The advantage of engagement over exclusion.
Whether reacting to major oil spills in our oceans or health risks posed by a pack of smokes, concerned stakeholders have stepped up to take action. Increasingly, constituents of large institutional investors such as pensions and endowments are demanding the integration of profit generation with social good. While not a new concept, over the past decades, many portfolio managers have asked themselves whether divesting from big oil, chemicals, defense, mining, tobacco, nuclear and other perceived “damaging” industries is the best way to invest responsibly.
Based on assets under management, exclusionary investing is still the most common path for investors to take, according to the recent Global Sustainable Investment Review. For example, the University of California in May announced it had divested itself from fossil fuels and Georgetown University in February said it plans to do the same over the next five years. Despite the popularity of divesting and walking away, many large asset owners and managers are opting for a different approach—keeping their seat at the table and advocating for change. This alternative is called active engagement, a practice popularized by EOS at Federated Hermes around the turn of the century.
Excluding particular companies, industries or even countries that do not reflect desired environmental, social or governance (ESG) criteria from a portfolio is, in theory, simple. Just hit the delete button. But, in practice, it can be complex in an interconnected world with unintended consequences. For example, would human rights concerns in Hong Kong preclude investing in a prominent Milan-based fashion house because it is publically traded on the Hong Kong Stock Exchange?
A more proactive option is direct engagement with a company about relevant and financially material ESG risks to generate positive change within an organization. By engaging, the focus is on improving the sustainability of companies with the goal of long-term wealth creation and, more broadly, to achieve positive outcomes for society.
CHOOSING TO BE ACTIVE OWNERS
Being an active owner of an industry or business model that has environmental, social or governance challenges requires ESG subject-matter expertise to engage in a collaborative dialogue with a company’s board and management. Investors who divest from a company lose their voting rights and seat at the table to discuss ESG issues directly with company leadership. Without years of intense and purposeful engagement on the long-term structural headwinds facing the energy sector, would one of the world’s largest oil producers recently commit to becoming a carbon neutral company? Active responsible investors are increasingly serving as shepherds who can help guide firms to see the possibility that change offers, keep them on the path of progress and, over time, experience the collective benefit when change is implemented.
STAYING THE COURSE THROUGH ESG CHANGES
As has been learned over the years, it is nearly impossible for investors to call the top of the market or recognize its nadir. So rather than trying to time the market, we choose instead to stay the course through volatility and avoid this behavioral trap. Similar logic applies when it comes to “ESG timing” and being able to fully understand the path that a company may be traveling toward sustainable value creation. If an investor had divested from the company, he or she no longer have their finger on the pulse and will not know when it is appropriate to revisit the investment merits. Without direct, forward-looking oversight, how would you know if a mining leader is revamping its health and safety practices to protect the wellbeing of its global workforce? Engagement affords a more comprehensive view to better understand positive ESG momentum. It’s not about where you’ve been; rather, it’s about where you’re going.
An exclusionary approach to ESG investing, whether by not investing in a company or divesting from an industry, results in fewer investment choices. This could lead to avoiding investments that would otherwise be appropriate for particular investors. By restricting the investable universe, an investment portfolio may have an increased tracking error when compared to its benchmark. Greater dispersion and volatility are often undesirable for certain investors, especially large institutions investing to satisfy long-term obligations and liabilities. Instead of removing a sector completely, gaining a deeper understanding of a sector’s secular winners and losers through engagement may lead to more optimal risk-adjusted returns.
History has taught us that true change happens from within. When an industry suffers from poor ESG characteristics, the most effective way to generate win-win-win outcomes for the company, investors and broader society is to create a purposeful dialogue about the ESG challenges and define a more sustainable path forward. While exclusion and divestiture have reigned in the past, proactive engagement and stewardship are quickly defining the future of responsible investing.