Honest Abe, The Rolling Stones and Investing for a Better World
On May 3rd, the Morphic Ethical Equity Fund (MEC), Australia’s first new ethically screened Listed Investment Company in more than ten years, will commence trading on the ASX.
After a month on the road meeting prospective investors in MEC, here are some reflections on what we learnt – and what has changed in our two decades in ethical investing.
Investing Ethically - Tales from the Road
Abraham Lincoln said: “You can please some of the people some of the time, all of the people some of the time, some of the people all of the time, but you can never please all of the people all of the time.” The observation encapsulates a key challenge in offering a Fund for those who want to invest to become richer, but not in a way that leaves the world a poorer place.
Twenty years ago, when our team at Hunter Hall adopted a “negative screen” ethical regime, the issues seemed simple. We excluded ‘sin’ businesses like tobacco, gambling and alcohol; and more broadly, companies involved in armaments and non-remediated environmental damage; as well as avoiding companies whose businesses involved animal cruelty.
Twenty years on, the debate had shifted. The main ethical issue today is seen as climate change. Interest in governance has increased, and also the linkages between companies and their suppliers. There is also more demand for exposure to firms that are seen making the world a better place.
We consulted widely in finalising the MEC’s investment guidelines. Past returns are no guarantee of future returns, but we also had to ensure we could replicate the process behind the compound annual returns of nearly 18% enjoyed by investors in our Morphic Global Opportunities Fund (MGOF), since it opened in August 2012. The MEC also has to match the MGOF’s consistent position in the top 10% of global equity funds offered to retail investors in terms of risk adjusted returns, as measured by Sharpe Ratio, over that time.
Finally we sought “Lincoln optimality”, that is: satisfying most of the people who wanted an ethical fund most of the time. We assumed that while our investors would be noble minded, they also lived, like Madonna, to “In a material world”. This meant we did not prohibit all mining or chemical industries, for example.
Our ethical charter is on our website. We exclude ‘sin’ stocks and armaments. We will not invest in companies involved in fossil fuels, nuclear energy, environmental degradation, factory farming or deforestation. We commit to having at least 5% of the Fund in companies working to make the world a better place, such as mitigating climate change, air and water pollution, or otherwise enhancing the human experience. We also invite investor feedback, give our non-executive directors a right of veto when it comes to grey areas, and make use of research published by the world’s largest ethical fund, Norway’s Sovereign Wealth Fund.
The complexity of meeting investor demands became even clearer when we set off around Australia marketing, including “town hall” style meetings in all capitals meeting investors face to face.
A threshold question in many meetings was: would our screens inhibit performance?
Our response was twofold:
1) There is now a substantial and consistent body of investment research suggesting that various forms of ethical screening tend to add rather than detract from performance. In the last three months good pieces have been published on this by UBS, Morgan Stanley and Goldman Sachs alone.
2) We believe that fossil fuel companies in particular are substantially over-valued by the market which assumes that they will be able to monetise most of their proven resources. In our view changing demand patterns and government regulations will mean they have to leave the bulk of their assets in the ground, and eventually this will slash valuations.
The bottom line is that people back us with an expectation of high performance, while not offending their personal values. If we can’t marry these objectives we shouldn’t be in the business.
On the other hand we met complaints that we had not gone far enough. Questions were asked why we didn’t have a blanket ban on all companies involved in animal cruelty. Our response was that on balance we felt this would be to deny the benefits of modern medical research.
A few also asked about our reluctance to use formulaic ESG metrics and disclosures as part of our process. We prefer to look at this on a case by case basis, emphasising substance over form. We see endorsement here from a recent report by Goldman Sachs that the depth of companies ESG disclosure back tests as a negative indicator of share price performance!
Some investors wanted more “positive screen” investing. Our minimum 5% level in this category ensures we are always researching promising new developments in alternative energy and social impact industries like microfinance. However opportunities may often be limited, and investors, whatever they may say, will never be happy if we lose money in speculative “concept stocks”.
Finally, our plans to make money by shorting stocks on our excluded list polarised views. To us a virtue of this is the public statement it makes about shorted companies’ unsustainable businesses or practices. At the margin we also hope to influence their cost of capital. Opponents complained that we could still be making money from an investment activity involving non-ethical companies. In the end we decided to stick to our guns. These opponents already want us to make investment decisions by excluding these stocks from our universe and this is simply a logical conclusion.
Australia lags most of the world in the ethical investment choices offered to the public. In the US 20% of all externally managed money is subject to some form of ethical screen. In Australia only one in 25 global equities funds is screened. Australia will catch up as investors’ misplaced scepticism about the impact on returns abates.
A slightly more pragmatic response to the difficult balancing act we managers face might help as well. Perhaps ethical investment specialists could consider taking some advice from the Rolling Stones: "You can't always get what you want, but if you try sometimes, you might find you get what you need."