For SWFs, is “Doing Good” Bad for Stakeholders?

March 23, 2015 by Loch Adamson

Sovereign wealth funds are increasingly screening their portfolios based on so-called social criteria. Does that hurt returns
For SWFs, is “Doing Good” Bad for Stakeholders?
Does screening portfolios on social criteria change corporate behavior?
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Sovereign wealth funds are increasingly screening their portfolios based on so-called social criteria. Does that hurt returns? Does it change corporate behavior? And does that matter?

As sovereign wealth fund assets surge, more investments are being screened for so-called environmental, social and governance (ESG) criteria. Norges Bank Investment Management (NBIM), which oversees Norway’s $861 billion Government Pension Fund Global announced just last month that in 2014 it had divested stakes in 49 companies, which it did not name, based upon ESG considerations, bringing the number of companies it has dumped in the past three years to 114.

NBIM culls companies from the fund based on a variety of criteria, ranging from human rights violations to environmental damage. Other sovereign wealth funds have their own restrictions. The $548 billion Kuwait Investment Authority (KIA) declares: "KIA does not invest in sectors where gaming or alcohol-related activities constitute the main source of business." The $21.5 billion New Zealand Superannuation Fund, among other things like nuclear arms makers, excludes companies that process whale meat. And Australia’s $95.4 billion Future Fund is not alone in nixing makers of cluster munitions and anti-personnel mines.

Even the often mysterious Qatar Investment Authority, with an estimated $304.4 billion in assets under management, says on its website that it factors in "environmental considerations into our investment decisions."

Given the diversity of the funds in question, there is some lack of consistency. For example, two of the Future Fund’s top holdings last year — Rio Tinto and Honeywell International — appear on the roster of companies in which Norway’s fund is forbidden from investing. And the Australian fund’s big alcohol-related holdings include Diageo, LVMH Hennessy Louis Vuitton and Heineken.

Stunning Outperformance

Sovereign wealth fund are just part of a pack of institutional investors applying ESG criteria to their portfolios. The United Nations-supported Principles for Responsible Investment lists 1,368 signatories with assets over $45 trillion. The group has a range of investment guidelines to which it expects members to adhere.

Most — but not all — social screening seems to zero in on the perfidy of tobacco stocks. Indeed, NZ Super devotes an entire section of its website explaining its rationale for shunning the perfectly legal industry, including the assertion that doing so would not materially damage fund returns. NBIM, the Future Fund and scores of pensions, endowments and mutual funds likewise avoid tobacco makers.

Now, new research shows that shunning cigarette makers and their ilk may hurt performance badly over the long-term. The data backing this up was published last month in the Credit Suisse Global Investment Returns Yearbook 2015 in a study by Elroy Dimson, Paul Marsh and Mike Staunton of London Business School.

The study looked at U.K. and U.S. tobacco stocks going as far back to 1900 — an exceptionally long time frame, though the U.K. tobacco stocks were traced back only as far back as 1919. U.S. tobacco stocks returned 14.6 percent annualized from 1900 through 2014, versus just 9.6 percent for the U.S. stocks overall. U.K. tobacco stocks showed a similar outperformance over a somewhat shorter time frame, returning 13.1 percent annualized from 1919 through 2014 as against 10.3 percent for the U.K. market overall.

Put another way, $1 put into a U.S. tobacco stocks in 1900 would have grown to $6,280,327 by the end of last year. That’s not a typo. The same $1 put into the U.S. stock market overall would have grown to just $38,255 by year end 2014. Any way you look at it, there has historically been a stunning outperformance by a sector that is now on many state-owned investors prohibited lists.

Screening Issues

The study feeds into a contentious issue for sovereign wealth funds — whether instituting screening helps or hinders returns. Over the years, studies have shown that socially screened investments out- or under-perform. It’s often a function of whether growth or value stocks are in fashion during the time frames studied, as well as the fortunes of industries like technology, industrials or hydrocarbons, which themselves fall into the growth and value categories.

Social screens helped in the technology bubble for example. "It will help in some markets like the late 1990s and hurt in the mid 2000s, when energy was doing well," says David Kathman, a senior analyst who tracks socially-screened investing at at Morningstar, the Chicago–based financial publisher. "It tends to balance out over time given a long enough time frame."

More data may be necessary. "The jury really is out," says professor Larry Catá Backer of Pennsylvania State University, referring to the question of how such screening effects performance. "I think on balance it doesn’t really hurt. It’s a big investment universe."

In the case of tobacco stocks, a 2000 study by Northfield Information Services in Boston examined the financial impact of the California State Teachers Retirement System’s decision to divest from all tobacco stocks that year. It found that the differences in risk and performance between the S&P 500 Index and a tobacco-free version of the benchmark were neither statistically nor economically significant. That’s not surprising given that at year end 1999 tobacco stocks accounted for less than 1 percent of the market capitalization of the index.

"What you can ask is if you take the stocks out of the portfolio, is that material?" asks Dan diBartolomeo, president of Northfield, a research firm that works with sovereign wealth funds on screening issues. "Is it small enough that you don’t have to worry about it?"

Creative Substitution

What explains the searing outperformance of tobacco stocks over the years? That’s hard to say, although having an addicted client base probably helps. Lloyd Kurtz, a lecturer at the Center for Responsible Business at the Haas School of Business at the University of California Berkeley, says it comes down to fundamentals. "The returns from tobacco stocks were factor driven," he says. "They were just cheap stocks." Fine, but also give some credit to sky-high dividends over some of that period.

Underpinning some of the tobacco stocks’ outperformance may be that they are simply riskier stocks, and investors are demanding higher returns for holding them. "If they are such outstanding bargains why haven’t they been bought out by a sophisticated buyer?," Kurtz asks. "If I was investing in a company that had a one percent chance of a catastrophic event, I would demand a much higher return. I think there’s some irrational risk delusion in the market."

The six major U.S. cigarette makers entered into a Tobacco Master Settlement Agreement with the attorneys general of 46 U.S. states in 1998, agreeing to pay an estimated $206 billion and to stop a variety of marketing practices. It proved a smart move for big tobacco, locking them in as the market leaders. But in the U.S. legal system strange things can and do happen. Hence the risk.

Enough about smokes — profitable as investing in them may be. What about other forbidden industries? "Decarbonization" is now a buzzword among institutional investors and the prospect of selling off hydrocarbon-spewing holdings like oil and coal companies is squarely on the agenda, if not for sovereign wealth funds, at least plenty of endowments and other institutions.

Then it becomes a question of a fund maintaining appropriate diversification if it decides to divest from energy stocks. "You’re going to have a different composition if you decarbonize than if you boycott tobacco," says Kurtz.

Ethical Argument

A possible solution is a sort of synthetic replication of oil producers’ characteristics — creative substitution. For example, DiBartolomeo says big box retailers do particularly well when oil prices fall. That’s not only because consumers are less worried about gas money when they drive to the local mall with more money in their pockets. Large retailers also spend an enormous amount of money on heating and air-conditioning. Falling fuel prices reduce costs and expand margins.

"So you short the big box retailers," says diBartolo, explaining that the net effect is equivalent to a bet on energy producers. "There are ways to compensate." He calls it portfolio optimization.

There are certainly limits to this tactic. Kurtz points out that a sovereign wealth fund aiming to purge its portfolio of atomic power producers is going to have a bigger problem. "If you exclude nuclear you’re excluding almost every utility." That’s hard to replicate in a synthetic fashion no matter how creative a portfolio manager is.

Ultimately, it may come down to this: If an ESG prerogative is to steer clear of a particular company or industry, it may just be that stakeholders will have to live with lower returns, less diversification and higher risk. That may not be such a bad trade off, depending on one’s world view.

"We think in terms of of risk and rewards," says Kurtz. "Social investing is something else...There’s a risk in terms of turning the ethical argument into a financial one." In other words, investors may just have to decide that surrendering some return is the price of a clean conscience. In the case of sovereign wealth funds it bears noting that as state-owned investors, they do, to one degree or another, represent a projection of their parent nations’ values as they invest around the world.


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