The Church of England made front page news last month when it was accused of hypocrisy because of its shareholding in Amazon.
The Church Commissioners, who are responsible for overseeing the organisation’s £8 billion portfolio, fired back a quick response: "We take the view that it is more effective to be in the room with these companies, seeking change as an active shareholder, than speaking from the side-lines."
The argument in favour of active shareholder engagement – where investors work to change companies, as opposed to simply avoiding them altogether – has rarely been aired so publicly and powerfully.
And the Church Commissioners’ stance is gaining traction. At Cazenove Capital growing numbers of our clients – private individuals, families and charities – seek more sophisticated ways of ensuring their values are reflected in how and where their wealth is invested.
In the case of the Church and Amazon, the issue at stake was aggressive tax avoidance – something which Amazon has been accused of and which the Church regards as “both a business risk and an ethical issue”. For many Cazenove Capital clients the concerns focus on other social and environmental issues, such as climate change and the role played by industries in either aggravating the problem or alleviating it.
These clients – like the Church – are realising that their views and values can be more effectively conveyed through positive investment strategies, rather than by shunning entire sectors, industries or stocks.
Investors increasingly understand the shortcomings of negative screening…
Negative screening – also known as “exclusionary screening” – remains a popular strategy for investors who do not want to support or profit from controversial activities. Over one fifth of global investments currently involve the application of screens of some sort, and this proportion is rising(1). The most popular screens include those which bar “sin” stocks – firms associated with gambling, pornography, alcohol and tobacco – and firms involved in weapon manufacture or sale.
But negative screening in this way precludes any possibility of influencing a business or its management. In the words of the Church Commissioners, if you don’t own the shares, you’re not “in the room”. Increasingly investors take the view that companies are critical components of society in their multiple roles as providers of goods and services, employers, taxpayers and in the environmental impact of their activities. Active shareholders in these businesses can encourage change for the wider social good.
Divestment – which is similar to negative screening except that it involves selling investments which are already owned – has a similar drawback. In theory, divestment may appear to be depriving an industry of capital, but in practice many of the businesses in question do not require capital from existing shareholders. Selling the holding results in merely moving the investor to “the sidelines”.
While negative screening is seemingly simple, as Schroders’ Sustainable Investment team highlights in the paper Demystifying negative screens: the full implications of ESG exclusions, screening out investments on ESG criteria (environmental, social and governance) is fraught with practical challenges. Apparently similar exclusion policies or principles can have different criteria and result in very different exclusion lists. For example, a screen might exclude stocks with any connection to an industry; or it might exclude stocks only where revenues from the targeted industry comprise more than 10% of total revenues. Whether one opts for the hard-line screen or the more permissive version can drastically affect the range of stocks qualifying for potential inclusion, depending on the sector concerned.
With tobacco, for example, an absolute “no ties” screen would involve excluding retailers, such as supermarkets. But a revenue threshold set at say 10% could bring most supermarkets back within the field of qualifying holdings. Differing screens aimed at alcohol have a similar effect. With nuclear energy exclusions, a very strict screen would exclude a large number of power firms. Again a revenue-linked screen would include those businesses where nuclear is only a part of the energy mix.
Investors seeking to have a greater influence on companies are better understanding the limitations and challenges of exclusionary screening.
How might negative screening affect performance?
Numerous studies have examined the effects of negative screening on performance. Schroders’ Sustainable Investment team focused on the effect of different negative screens on index returns between 1997 and 2017, and discovered that returns barely moved when a range of screens (including tobacco, fossil fuels, nuclear, weapons, alcohol and gambling) were applied(2).
Schroders’ research concluded that while outperformance from certain excluded sectors did occur, when calculated within a much larger index the impact was slight. Overall, negative screening did not have a significant impact on long-term returns.
Negative screening, however, can affect short-term performance. The limitation it places on the range of potential holdings means performance will vary from the benchmark in many circumstances, potentially making it harder for investors to judge an active portfolio manager’s success.
Negative screening also impacts a portfolio manager’s ability to execute certain investment strategies – and their ability to meet the investor’s financial objectives. If income is an objective, for example, negative screens which remove tobacco and energy stocks from the list of potential investments may have a significant effect. Another solution to the requirement for income may need to be found.
Engagement with companies is key to improving their future performance
Key to the concept of being “in the room” and engaging with companies is a wish to safeguard and improve their future returns.
When the Church Commissioners spoke of “a business risk” in relation to Amazon’s alleged tax avoidance, they were outlining their efforts to protect the Church of England’s asset. Putting the ethical concerns to one side, it is not in shareholders’ financial interests for any business to engage in practices that threaten to make it an enemy of governments, customers, employees or the wider public.
The efforts of being made to grow the numbers of investors to engage is making businesses change their practices and plans. It is helping guide businesses to a more sustainable future.
Screens make only a minimal difference to long-run index performance…
Cumulative return of MSCI World Index with different screens applied
*Sin stocks include tobacco, alcohol, gambling and pornography. Exclusions for fossil fuels and all sin stocks are based on 10% revenue cut off, as defined by MSCI. Exclusions for weapons, fur and nuclear are based on business involvement, as defined by MSCI. Index returns calculated using quarterly rebalancing of the MSCI World Index over the last 20 years, resulting in slight differences from the true performance of the index. Past performance is not a reliable indicator of future results, prices of shares and the income from them may fall as well as rise and investors may not get the amount originally invested. Source: Datastream and Schroders, 2017, as at 30 June 2017.
(1)Global Sustainable Investment Review 2016
(2)“Demystifying negative screens: the full implications of ESG exclusions”, Schroders, December 2017