To divest or not to divest? That is the question

Responsible investing has proven to be more than just a fad, with investors in growing numbers choosing to go green and quit the bad stuff cold turkey. Coal and the armaments and tobacco industries have copped divestments in large numbers, with fund managers most notably pledging for Tobacco Free Finance at the United Nations earlier last year. 

The Responsible Investment Association Australasia (RIAA) recorded that, as at 31 December 2017, responsible investments constituted $866 billion in assets under management, which was up a whopping 39 per cent on the previous year. 

This means over 55 per cent of total assets professionally managed in Australia were responsibly invested, and the Association reported funds that implemented responsible investment strategies even managed to outperform traditional Australian and international share funds and multi-sector growth funds over most time horizons. 

The RIAA quoted the top drivers of growth in the responsible investment sector as growing demand from institutional and retail investors; the importance of environmental, social and governance (ESG) factors to investors; and the alignment of investments with investors’ missions. 

The top detractors from growth in the sector were a lack of understanding and advice; a lack of awareness by members of the public; and performance concerns. 

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Responsible investing however, is a broad spectrum, and what constitutes responsible to one fund manager may not suffice for another, and vice versa. 

So, how far under the hood do investors need to look for a truly responsible fund, and should they simply divest from “bad” companies, or should they be using their stake to change the inner workings of companies? 

It takes an active approach

Måns Carlsson-Sweeny, head of ESG at Aubsil, said a good ESG fund would actively demonstrate both a clear link between the investment philosophy and the ESG integration strategy, and have a genuinely engaged focus on active ownership. 

He stressed that, at least for Ausbil, this meant better informed investment decisions, and a true active ownership, which includes attending meetings, visiting company boards and executives, reviewing supply chains and corporate culture and actively engaging and voting on any relevant ESG issues that arise.

In order for investors to be sure the fund they’re investing in is genuinely responsible, rather than simply a marketing tag to bump fees, Carlsson-Sweeney said they must be sure the fund is doing its own research with an element of independence to collaborate positively with companies to achieve better ESG and investment outcomes. 

And, if you’re looking at companies with sustainable earnings and quality management, you’re looking at positive earnings and a hike in share prices. 

“A business model that relies on under-priced pollution, misinformed customers, or underpaid workers, is unlikely to produce sustainable earnings over time.”

And, he said being ESG focused doesn’t necessarily mean you are looking at bumped fees, with Ausbil using an in-house research team as part of its overall investment team, as opposed to sourcing it externally.

But it’s no rumour that such high-fee ESG funds exist, with Australian Ethical’s Advocacy, Diversified Shares and International Shares funds all among the top five funds with the highest fees last year.

While the retail funds are expensive, Leah Willis, head of client relationships at Australian Ethical Investment, told Money Management the Diversified Share and International Share funds’ wholesale equivalents had management expense ratios of 0.95 per cent and 0.85 per cent respectively, which was consistent with peers. 

But while low-fee passive responsible funds like BetaShares’ Global Sustainability Leaders ETF, which charges a management fee of just 0.49 per cent, are also on the rise, Carlsson-Sweeney said it takes an active investment strategy to be an ESG manager. 

“Yes, passive investors are offering alternative index-linked funds with ESG themes, but can they truly exercise their influence without the ability to actively allocate capital away from companies, and maintain an intense engagement meeting program with corporate leaders?” he asked.

“Because of ESG’s impact across both the tangible and intangible parts of a business’ value proposition, active engagement across both these parts can achieve better ESG and investor outcomes.”

Putting governance front and centre 

Mercer’s global business leader of responsible investments, Helga Birgden, says while environmental and social responsibilities are important, it’s governance that is absolutely core and foundational to responsible investing, and it’s transparent companies that are hitting the mark best. 

Governance, she said, is about the stewardship of the assets in the board’s care, and now more than ever, governance requires boards to understand and assess a wider set of risks that may impact value or be material to their fiduciary duties. 

“It’s about having a robust risk management process in place and being able to speak to the process of assessment of, for example, climate resilience at a governance level, or report in light of it as part of their fiduciary duty,” she said.

Active ownership, voting and engagement are key to Mercer and its clients’ involvement in examining governance processes, and executive remuneration is one example of an issue that has come under stakeholder scrutiny, according to Birgden. 

“Increasingly, shareholders are looking at governance issues like the level and structure of executive remuneration, and they want to see that pay structures are aligned with the success of the business or the fund, and that they have an appropriate balance between base pay, short and long-term incentives,” she said. 

Birgden picked out the National Australia Bank (NAB) annual general meeting (AGM) in December last year where executive remuneration was a topic of the bank’s report. 

At that AGM, NAB was hit with an 88 per cent vote against its report, something that Birgden said was due to the bank’s short-term focus on executive remuneration, which was too generous in light of it’s financial performance. 

Contrastingly, Whitehaven Coal received 40 per cent shareholder support for its climate change resolution to increase its disclosure on tackling climate change. 

“That’s the way funds are expressing their views about governance, in that AGM and voting process,” she said. 

Stewart Investors’ emerging markets (EMs) manager, Jack Nelson, believes investing in a company with responsible governance practices means investing in a company with a good sustainable growth outlook.

From the outset, companies with good corporate practices are generally not found in emerging countries, where low wages are rife and working conditions are sub-par. But, Nelson said this isn’t something that’s niche to just EMs. 

“Companies with attractive prospects for profitable growth, truly sustainable business models, and with owners who allow minority shareholders to participate in their success, are rare in emerging markets,” he said. “We would also argue that this is true of companies in developed markets.”

He said while EMs had some of the worst approaches the firm had seen with regards to corporate governance, treatment of employees and the environment, and attitudes towards responsibilities in general, they were also home to some of the most forward-thinking, well-stewarded and progressive corporates in the world. 

One of these examples, he said, was India’s Dr Lal PathLabs, a small-cap medical diagnostics chain which had attractive economics and an owner with a track-record of treating investors fairly, alongside a naturally sustainable business model. 

“Of the largest 100 companies in India, we would never invest in around 85 of them, at any price,” said Nelson. “In equities, your downside is 100 per cent regardless of what price you pay; and a majority of the largest Indian companies have issues with corruption, or have unscrupulous owners or low quality or unsustainable business models.”

“However, there are thousands of corporates to choose from, in India and other emerging markets, such that building high-quality portfolios geared towards sustainability is eminently possible.”

Finding Dr Lal PathLabs was a case of bottom-up stock picking, and Nelson said all investors in EMs should approach the asset class in a truly active way, disregarding the benchmark entirely. 

Hold and engage

Lonsec Research’s general manager ESG/SRI research, Steve Sweeney talked about “engaging the enemy” in an article discussing the dilemma of divestment and engagement. 

Sweeney questioned whether divestment, which was an option favoured by those seeking to align investment decisions with their moral views, was as powerful as engaging with company boards to positively impact company practices and culture. 

“By divesting,” he said, “investors lose a seat at the table and may sell to a buyer who has little interest in sustainability outcomes.”

From an on-the-ground perspective, Carlsson-Sweeney said there was definitely a shift away from divestment to hold-and-engage strategies, because divestment could lead to unintended consequences, while hold-and-engaging could increase the investable universe for ESG investors. 

This came into play, he said, following the Rana Plaza building collapse in Bangladesh in April 2013, and the sentiment among Bangladeshi garment workers after the incident.

“I visited Bangladesh in 2014,” he said, “the workers I spoke with on this site visit did not want Western brand companies to leave Bangladesh. They wanted the brand companies to keep buying from Bangladesh for their industry, but in return, they just wanted decent working conditions.”

By simply divesting the shares in a company that has an ESG issue, Carlsson-Sweeney said those shares may end up in the hands of an investor that does no corporate ESG engagement at all. For the workers in Bangladesh though, the best option was to work to continually improve working conditions though active ESG engagement. 

“Improved ESG performance can be a lead indicator of improved operational performance and can be a step in the journey towards premium valuation in the future,” he said. 

In practice, while there are cases where ESG engagement leads to no measurable improvement, he’s seen many cases where companies adopt suggested changes and strengthen their ESG risk management. 

“By engaging with companies, you can make better informed investment decisions, protect from capital destruction and also potentially expand your investible universe,” he said. 

Birgden says it’s not so clear cut though, and divestment and engagement aren’t mutually exclusive. 

“There’s no such thing as a perfect company, so engagement is really the more mainstream idea, rather than divestment or exclusion,” she said. 

But, where divestment is most prominent, she said, is in the 60 per cent of APRA-regulated funds that have excluded tobacco or controversial weapons from their portfolios. 

While stock pickers chose not to engage in this instance, Birgden said it was a less about the investment decision, and more about an understanding that companies and funds are part of society, and investors increasingly don’t want to capitalise or have the reputation risk of allocating to companies that are harming humans at the primary level. 

“Divestment is a very fund-by-fund related issue,” she said. “There is a point at which investors will decide (in line with their investment beliefs and their policy and what they’re doing as a fund) that divestment is a useful tool, but that’s not to say it’s the only way you can deal with this issue.”