Investment

Doing the right thing

Ethical investment keeps pushing its case despite economic pressures to chase profits at any cost, writes John Kelly

Ethical investment strategies have not historically been a major concern for independent schools. In substantial part this is because the obligation to work limited assets hard to achieve the required level of return has been paramount. Trustees may have sympathy with ethical objectives, but a concern that a portfolio with its opportunities reduced due to ethical exclusions might not achieve the best possible returns, has meant that such considerations have not been adopted as part of the investment strategy.

There have been other concerns too, not least that the increasingly cosmopolitan nature of the school environment raises questions of how best to define the ethical criteria to be employed. They must meet the overall objectives and yet do so without alienating or being irrelevant to a large part of the audience.

New horizons
Times have changed, however, so that new and broader definitions of what denote ethical investment and, in particular, the inclusion of social and responsible standards, together with developments in investment management, have meant that many of the old objections have fallen away. Public attitudes have changed too, with a greater awareness of and sympathy with substantial parts of the agenda, from climate change to human rights. The result of all these changes is that a sector, which until now has not substantially embraced ethical and responsible investing, may well find it attractive to look again.

The key development has been the broadening of the focus from an approach based on the exclusion of prescribed sectors – the old “sin lists”, to one which seeks not merely to exclude the bad but which seeks also to identify the good – “good” in these instances being defined to include companies following best practice in areas such as corporate governance, employment policies, involvement overseas and so on. Exclusions can still apply for stocks or sectors, but at the company level the exclusion process typically occurs after a period of engagement, during which concerns are discussed with management and attempts are made to find common ground acceptable to both parties.

Does the public like it?
What has become clear in terms of public acceptance is that while there are a limited number of investors who support blanket exclusions of certain sectors from their investment universes, there is a large and growing group that want their investment policy to work on more than one level. They recognise that achieving good returns is a key goal but can see no discrepancy between that and biasing the portfolio away from companies that don’t meet international standards. As the definition of what is encompassed by ethical investment has broadened out, so this enlarged group has become engaged, making this one of the fastest growing segments of investment markets.

From the perspective of investment performance, the historical reality of ethical investment is that from time to time it has distorted returns relative to those achieved by unconstrained investors. This is common sense: it is clear that excluding parts of the market from portfolios will mean that the returns achieved by those portfolios are different to those achieved by an investor with a full set of choices. The scale and direction of the differences will depend on the relative returns of the excluded sectors and are certainly not necessarily negative over time. The “down” years, however, can cause concerns over opportunities missed while, when trying to measure performance, the comparisons of the returns of a constrained portfolio with those of the stock market as a whole, or with other managers following different strategies, inevitably lack clarity. This can cloud trustee understanding of how well the manager has performed and, within the performance calculation, how much has been contributed by the decisions of the manager and how much by the effects of the ethical policies.

These issues are much less of a concern when the strategy is based on an inclusive rather than exclusive philosophy. Sectors are not by definition excluded. Indeed the focus is commonly at the stock level, with potentially all companies’ potential investments and selection between them based on meeting international standards. The result is that the structural differences between portfolio and market are much less pronounced, reducing performance differences and increasing the relevance of performance comparisons. Furthermore, although the data on this is not yet conclusive, there is some evidence that biasing the portfolio towards companies exhibiting the highest standards of behaviour actually reduces real world risk in that the chances of exposure to a corporate disaster such as Enron or Union Carbide are much reduced.

Food for thought
What makes these developments so interesting to a fund manager is that they have coincided with some important advances in investment techniques and risk analysis. These have meant that managers can now analyse the likely behavioural characteristics of individual shares and by extension portfolios. With this knowledge it is possible to build a portfolio that is completely true to the letter and spirit of an ethical or socially responsible investment mandate, but where the performance is likely to be very close to that of the market as a whole. To be clear: the approach is not perfect and from time to time there will be differences, but not on the scale or for the duration which has raised doubts about the true cost of ethical investment in the past.

The result is that over time the performance penalty is massively reduced if not eliminated altogether, allowing trustees the comfort of knowing that their investment principles are not being achieved only at the cost of sub-optimal investment returns.

Why might these developments be of interest to the sector? Firstly, there is now an ability to put in place ethical or responsible programmes that trustees might have wished to implement but have previously been deterred from so doing by concerns over the potential impact on investment returns. The second issue relates to the facility now to put in place inclusive, inspirational investment policies focused on those companies that meet international standards in any of a wide range of areas, rather than simply relying on excluding industries per se. The third reason is to reflect the positive public momentum that is behind socially aware investment programmes. These can be structured to reflect the ethos of the school and can provide a qualitative differentiator in a competitive business environment.

John Kelly is head of client investment at CCLA.

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