Is Sector exclusion Lazy? Responsible Investing

I have some sympathy with the view that excluding sectors is lazy.

Doing so alone does not make one a Responsible Investor (RI), more an ethical investor.

Nevertheless, excluding sectors (negative screening) could be part of an Investor’s RI approach.

 

This post is in response to a recent GoodReturns article, Sector exclusions lazy CIO says.

 

In my mind, RI can be thought of as a continuum, at one end is do nothing, non RI, and at the other end is ethical investing, which would include a number of exclusions depending on ethical positions.  In between are different shades of RI.  RI is a broad church.

For most institutional Investor’s their RI approach centres around the United Nations supported Principles of Responsible Investing (PRI).  PRI has six principles, see below.

 

Whatever the “Responsible Investing” approach it should be based on a documented policy, preferably approved by the Board.  The policy would provide RI philosophy, approach, and guidelines e.g. the exclusion of sectors based on a investment research position or set of values.

I think the approach to RI should be addressing the PRI’s six principles.

 

With regards to impact on performance.  I’d see RI as having the ability to add value, certainly improve risk-adjusted returns.  There is increasingly more evidence suggesting this, particularly at the stock selection level for equities and bonds.

Likewise, heading down the road of excluding a large number of sectors will increase variability of returns relative to broad market indices (that is the math).  Nevertheless, I’d argue this is ethical investing, not RI.  Perhaps the two will come closer together over time.  That will need a growing consensus of what sectors are acceptable and what are not i.e. tobacco has wide acceptance as being excluded currently.

 

RI to me is much more about risk management.  Environment, Social, and Governance (ESG) factors can impact on the long term financial outcomes of a company and a broader portfolio.  Well researched ESG positions will improve risk-adjusted performance.  Such a research driven approach may result in the exclusion of some sectors.  It may also result in making investment decisions a non-RI approach would not consider e.g. impact investing or reducing a portfolio’s carbon exposure given changing government regulations and taxes.  I have a preference that the ESG approach focuses more on a portfolio’s financial impacts, rather than ethics.  Albeit, RI should be set within a sound philosophy and values framework.

The ESG factors should be integrated into the investment process, through selection and monitoring of investments.

Therefore, the consideration of ESG factors will help improve long term risk-adjusted returns, provide better insights into the risk of companies and potentially wider portfolio risk exposures, not just listed equities but unlisted assets such as infrastructure and property.  ESG assists in considering portfolio risks more broadly.  RI can make for more robust portfolios.

RI also includes engagement, with companies and the industry.  It is proactive, e.g. proxy voting and engagement with companies.  RI is a lot more than just excluding an equity market sector.  From this perspective, an investment manager can do more good through engagement than just excluded particular sectors.  They can make a conscious and research based decision not to invest in a company with the consideration of ESG factors.

RI is consistent with being a long term investor and stewardship.  In this regard, RI is as much about sustainable investing.

And that highlights a problem, there is so much terminology in our industry, particularly within this space.  This leads to inconsistency in meaning across the industry, which is reflected within the media e.g. Ethical Investing and Social Responsible Investing are often described as “RI”, which is not really true, at best it is at the far end of the RI continuum and based more on values than financial impacts, it is a subset of RI at best.

 

As an aside, one of the best books I have read on sustainable investing is, Sustainable Investing for Institutional Investors, by Mirjam Staub-Bisang.  I am interviewed in one of the chapters (no I don’t get any royalties) along with Amanda McCluskey, chpt 16.  Both are wonderful people.

 

 

Happy investing.

 

 

Please see my Disclosure Statement

 

Global Investment Ideas from New Zealand. Building more Robust Investment Portfolios.

 

 

PRI Principles:

Principle 1: We will incorporate ESG issues into investment analysis and decision-making processes.

Principle 2: We will be active owners and incorporate ESG issues into our ownership policies and practices.

Principle 3: We will seek appropriate disclosure on ESG issues by the entities in which we invest.

Principle 4: We will promote acceptance and implementation of the Principles within the investment industry.

Principle 5: We will work together to enhance our effectiveness in implementing the Principles.

Principle 6: We will each report on our activities and progress towards implementing the Principles.

 

 

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