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Muddying the Waters

By Alistair Meadows

Posted on October 12, 2018 under finance

Ethical investing is most definitely in! In the last 5 years, the business of Socially Responsible Investing has seen huge growth, as investment "consumers" start to think more carefully about the effect they have on the world in a myriad of different ways, leaving fund management groups scrambling to react, (or board the bandwagon, depending on your view). There are now more than 200 funds available to UK investors, and flows via platforms (i.e. from retail investors) were up 19% in the first half of 2018, according to ESG Clarity an ethical investment-focussed website for investors. Amundi, a prominent ETF fund manager, has announced it will fully incorporate ESG [1] into its' money management and voting practices by the end of 2021, with a view to influencing Corporate managements across the Globe. Pressure is mounting on fund managers as Local Authority pension schemes are being pressed to divest their holdings in "sin stocks" (tobacco, alcohol and sugar-laden soft drink manufacturers) and even the Norwegian Sovereign Wealth Fund is getting criticism for their Oil shares holdings, (which at least makes sense as the original purpose of the fund was to reduce the country's over-reliance on Oil prices). Momentum is building for wholesale selling of shares in firms that are seen as "unethical", which could change the make-up of markets (and even Indices) should this sentiment prevail.

There is an increasing number of choices available to Investors, with regard to both funds and Indices against which to track their performance [2]. In 2001, FTSE introduced the 4Good Index series, a family of Indices which measure the financial returns of those firms meeting globally recognised Social Responsibility standards, thus eliminating from their consideration firms engaged in Tobacco production, Nuclear power generation and the production of arms and munitions. Those left from this screen then have their performance in areas such as labour standards, human rights and corruption evaluated. Those that score badly on these factors are eliminated (and can also receive the same treatment should they fail to maintain these standards). To add to the complexity, some firms use positive screening to mark a firms SRI related performance, so as to invest in the "best-in-class" companies, whilst some Indices (the FTSE4Good for example), rely on negative screening (as described above).

As the chart below shows, returns have lagged behind the respective Indices in both the UK and Developed markets, but not by much - just a 0.46% per annum shortfall in the former case and a 0.11% lag in the latter market since 2003; over the last 3 years, returns are almost identical in both cases - only 9 basis points (0.09%) separates the performance of the FTSE Developed Index and the equivalent 4Good Index over that period for example. So, the cost of "doing good" seems to be negligible over both time periods, (though how much that has to do with the flows of money into the sector causing price gains due to demand for the shares rather than the underlying performance of the index constituents is not clear).

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At the fund level, however it is a slightly different story - although some cite "evidence" in favour of SRI Investing being better than or at least similar to traditional investment strategies, the fund cited in the article as that evidence, has lagged behind its Benchmark for most of the last 3 years (see the first chart); many more (Kames Ethical Equity, Aberdeen Ethical World Equity, and others) have also under-performed, the latter massively so (second chart). The essential (active management) problem remains; how does one know (in advance preferably), which active manager will outperform the benchmark. It IS possible to invest Passively, but are Passively Managed funds able to cater to the diversity of risks/opportunities presented by SRI investing, based as they inevitably are, on Indices that may not be sufficiently ethical for many investors' tastes?

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There are still major definitional problems with SRI/Ethical investing, however, which boil down to what constitutes a generally acceptable method of describing what this sort of investment actually is - even the Head of Responsible Investment for FTSE Indices admitted that "many sustainability Indices have a pretty opaque methodology", particularly when it comes to the reasons for addition and deletions from the Indices. Famously, in 2010, AOL and Chubb Corporation (a US insurance company), were both deleted from the Dow Jones Sustainability Index, whilst simultaneously being added to the FTSE4Good Index! BP was ejected from both Indices post the Deepwater Horizon oil disaster, but what were they doing there in the first place? Are the indices truly reflecting future corporate performance or that of the past? It is also true that firms that have the capacity to respond to questionnaires/surveys etc. are better placed to be included, which benefits larger, rather than genuinely compliant businesses (since the former have the manpower to fill out these forms), leading to a potential "Large Cap" bias to Indices.

Looking at the FTSE4Good Index Factsheet, one can see a number of anomalies - in the UK Index, both Shell and HSBC (a combined 20% of the Index) feature; the latter has an already proven track record of, ahem, questionable behaviour, which has been repeated across a wide variety of markets and activities. Whilst not necessarily unethical, the efforts being made by Google to facilitate the Chinese government's Internet censorship programme also leaves us wondering how Alphabet got into the 4Good Developed Index (2.81%). Of course, NOT including large sectors (e.g. finance/Tech etc.) leaves the Index vulnerable to high Tracking Error vis-a-vis conventional Indices, but that surely is part of the idea - an investor concerned with having a positive impact on Corporate behaviour has to have different weightings etc. or the point of the strategy is lost.

Another question is whether it has any effect - Corporations' cost of capital is wholly unaffected by what happens in the Secondary capital markets - only when a Firm tries to raise capital (via an equity issuance or a new bond) do investors have chance to influence their decision-making, (since a higher cost of capital, caused by having to pay higher yields on new bond issuance for example) can cause them to change their strategic course. But as this process is dominated by the big Institutions, individual investors do not get a (direct) input. It can take a long time for the latter's views to reach the ears (and more potently, the wallets) of CEO's etc.

No doubt, investors have the best of intentions here, but will these principles survive a bear market? It is quite easy to "go green" especially if one has already taken as read that the bull market in financial assets will always be with us; possibly some have psychologically "banked" the bull market without wondering what they would do if prices actually fell. Would opinions change if we were to experience a 20% market fall? And to whom would investors sell if they did? It is reasonable to assume that most of those disposed to allocate investment capital on the basis of Ethical/Green/Socially Responsible criteria have already done so; who is left to pick up the price "slack" in a decline? Those not thus far inclined to do so might require a hefty price discount to encourage them to buy into this strategy.

10 years ago, the world's Central Banks cut interest rates to zero (and below in some nations), leading to a scramble to buy shares that paid a high dividend yield so as to use dividend income to offset this loss of bank savings power - but as it became popular, it started to under-perform, such that in the last 3 years it has lagged the FTSE All-Share Index (itself a global under-performer) by 2% per annum on an annualised basis, and by 2.06% p.a. on a World equivalent basis (see below). We do not hear too much about the benefits of "Income investing" these days and it does not take too much imagination to foresee a similar investor reaction should this fate befall SRI.

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EBI has always advocated a "total return" [3] approach to investing - we aim to maximise the investment choices to include the whole universe of assets; doing otherwise risks missing out on opportunities; this means we do not invest in (for example) solely Income- yielding assets, which means we did not see any negative drag on performance from the un-winding of the Income investing strategy's popularity. SRI/Ethical investing may (or may not) suffer the same fate, but it will have little effect on overall portfolio returns via EBI. So we can watch events unfold with equanimity - it may be that this is a different situation, but we are somewhat skeptical of this. Human nature does not change because humans don't.


[1] ESG stands for Environmental and Social Governance.

[2] A guide to all the (sometimes conflicting) trends and jargon can be found here.

[3] We invest for both Capital Gain AND Income; thus yield is not an aim in itself, but a by-product of the investments we make. By excluding some sectors or companies from our investment universe (only investing in dividend-paying firms or those who meet ethical criteria), we run the risk of sector or market concentration, since many of the "worst" firms are in the same sectors (oil is just the most obvious example of this).


About the Author

Alistair Meadows is a veteran of stock markets having started his career in the City of London during the heady days of the mid 1980s. After 10 years he moved into (active) fund management in 2000. He repented of his ways and joined EBI in 2014 and is now responsible for helping advisers and investors get the same flow of timely information and quality analysis that is available to professional investors. He qualified as a Chartered Financial Analyst in 2005 and refreshed his skills in 2015 by gaining the Investment Management Certificate.
The views expressed in this blog are the author's own and not necessarily those of EBI Portfolios Ltd.