ESG – Industry view – LGPS Central TO ENGAGE OR TO EXCLUDE


Michael Marshall, director of responsible investment & engagement, LGPS Central


Amelia Gaston, responsible investment and engagement analyst, LGPS Central


“To engage or to exclude” remains the most significant policy choice for respon- sible investors. Does engagement actually work? Does exclusion cost you money? Can you enhance portfolio performance through engagement? If you sell your shares back to the market, are you wash- ing your hands of a moral responsibility? Let’s have a look at the evidence. We need first to define key terms. By ‘di- vestment’ or ‘exclusion’, we mean selling all securities associated with a broad sec- tor, geography or product. The motivation for which is usually ethical but can be financial. By ‘engagement’ we mean the conduct of an objectives-led dialogue with a company, the aim of which is to improve the company as an investment proposition. In theory, a successful engagement with HSBC ought to be favourable to any investor with a long position in HSBC. Whether the topic is capital allocation, cli- mate risk, executive pay or workforce issues, an observable improvement in a financially material topic ought, over the long-term, to be correlated with an uptick in fundamentals or valuation. Academics have used econometric analy- ses to see if the theory plays out in prac- tice. Dimson, Karakas and Li (2015) found (adjusting


for size) that successful


engagements lead to, on average, an alpha of 2.3% as well as lower volatility, improved operating performance and increased institutional ownership among the shareholder base post-engagement. Hoepner et al (2018) found that success- ful engagements lead to lower reduced downside risk and lower value-at-risk in target companies. A different type of anal- ysis in Becht et al (2009) reviews evi- dence from an active equity portfolio, esti-


28 | portfolio institutional March 2020 | issue 91


mating that around 90% of the 4.9% net outperformance derives from engage- ment activity. Evidence on the financial consequences of divestment is harder to come by, partly because divestment is rare, partly because it is novel and partly due to survivorship bias (where only good news is reported). Some ETFs that exclude sectors or prod- ucts have outperformed over certain time horizons and in certain market condi- tions but have underperformed if the time horizon or market conditions are altered. All we learn from these examples is that sectors come in and out of favour at different times. Real


examples of divestment


consequences include a 2018 report esti- mating that CalPERS has forgone c$3.5bn (£2bn) of investment performance as a result of its tobacco divestment in 2000. The Government Pension Fund of Nor- way reported in 2016 10-year foregone performance of $1.9bn (£1.4bn). Interest- ingly, the California Public Employeess’ Retirement System decision was motivated by a financial argument fore- casting the decline of the tobacco sector, whereas Norges Bank was applying an explicitly ethical position. Neither pen- sion fund has reversed its divestment decision despite lower returns. While loss of capital is dependent on tim- ing and market conditions, some things are guaranteed. To apply an exclusion, an investor must pay for data – often in higher index fees – to highlight which securities are to be excluded and assem- ble compliance systems to ensure the exclusion is systematically maintained. For fans of Modern Portfolio Theory, e xclusions limit diversification opportuni- ties and constrain the ability of an inves- tor to extract an efficient rate of return per unit of risk. Exclusion can affect a portfo- lio’s exposure to style factors (particularly income) which could disrupt trustees’ capacity to maintain a balanced portfolio. So-called “sin stocks” are frequently the largest and most reliable contributors to


pension funds’ dividend income. Inves- tors need to weigh up whether these effects constitute risk of “significant financial detriment” (to quote the regula- tions) and of neglecting ‘fiduciary duty’ (a topic worthy of its own article). A divestment approach waives the oppor- tunity to influence companies through engaging and voting shares. At scale, this could lead to perverse consequences of exclusions that are otherwise well-inten- tioned. For example, had members of the Climate Action 100+ initiative exited Shell and BP three years ago, would we have their pledges – long-term and insuffi- ciently detailed though they are – to (re- spectfully) halve their net carbon foot- print and get to net zero by 2050? Advocates of exclusions argue that wides- cale divestment can put financial strain on companies and lead to the cessation of controversial conduct. Some cite the 1980s anti-Apartheid divestment and boy- cott as support for this view, but we’re not sure the empirical evidence is supportive. Teoh et al (1999) found the South African financial market remained unaffected by the boycott and share prices did not decrease despite the popular conviction they would. Neither is it clear that finan- cial strain for developed market publicly listed energy companies would reduce greenhouse gas emissions, as energy sup- ply shortages would continue to be met by state-owned and unlisted companies pro- vided the demand for energy remains high. Focussing on excluding the supply side of the energy equation risks failing to pay due attention to demand. The engage vs exclude dilemma is not going away. We feel our current position – a preference for engagement – remains borne out by the evidence, and we retain our conviction that the benefits of robust stewardship are essential for investors and the societies they serve.


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