The Engaged Investor: When dialogue fails…
...exclusion prevails. Although in most cases a matter of last resort, negative screening among some pension funds is slowly on the rise, as Nina Röhrbein reports
Not long ago, positive screening was all the rage among responsible investors. Negative screening - and therefore exclusions - was often frowned upon by mainstream investors who wanted to distinguish themselves from the notion of the ethical funds of the 1990s. However, slowly but surely the number of exclusions has crept up again.
"Among the average corporate pension funds, exclusions have never been a big issue and will likely remain a minority issue," says Emma Hunt, senior investment consultant at Towers Watson. "However, among some funds, such as sovereign wealth or large public funds, exclusions are becoming increasingly used, in part as a reflection of their identity and approach."
Hunt believes that public funds have recognised that they have a reputation to maintain and an increasing responsibility to report and disclose to their stakeholders. "Investors have become very transparent about the reasons for exclusion of a company, thereby leaving the door open for possible re-investment," he says. "For some companies, this can be a stimulus to change."
Karina Litvack, director head of governance and sustainable investment at F&C Asset Management, is astonished at the number of investment institutions that have adopted certain exclusionary screens. "After a decade of engagement, a number of large institutions have come forward and asked us to exclude a limited number of companies on the basis of serious concerns," she says. "The main reason is much greater public awareness around issues such as manufacture of weapons which breach ratified international arms treaties."
Manufacturers of controversial weapons such as cluster bombs and anti-personnel landmines are high on the exclusion list because, investors reason, there is no point trying to engage with those types of companies.
Exclusions are much more likely to be a result of behaviour, such as corruption and bribery or breaches of human rights and labour standards, rather than to be based on entire sectors such as alcohol or mining.
"Large investors are undertaking engagement with regard to corruption and bribery, especially in the mining and resources sector," says Hunt. "If there is a feeling of movement they are most likely to continue with their engagement strategy but if, after a number of years, there is no improvement they will feel comfortable in excluding a particular company."
Litvack notes that there have been several high-profile divestments in the mining sector, such as exclusions of India-based Vedanta Resources. "Others - including Rio Tinto and Freeport-McMoran - have also been the subject of divestment actions by some shareholders over issues such as riverine tailings disposal [the practice of dumping the waste from ore processing into waterways]," Litvack adds.
Annika Andersson, head of corporate governance and information at Sweden's AP4 and chairwoman of the Ethical Council collaboration between AP funds 1-4, agrees: "The mining sector is a problematic sector as there are a lot of incidents." However, for the Swedish buffer funds exclusion is the last resort.
"Our philosophy is to have a dialogue with companies that breach international conventions," says Andersson. "At present, we have 3,500 companies in our portfolios and have excluded only 11 - that shows how rare exclusions are for us."
The exclusions list of AP1-4 comprises 10 companies that produce cluster munitions and anti-personnel landmines, as well as an Israeli company active on the West Bank's occupied territory.
Dutch asset manager Robeco currently undertakes 12 minimal exclusions - all companies that are engaged in the trade or production of controversial weapons such as cluster munitions, anti-personnel mines and biological and chemical weapons - under the first pillar of its exclusions policy, which is based on international conventions. Under its second pillar it excludes countries that have a unanimous UN Security Council resolution against them, such as North Korea, Iran and Somalia. The third pillar is enhanced engagement and concerns companies suspected to be in breach of UN Global Compact standards. If dialogue with these companies leads to no results, they will be excluded as well (the timeframe that applies to the engagement process is set at three years, but it is flexible).
As Robeco's three-pillar exclusion policy only came into effect in February 2010, the asset manager is still in the first year of the evaluation period and therefore unlikely to undertake any exclusions for now. But at present, Robeco's total enhanced engagement list contains over 100 companies in various sectors and jurisdictions.
Sweden's Ethical Council is currently engaging with nine companies, ranging from Wal-Mart in the US to Vedanta in India, based on labour law, human rights and environmental infringements. Dialogue with two other companies has been terminated pending the outcome of legal proceedings.
"We always discuss whether the dialogue is working or not and the Ethical Council is always prepared to recommend the funds to exclude," says Andersson. "The four funds then separately take the decision."
Investors have come to the conclusion that blacklisting a few companies is not going to have a negative impact on the risk/return profile of a global equity or bond portfolio long term.
In F&C's Stewardship fund, where significant portions of the index are excluded, divestments can have an effect on volatility, tracking error and, in the near-term, performance. "Based on research we have undertaken, the negative impact of exclusions is negligible over the longer term for a broadly diversified portfolio," says Litvack.
Robeco has undertaken quantitative research on the effects of exclusions on its portfolios. The asset manager concluded that there are good alternatives in the aerospace and defence sectors. "In case an exclusion significantly impacts the risk/return profile of a fund we have a clause in our exclusion policy that at that moment we will apply a change to the benchmark of the fund in question," says Erik Breen, senior vice-president, responsible investing.
But exclusion is not irreversible. Life insurance and pension provider Storebrand follows up its exclusions through questioning of the companies. If - as in the corruption cases of Volkswagen and Siemens - the issues have been resolved and Storebrand has proof of, for example, good anti-corruption systems in place, it may resume investment again.
Similarly, the Ethical Council closely follows companies for five years after their exclusion to see if there have been changes. Robeco's inclusion policy revisits and re-assesses its excluded companies on a periodical basis. It takes companies off its enhanced engagement exclusion list if, for example, the breaches are more than 10 years old and there has been no repeat in recent years, or if a breach that occurred in a subsidiary was solved over three years ago.