Understanding ethical investing

Photo of Jack Lowenstein, Morphic Asset Management By Jack Lowenstein, Morphic Asset Management

min read

Insider reflects on ‘doing the right thing’ and still making money.

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.

In May, the Morphic Ethical Equity Fund (MEC), Australia’s first new ethically screened Listed Investment Company in more than 10 years, began trading on ASX.

After a month on the road meeting prospective investors it is an opportune time to reflect on what I learnt and what has changed in two decades of being involved in ethical investing, from personal, public and investment community perspectives.

And an opportune time to give an insider’s take on the thinking and philosophy behind deciding which companies go into an ethical fund, which are excluded, and why.

Twenty years ago, when my then team at Hunter Hall adopted a “negative screen” for a portfolio, the issues seemed simple. It excluded “sin” businesses such as tobacco, gambling and alcohol, and more broadly, companies involved in armaments, non-remediated environmental damage and those whose businesses involved animal cruelty.

Over the years, the debate had shifted. The main ethical issue today is climate change. Interest in governance has increased, and the linkages between companies and suppliers. There is also more demand for exposure to businesses that are seen to be making the world a better place.

For the new MEC fund’s investment guidelines, we consulted widely, including financial advisers with clients wanting ethical options. And debated what mattered within our own team.

Past returns are no guarantee of future returns, but we had to ensure the new fund could replicate the process behind the compound annual returns of 17.5 per cent enjoyed by investors in the Morphic Global Opportunities Fund (MGOF) since it opened in August 2012 – matching MGOF’s consistent position in the top 10 per cent 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 our investors would be noble minded but also lived in a material world. This meant not excluding all mining or chemical industries, for example.

The ethical charter on our website excludes “sin” stocks and armaments, companies involved in fossil fuels, nuclear energy, environmental degradation, factory farming or deforestation. There is a commitment to having at least 5 per cent 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.

Investor feedback is invited and non-executive directors have a right of veto when it comes to grey areas. Use is made of research published by the world’s largest ethical fund, Norway’s Sovereign Wealth Fund.

The complexity of meeting investor demands became even clearer on the marketing roadtrip around Australia, with Town Hall-style face-to-face meetings in all capitals with investors and the public.

Many investors at the meetings were more excited about the MGOF’s historic returns than MEC’s ethical charter, and a threshold question was would our screens inhibit performance.

Our response was multifaceted:

  1. The MGOF is fully compliant with the MEC negative screen and has usually been so since inception. When the performance was back-tested to strip out all historic exposures to fossil fuels, it was found this would have added about 0.2 per cent a year to returns.
  2. Investor skill is seen as more important to returns than the screening. All my investment career before setting up Morphic was spent running ethically screened portfolios at Hunter Hall. Like my co-founder, Chad Slater, I had a strong record of outperformance.
  3. There is now a substantial and consistent body of investment research suggesting that various forms of ethical screening tend to add to, rather than detract from, performance. In the past three months, articles have been published on this by UBS, Morgan Stanley and Goldman Sachs, among others.
  4. We believe fossil fuel companies in particular are substantially overvalued by the market, which assumes 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.

The bottom line is that people back us with an expectation of high performance, while not offending their personal values.

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.

Another question was about a reluctance to use formulaic Environmental, Social and Governance (ESG) metrics and disclosures as part of our process, preferring to look at this on a case-by-case basis and emphasising substance over form. We see endorsement in 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. A minimum 5 per cent level in this category ensures we are always researching promising new developments in alternative energy and social impact industries such as 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”.

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 per cent of all externally managed money is subject to some form of ethical screen. In Australia only one in 25 global equities funds is screened.

In the United States, ESG funds under management are growing at 29 per cent a year. Australia will catch up as investors’ misplaced scepticism about the impact on returns abates. A slightly more pragmatic response to the difficult balancing act managers face might help as well.

About the author

Jack Lowenstein is joint chief investment officer and managing director of Morphic Asset Management

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