clean energy alternatives by becoming involved with them. And that means becoming a shareholder.

In summary

An ethical investment policy can both exclude companies which generate profits from activities considered to be unethical and it can encourage change through the ownership of shares in companies where engagement can make a difference.

Ethical investment policies come with a cost, though. Portfolio managers will likely require higher fees as the policy becomes more complicated. And the risk of underperforming the portfolio’s benchmark increases as the allowed investment universe looks decreasingly like the universe used to calculate the benchmark.