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Special Report

ESG: The metrics jigsaw


Making companies mend their ways

As a result of an extensive analysis of official documentation relating to the United Nations, it turns out that some of the companies in which the 7th AP Fund owns shares are failing to maintain the environmental and ethical standards that the fund uses as guidelines for its investments.
The 7th AP Fund’s decisions are based on court judgements, official investigations or direct admission on the part of the companies’ management after investigations of their record regarding violations of human rights.
The 7th AP Fund therefore decided to
originally exclude 27 companies from its portfolio, and more recently added a further 20 companies to the list. The companies excluded in 2001 (see Box) include major names:
According to our policy, companies will be excluded from the fund’s investment portfolios for a maximum of five years after they have been judged in a court or after documents have been published by a public supervisor of an international convention in which reference is made to the company, or the company’s management has acknowledged the violation.
Ethical considerations in fund management are not a new phenomenon. In the US, a growing proportion of the assets of funds are invested subject to some type of ethical restriction. This trend can also be observed in Sweden. However, it is not easy for a fund manager to define what exactly environmental and ethical considerations involve; on the one hand, the criteria shall be objective and sustainable, while on the other account must also be taken of yield requirements.
There are probably very few shareholders or fund managers who wish to own shares in companies that manufacture land mines, carry out regular menstruation tests on employees or who fail to pay the agreed wage. These violations are so serious and obvious that no fund manager would hesitate about excluding such companies from a portfolio.
But a company’s unethical actions are not always so obvious. For example, it is regarded as ‘not the done thing’ to own shares in companies that manufacture alcohol, tobacco or weapons, even though most people in Sweden drink alcoholic beverages, many of them smoke, and the great majority support the idea that sovereign states should be entitled to defend themselves by force. Moreover, Swedish voters have voted in general elections in favour of a parliamentary majority that sees no reason to prohibit the manufacture of alcohol, cigarettes or weapons. Fund managers that exclude companies which manufacture products of that type are, however, evidently responding to demands on the part of some individuals and in so doing play an important role on the market.
As a state fund manager, with the vast majority of the Swedish population as customers, it would, however, be unreasonable if the 7th AP Fund were to exclude companies on the sole grounds that they are engaged in that type of production.
Furthermore, where should one draw the line? It is difficult, not to say impossible, to decide this if one applies such a narrow ethical policy. Is the manufacture of trucks or truck seats to be regarded as the manufacture of military material? Are cider and light beer alcohol? SAS serves alcohol to its passengers – should it be excluded on that account? Is it unethical to invest in government securities? The Kingdom of Sweden is heavily involved in the manufacture and sale of weapons, alcohol and tobacco, to which we may also add gambling and gaming. In practice, all securities funds, including ethical ones, own some Swedish government securities, but against this background it could be claimed that it is unethical to buy Swedish government bonds!
The parliamentary bill that provided the guidelines for the 7th AP Fund’s ethical and environmental investment policy stated as follows: “Account shall be taken of environmental and ethical considerations in the investment activities without compromising on the overall target of earning a high return.”
According to financial portfolio theory, the exclusion of certain securities from an investment will have a detrimental effect on the risk-adjusted return. The reason for this is that if certain possible investments are excluded from the set of available securities, the spread of risk will be less efficient than would otherwise have been the case. This in turn means that the expected return will be lower, given an unchanged level of risk or, vice versa, given an unchanged expected return, the risk will be higher. How much lower the return will actually be depends naturally on how many and which securities are excluded from the set of available investments. Excluding the number of companies it does from a global equities portfolio, as the 7th AP Fund has done, turns out to be of only marginal significance. The actual return over the past two years has been compared with a similar portfolio from which the companies in question were excluded. The simulation shows that the aggregate return earned during this two-year period by the portfolio that excluded these companies was 0.15% lower. The total effect on our portfolios is less than 0.1% as these portfolios also include other types of asset.
In my view, ethical investment management should not involve identifying companies whose results have improved as a result of their ethical profile. Ethical investment simply means refraining from investing in certain companies on strictly ethical grounds, regardless of whether the company is expected to do well or badly. The underlying – the only – reason for excluding companies is the hope that they will be persuaded to change their production, employment policy or whatever it was that led to their being excluded.
The benchmark indexes against which the 7th AP Fund judges its performance include holdings in almost 2,000 companies from the whole world. All of these companies have been investigated and will be regularly investigated from an ethical and environmental point of view with the aid of an analytical model developed by Etikanalytikerna, a Stockholm-based firm of consultants in this field. The model includes investigating the companies with regard to violations of the following:
q human rights;
q the UN convention on the rights of children;
q International Labour Organisation conventions;
q international environmental conventions, and
q conventions against bribery and corruption.
Our policy is based on the ethical principles applied by the Swedish state. This therefore means that no companies will be excluded solely because they produce certain products so long as they comply with existing laws and regulations. Over and above that, the 7th AP Fund’s position will be based solely on court decisions, official investigations or direct acknowledgement on the part of the company’s management, and not on arbitrary assessments. When a supervisory organ has investigated the case, this will serve as a basis for a decision on whether or not to exclude the company from our portfolio. It is therefore not enough for a potential case to be reported in the mass media or have come to the attention of the fund in any other way.
The ultimate object of our environmental and ethical policy is of course to exert pressure on the companies concerned so that they better their ways. By annually releasing the names of those companies that have been excluded from our portfolios and explaining the reason fully, we hope that the companies will accept their responsibility, improve their internal policies, and thus qualify to be included in our portfolios after five years. The fact that the 7th AP Fund takes such measures can hardly be expected to change the practices of multinational enterprises. However, if more fund managers adopt a policy similar to ours, I am convinced that in the long run this will have some effect.
Peter Norman is executive president of the 7th AP Fund in Stockholm

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