The Perils of Ethical Investment for SWFs

If a small investor wants to invest ‘ethically”–and I do not define that term with any precision, as I believe investors will differ somewhat in what they believe ethical investing to be–the challenge is difficult but not insurmountable.  If you are investing in equities on your own, simply screen your portfolio companies by reviewing the public filings and other sources of information, and keep up with what the companies are doing.  Or, you may just choose to have someone do the work for you by investing in one or more of the many funds set up to pursue only ethical investments. 

Perhaps not as easy (or, frankly, as profitable) as selecting broad-based, no-load mutual funds, throwing darts at the stock pages, or even letting a monkey throw the darts for you, but not very difficult. 

But have a care for fund managers who have to select “ethical” stocks according to guidelines set up by fund owners.  Their job is significantly more difficult for two reasons:

1. The composition of the portfolio is likely to be public knowledge (I suspect a high correlation between fund transparency and funds that would have an ethical investment mandate), so the activities of portfolio companies will be scrutinized and any taint from those activities will reflect on the fund.  Because of this, funds will need to have an ongoing compliance program in place to make sure that portfolio companies are acting in accordance with the guiding ethical principals of the fund, and if not, the fund must either divest or attempt to influence the offending company management.  However. . .

2. Compliance programs are expensive, and the expenses rise with the size of the fund (although some overhead costs do not rise steeply as more portfolio companies are added), and . . .

3.  Huge funds like Norway’s Government Pension Fund-Global have huge amounts of money to invest and limited places to put their funds.  Ethical investing significantly reduces the universe of investment targets.  This becomes a bigger problem as the fund grows larger.

Some of these difficulties are apparent in a recent Reuters report on the GPF-G’s ethical investments:

Norway’s oil fund, the world’s largest sovereign wealth fund, has no strategy for dealing with possible violations of human rights by the companies in which it invests, an independent committee set up to safeguard OECD ethical guidelines said.

The Norwegian committee pointed to the fund’s investment in South Korean steel maker POSCO, which plans to build a $12 billion steel plant in India, saying the fund was not doing enough to protect against human rights breaches.

Several non-governmental organisations say the plant in Odisha state would displace more than 20,000 people, among them indigenous people who receive special legal protection.

While the committee of experts, set up by the Norwegian government, has no legal power, its criticism could potentially damage the fund’s reputation as a socially responsible investor.

The oil fund, whose investments totalled $740 billion on Monday, is one of the world’s most transparent wealth funds and has excluded companies for what it has deemed to be unethical behaviour, such as the production of nuclear weapons and tobacco or the use of child labour.

The committee said on Monday that the fund had “failed to take appropriate steps to prevent or mitigate negative human rights and environmental impacts in connection with its investment in POSCO”.

The fund lacked “a strategy for identifying and handling possible violations of human rights in the companies they invest”, it said.

Hans Petter Graver, head of the committee, said a company or investment group that had this type of complaint directed at it might face questions from future business partners.

 

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