Investing with Conscience.

By July 27, 2018 April 4th, 2019 PFA Ponderings

“When someone says it’s not about the money, it’s about the money.”

– H.L. Mencken

That old chestnut may be true, but there are times when investment decisions are made for reasons that go well beyond simple rate-of-return considerations.  The increasing number of individual investors in the market has led to a significant increase in focus on more ‘qualitative’ information than pure quantitative data.

Corporate ownership (stocks) and loan-making (bonds) are now seen as opportunities for individuals to reward behavior they like, and to potentially influence outliers to get in line.

Socially Responsible Investing (SRI) has been a part of the landscape in the US as far back as one cares to look.  Way back in the mid-1700s, the Quakers prohibited their members from participating in the slave trade.  In the more modern era, the 1960s and the Vietnam War produced a bunch of interest in investing away from companies seen to be part of the war economy, and the Civil Rights Movement drove  to invest more responsibly.

Since then, much attention has been paid to the idea of using investment as a tool to promote desired social outcomes and to starve funding to, or pressure change of social scourges like apartheid in South Africa.  Environmental and humanitarian disasters like the Exxon Valdez and Bhopal focused investor attention on sustainability and sought to punish corporations who disregarded environmental protections.

Socially responsible investment vehicles, particularly mutual funds, have grown significantly in popularity.  One major challenge, however, when talking about SRI, is that it means vastly different things to different people.  A climate-focused fund may have very different objectives than a fund that seeks to invest guided by biblical principals or sharia law.   A fund that omits tobacco and firearms because of their public health concerns may still invest in companies that make sugary soft drinks.

Today, the term “SRI” has largely been replaced. The new industry buzzword, ‘ESG,’ stands for Environmental, Social and Governance and represents the three major categories focused on by investors today.   Environmental issues such as man-made climate change are fundamental considerations for investors.  Additionally, social issues, such as how a company treats its employees and whether the company creates a product or service that serves the greater good are a major focus.  Governance refers to how a company is run overall, with attention being given to whether the company is up front with the investing public, whether it has an independent board of directors promoting the interests of shareholders, or whether the management and directorship of a corporation reflects the diversity of all the company’s stakeholders.

Asset managers use various ESG techniques.  Following the lead of early SRI investing premises, some investors seek to eliminate certain offending companies, industries or governments from their portfolio.  Others will actually target specific companies to invest in so that they have a seat at the shareholder table, and can be a voice for change in the corporation.  An interesting result is that these types of investors may actually invest in companies with poor ESG scores, in an attempt to use the ‘bully pulpit’ afforded to major shareholders to spur the desired change.  Lastly, “Impact Investing” seeks to target particular desired outcomes in addition to financial criteria, and proactively seeks to deploy assets in areas where these outcomes can be spurred along.

Interestingly, there is some debate about whether an investment fiduciary like PFA can or should use ESG criteria in selecting investments for client portfolios.  Let’s say an asset manager is considering adding one of two investments to a client portfolio.  Company A may be more financially attractive than Company B, but Company B has much better environmental practices than Company A.   In Europe, an investment fiduciary can consider factors that accrue to the ‘greater good,’ even if they don’t directly benefit the client.  By contrast, US Fiduciary Law requires a fiduciary to act only with regard to the interest of the client, disregarding any other factors.

This stricter form of fiduciary obligation leads some in the industry to believe that they should not incorporate ESG into their research and focus rather on purely financial data.  We disagree with this.  We feel, on the contrary, that serving our clients’ best interests actually requires consideration of ESG factors in selecting investments for a portfolio.  We aren’t alone.  Many asset managers, including most of the largest of them, have adopted ESG analysis as a part of their fundamental criteria, not just a separate consideration for assets they want to label as ‘socially responsible’.

It makes sense that, in conducting proper stewardship over client assets, reducing risk exposure is a major consideration.  Companies with problematic environmental or social practices certainly add a level of financial risk that must be considered.  Companies with good records and sound practices in these areas may very well have a strategic advantage in attracting customers, employees, and other stakeholders than companies who fall short.  And any company whose corporate governance gets low marks raises a significant red flag.  It doesn’t take too many WorldComs or Enrons to bear this out.

In our view, ESG factors speak to the corporate stewardship of shareholder money, and we’re charged with exercising good stewardship over our client’s assets.  In the end, it really is about the money and ESG is just as much about doing WELL as it is about doing GOOD.