Challenges in Responsible Investing
by Dennis Hammond, Head of Institutional Investments
Many investors today are committed to engineering investment portfolios devoid of companies engaged in reprehensible and abhorrent practices and products, such as those which put human lives at risk, denigrate human dignities, disrespect rights of laborers, chip away at the fabric of our environment—aqua-culturally, agriculturally, or otherwise, or simply exacerbate corporate greed and irresponsibility.
Examples of investors’ concerns abound across industries as diverse as mining, textiles, manufacturing, and farming, and include widespread practices such as forced labor, migrant worker abuse, human trafficking, stem cell and human cloning research, human organ trafficking, discrimination against women, children and the poor, manufacturing of anti-personnel and nuclear weapons, production of greenhouse gases, toxic waste and pollution, and depletion of natural resources.
Whether based on issues of faith, moral compass, environmental concerns, or basic human and social rights, these investors, like many consumers today, are deciding now is the time to eschew profits from goods and services based on these materialistic practices and products. These investors are endeavoring to act morally and responsibly: they would rather earn less with clean hands, than more with dirty. Some are doing well without sacrificing returns. Whatever their approach, they are consciously discarding agnostic indices in favor of responsibly-built stock and bond portfolios with low tracking error to their benchmarks.
Responsible Investing is the practice today of replacing agnostic stock indices with one or more responsibly-built portfolios. Responsible portfolios are readily constructed by screening out bad corporate actors based on faith, environmental, social, and sustainability screens, accentuating the weighting in the portfolio of good actors, and re-optimizing the resulting portfolio to an acceptably low tracking error to the original benchmark(s).
There is, however, a problem inherent in making these judgements. The vast majority of these responsible investors are relying on a handful of mainstream rating services to provide the information necessary to reach informed judgements on corporate behavior. In most cases, the ratings or scores serve as the sine qua non for investors. Unfortunately, there is a dark secret lurking in the data--the ratings are not always based solely on corporate violations or their absence. Instead, some mainstream data providers now also take into consideration both a company’s willingness to disclose its shortfalls and any steps it may be considering to demonstrate its remorse. In other words, the ratings providers are including, not just the good or bad the company may be doing, but the company’s perceived ability, propensity, and commitment to confess their activities and to do something about them.
Why do they allow companies to improve their scores and evade their excluded company lists? The joke has been that if all of the bad actors caught in negative screens today were removed from Buy lists, there would be no stocks left to buy at all.
It is for exactly this reason that many mainstream ratings services do not cut bad actors from their list so long as the company discloses their involvement in bad acts and shows some nascent signs of remorse. Simply join a Roundtable or build a school for the locals—then all is forgiven. Of course, skeptics could see these acts as disguised corporate bribes to permit the company to go right back to raking in revenues from morally and fiscally irresponsible practices and products.
The problem is that just disclosing bad acts or committing to “do something” about them, does not stop the harm from continuing. It does not relieve the children forced to harvest cocoa bean for our chocolate bars from the yoke of slavery in the Ivory Coast. It does not lessen the abuses under which countless souls labor in sweatshops for our couture in the garment trades of India or Bangladesh, nor does it improve the war-torn lives of those scratching blood diamonds from the dimness and claustrophobic depths of African mines for our Sunday-best jewelry.
What if instead, investors develop their own, shared, list of bad actors? The list may be assembled from diverse sources such as Know the Chain (knowthechain.org), Corporate Human Rights Benchmark (corporatebenchmark.org), the U.S. Department of Labor 2018 List of Goods Produced by Child Labor or Forced Labor (dol.gov), As You Sow (asyousow.org), JUST Capital (justcapital.com), HowGood (howgood.com), and numerous other online sources. The United Nations Human Rights Watch is an excellent source for up to date information on topics of interest to those committed to basic human rights globally (www.hrw.org/topic/united-nations).
Companies excluded based on research from these and other sources can be added to exclusion lists already provided by the mainstream data providers for a more comprehensive picture of who’s doing what to whom. Essentially, a complete "Blacklist" of harmful companies is needed, even if investors must assemble it themselves, if they wish to ensure they are excluding all companies which should be excluded and dealing only with those which have clean hands.
If, after such added exclusions, too few stocks remain for a normal-sized public equity allocation, investors might consider simply lowering their public equities allocation. The erstwhile public equity dollars could then be re-allocated to private equity and debt in companies with clean hands and a practice of doing good. These will be equity and debt IMPACT investments and can actually be expected to improve the world and not simply continue bad practices and bad products, even if well disclosed.
In so doing, responsible investors must decide for themselves whether to employ the now-ubiquitous threshold for exclusion, such as when violations cross an arbitrary revenue threshold of some amount, say, 5% or 10% of a company’s total revenues. Note these are relative thresholds, that is to say, they are expressed relative to the company’s total revenues, such that the violation(s) themselves could easily total millions, if not hundreds of millions of dollars in revenues as part of a multi-billion-dollar company’s revenue base.
Instead, the best place to start may be to exclude all companies for which a minimum amount of revenues, say $50 million or $100 million, is derived from bad practices or products. In so doing, thoughtful investors will reject the relative threshold approach entirely. This is a significant departure from the mainstream data providers’ decision tree, which employ a threshold for many screens to enable companies to avoid exclusion, thereby permitting bad practices to persist so long as the revenues produced by the violation(s) fall short of the threshold.
Ask yourself, if you allow a company to engage in bad practices up to an arbitrary threshold based on their total revenue stream, do you really help those directly harmed by the violations? Of course not. Rather, your investment in such a company exacerbates the problem and extends the time until the company takes real steps to remove such practice(s) from its behavior. Investors' acquiescence in the threshold actually supports and encourages bad corporate actors to continue what they're doing. Better to step back from investing in such companies until they clean up their act. Tell them clearly, in or out. Clean hands or no investment.
Some investor’s corporate blacklists today are long and growing. These investors, like myself, are mostly absolutists who refuse to excuse even "minimal" violations. Of course, doing their own homework requires hours of digging and personal research. But at least these investors can sleep at night knowing not a single penny of theirs aided or abetted companies with abhorrent and reprehensible practices or products.