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What is the cost of putting sin stocks on an exclusion list?

9 Apr 2020

Sin is dead. Forget about exclusions and divestment, these days no company is damned. All stocks are virtuous now, though some are more so than others. Partly this shift in attitudes is because there is no agreed definition of what constitutes a sin stock.

Historically, sin stocks have been seen as a holding in a company that undertakes an activity or sells products that goes against the morals or ethics of a particular group of investors.

Cindy Rose, head of responsible capitalism at Majedie Asset Management, explains that is difficult to find consensus on what activities or products constitute ‘sins’, with some people finding alcohol, abortifacients or pork products to be areas of avoidance, whereas others might find them to be acceptable investments.

“There’s no single, definitive list of what constitutes ‘sin stocks’, which are avoided purely on ethical/moral grounds – not for financial reasons based on the underlying fundamentals of the company, sector, product or activity,” Rose says.

Along with some confusion about which morals and whose ethics get to define what a sin stock is, a more nuanced approach to the investment in controversial stocks has emerged. Rather than blanket bans on sectors and stocks, positive engagement with companies is encouraged and the power of persuasion is deployed.

Wolfgang Kuhn, director of investor engagement at ShareAction, a charity that promotes responsible investment, says that every investment will, to a greater or lesser extent, have impacts or negative externalities. “There’s no good or bad, it’s about more or less negative impacts,” he adds. “In a way you could say every investment is a sin stock because it will have some negative impact.”

Oil and the multiple uses to which it can be put is a case in point. While from a global warming perspective, it would be desirable to reduce fuel emissions, oil isn’t just used for fuel but is part of manufacturing plastics, including devices such as heart valves and artificial limbs.

Mark Hedges, chief investment officer at Nationwide Pension Fund, says blanket bans on investing in oil and gas are the wrong response. “It’s a complex question and we clearly need to encourage a shift to a more carbon neutral system of energy production that does not impact the climate,” he says, adding: “BP and Shell do invest in renewables but you want them to do more.”

Another complicating factor when it comes to assessing which stocks meet ethical benchmarks is that of the chains of ownership between companies and their subsidiaries. Kuhn notes that Spanish telecom firm Telefonica would appear at first glance to be an uncontroversial stock, but it has a media subsidiary which is supposed to have provided access to pornography.

Similarly, ESG funds are of limited use when it comes to screening out firms with unethical practices. “Amazon is in most ESG funds which is a surprise because I don’t think they have a good reputation when it comes to how they treat their workers,” Kuhn says.

Sin premia

The attraction of sin stocks is their supposed propensity to produce better returns. Certainly, there is a school of thought that institutional investors like pension funds are constrained to hold less virtuous stocks to produce returns for their members.

If there’s anything that counts for inclusion in the sin bin, it’s tobacco. Research by Dimson, Marsh and Staunton of the London Business School shows just what investors would have given up by excluding tobacco from their portfolios.

Performance data for 15 US industries back to 1900 shows that the best performer was tobacco, which gave an annualised return of 14.6%, and a terminal value of $6.2m (£4.7m), more than 5,000 times as much as shipbuilding and shipping.

Yet Derry Pickford, an asset allocation principal consultant at Aon, is sceptical about whether tobacco’s sustained outperformance is attributable to sin premia, the evidence for which he does not find especially robust.

“With all of these analyses of historical returns how much is due to an equilibrium risk factor and how much is just purely a function of luck is highly debateable and people will argue about how you explain those historic returns.

“I think we must acknowledge that luck probably played a large part in the outperformance of tobacco stocks since 1900,” he adds. “You wouldn’t anticipate luck to keep on favouring tobacco stocks.”

Possibly also undermining the theory that tobacco enjoys a sin premium is the more mundane consideration that in the early 1980s tobacco stocks were cheap, as people didn’t appreciate the sustainability of their profits and were overly concerned about litigation risks. It’s less clear that they are extremely cheap now and that’s even with people divesting because there are others out there who will like the other characteristics of these companies.

Notwithstanding the preferences of pension scheme members for virtuous investing, in many cases decision-making is out of their hands because pension schemes are invested in passive funds, which come with the additional advantage of having lower fees than their active counterparts.

However, there are also quasi-passive indices which investors can track which are tilted towards strong ESG companies. The Nationwide Pension Fund is reducing its equity holdings but those it does hold are invested passively. Instead the scheme’s approach has been to urge fund managers to engage with companies in terms of their governance. But ethical considerations did play a part in it turning down a fund manager recently.

Reputational risks

Hedges says that although the private debt manager would otherwise have been a perfect fit for the fund, it was felt that some of its investments posed too much of a reputational risk for the scheme. “When we delved into their portfolio of underlying loans and analysed them, we felt somewhat uncomfortable they had an online gambling business and one of their loans was to a business that made electrical equipment for adult services,” Hedges says.

The two things that proved too much for the scheme were the fund manager’s loans, first to a business selling loans to an online gunbroker and then to an online gun retailer. This would not prove problematic in the US where 30% of the population owns a gun but in the UK it is a different matter, underscoring the regional differences in what is and is not considered ethically acceptable.

“We got the impression their US investors had never raised an issue around it but we felt that we wouldn’t want to be associated with loans to those sort of businesses so we decided to not proceed which was a bit disappointing because we’d spent rather a lot of time on due diligence and meeting the team,” Hedges says.

Exclusionary investment policies are much more viable in active areas, where pension schemes can be more explicit about the stocks in which they will not invest. There is, in fact, an inverse relationship between sin stocks and costs but it is a more intricate one than supposed and involves the designing of indices for passive investment.

“When you have a passive mandate, you have to start thinking about how to construct a particular index that carves things out, whether someone offers that index and what the cost of it is,” Hedges says. As the fund continues to reduce its equities, passive equities, which are currently down to 15%, are becoming an ever smaller part of its asset allocation.

The scheme uses the MSCI All World Index and so will have holdings in oil, gas and tobacco. By contrast, the scheme has 20% in private markets, the area that’s driving its returns and in which it has been more active in considering various ESG issues.

The challenge for Nationwide would be to construct an index for its passive equities but that would mean it had to have a segregated mandate which would add layers of expense to the scheme.

“There are developing changes to the way certain indexes are constructed, the question is whether they can be delivered as cheaply and efficiently on a pooled fund basis as existing indexes and if you can get to that it may well may be we’ll see more funds transition to that. Or they take the view mentioned earlier, a lot of this is about active engagement,” Hedges says.

He points out that Nationwide uses LGIM, which he says has been vociferous on certain controversial issues, citing its reaction to Unilever’s announcement that it would close its London offices, which was followed by a swift about turn by the pharmaceutical giant.

“Behaviours can be changed but they are not going to be changed by small pension funds,” Hedges comments, adding: “It needs to be a big collective, and that is the benefit of large pooled funds, they have a collectively larger investment.

LGIM holds billions [of pounds] on behalf of smaller investors that it has more of an impact.” Yet despite the more nuanced approach to sin stocks, there is clearly a preference among investors for more virtuous stocks, if one were to take attitudes to ESG as being the ethical opposite of attitudes to sin stocks. Surveys of fund managers and analysts show time and again that interest in ESG is far from abating.

The same cannot be said of their less virtuous opposite numbers. Pickford is in no doubt that there’s clearly far more intra-client interest in allocating to ESG managers than there is investing to managers specialising in sin stocks. “Of the clients I have spoken to on this, I have never heard any of them say: “I’m interested in taking contrarian stance to ESG and investing in sin stocks”,” he remarks.

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