Fiduciary responsibility: the moral dilemma

27 Feb 2014

The negative media coverage of Comic Relief’s holdings in alcohol, tobacco and armament companies as well as the Church of England’s indirect investment in pay day lending firm Wonga, highlights the dilemmas these organisations face.

The negative media coverage of Comic Relief’s holdings in alcohol, tobacco and armament companies as well as the Church of England’s indirect investment in pay day lending firm Wonga, highlights the dilemmas these organisations face.

In other words, is it possible to generate the required risk-adjusted returns for charitable projects or pensions by adopting an environmental, social and governance (ESG) framework? The answer, as with all these things, is not quite so straightforward.

The Church and Comic Relief are both conducting a review of their investment processes. It was particularly embarrassing for the Archbishop of Canterbury Justin Welby, because he publicly criticised Wonga without realising that the Church had a stake in the firm. The Church’s Ethical Investment Advisory Group “recommends against investment” in companies which make more than 3% of their income from pornography, 10% from military products and services, or 25% from other industries such as gambling, alcohol and high interest rate lenders.

“What happened at Comic Relief and the Church of England will be ringing alarm bells at many charities with invested reserves,” says Catherine Howarth, chief executive of responsible investment lobby group, ShareAction UK. “There is no longer an excuse for trustees and senior executives of charities not to ask a few more questions of their asset managers. Divesting of particular stocks and industries is only one relevant approach for charity investors concerned with corporate ethics. A growing number are using shareholder dialogue to encourage positive behaviour and best practice.”

Charities though are in a different position from institutional investors in that under the current legislation they are not required to make investments that conflict with their aims. Corporate defined benefit pension plans fall under a different category and trustees have flexibility when considering ethical issues. This goes back to the often cited case of Cowan v Scargill in 1984 whereby the High Court ruled that trustees of a miners’ pension fund were not entitled to let their ethical objections to certain investments override the financial interests of the fund.

Fast forward to today and the Court’s findings are still a great source of debate. It coincidentally forms part of the Law Commission’s review on Fiduciary Duties of Investment Intermediaries borne out of Professor John Kay’s 2012 government-sponsored report on long-term investment. It cited the Scargill case and recommended that the fiduciary responsibilities of fund advisers should be reviewed by the Law Commission including whether ESG issues should play more of a role in investment decisions. The consultation period, which closed in mid-January, found that ESG can have an impact on financial performance, and as such, trustees are “clearly” permitted to take them into account. The final version of the report is due in June of this year.

“There is no clear mandate for corporate pension plans to take account of non-financial decisions,” says Jane Goodland, senior investment consultant at Tower Watson. “I think the Law Commission review of fiduciary duty could give trustees the permission to look at risk in the broadest and most holistic sense. For example, going beyond traditional measures of and looking at potential problems outside of the balance sheet such as labour supply, safe and healthy and environmental disasters that can impact a company. We have seen too many examples of these issues over the years, but ironically I think it was the global financial crisis that highlighted the weakness of systems and the lack of clarity of roles and responsibilities of the different market participants. This led to the Kay Review and UK Stewardship Code.”

Shades of grey

Of course there is no one-size-fits-all ESG strategy and, as the Church of England and Comic Relief incidents demonstrate, it is an ongoing process. It can however be easier to exclude certain sectors than others. “There are shades of grey and not every sector makes a difference. For example, not having a company like Wonga in a portfolio will not impact financial returns,” says Tim Currell, partner and global head of sustainable investment and corporate governance at Aon Hewitt.

“However, that may not be the case with tobacco because it has the right characteristics that fit a pension scheme’s requirements – stable cash flows, good dividend yields and performs well when the economy is suffering. If you were Cancer Research you would not invest, but if you were a local authority you may need a more finely-balanced argument. This is where engagement comes in. Tobacco companies are not involved in any illegal activity but discussions can be held, for example, if there are concerns about possible nefarious practices in emerging markets.”

Targeted engagement

A new report by the European Sustainable Investment Forum (Eurosif), a pan-European network of consultancies and think tanks specialising in improving sustainability in business, entitled Shareholder Stewardship: European ESG Engagement Practice 2013 supported these views. It found that investors can best achieve positive results from ESG through constructive, strategic and targeted engagement based on sound business analysis. It noted that it not only has the potential to deliver value by generating profits, but can also reduce risks, encourage better business practices, change ethical behaviour and enhance reputations.

Analysis is also key. As Matt Christensen, global head of responsible investment at Axa Investment Managers, notes: “We will engage with companies but also identify the key ESG risks. If there is no change in two years we may seek to do something more aggressive through proxy voting or other means. We believe though that integrating ESG factors into the mainstream investment process is a good way to manage the portfolio. For example, take energy, we will look at the impact that shale gas, skills shortages in the sector, locations of discoveries and the management has on the company.”

Christensen along with others is an advocate of so called ‘impact investing’ which involves allocating to companies that are making their ESG mark while also generating a return. Last year, Axa IM’s Responsible Investment team applied this to sovereign debt. It took a two-pronged approach with the first phase focusing on limiting reputational risk by screening the investment universe using specific ESG criteria. It then built the portfolio, weighted according to the size of gross domestic product which reflected its forecasts for the strength of countries’ economies.

The French asset management group found an ESG overlay within defined risk parameters does affect country allocation and can improve the ESG performance of a sovereign debt portfolio, while having a limited impact on other portfolio characteristics including quality and duration.

Governance and performance

One of the biggest challenges of impact investing is the lack of standardised frameworks to calculate and communicate performance. Recent initiatives such as IRIS (Impact Reporting and Investment Standards) and labels such as GIIRS (Global Impact Investing Rating System) are expected to help address some of these issues. In addition, a recent report by Hermes Fund Managers showed that well-governed companies outperformed poorly managed organisations by 3.5 percentage points a year since the start of 2009 against the MSCI World Index. This translates into 30 basis points a month. Drilling down, firms with poor oversight underperformed in 62% of months during the period.

The study, entitled ESG Investing – Does it make you feel good, or is it actually good for your portfolio?, focused on governance risk factors such as board independence, shareholder rights plans (or ‘poison pills’), remuneration, independent directors, split chief executive and chairman role, risk management, business ethics and proxy voting. While strongly-governed companies were shining examples, this was not the case when looking at those with high environment and social rankings. In fact, over the five-year period, there was no evidence to support suggestions that organisations who valued environmental factors such as carbon footprint and water usage, and social factors, including human rights and employee turnover, offered lower-cost capital, better risk profiles or less share price volatility.

Moreover, there were sector and geographical disparities. For example, while governance ratings were a useful indicator of shareholder returns in Asia and Europe, they were less valuable tools to assess holdings in North America. This is because the markets “are subject to more robust regulation and companies are at higher risk of litigation”, according to the report.

As for sectors, telecommunications services firms with low quality governance underperformed by around 70 basis points a month while IT companies showed positive relative returns of almost 60bps. One of the reasons is the IT sector is dominated by a small number of companies whose performance over the past five years has been stellar despite a lower focus on their governance structure.

“There is a lot of anecdotal evidence that some aspects of ESG are beneficial, but our studies found that good governance adds to a company’s performance in almost every sector,” says Saker Nusseibeh, CEO of Hermes Fund Managers. “Overall, investors should not just look at the short-term impact of ESG but take a longer-term view.”

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