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By Jon Hale, Ph.D., CFA and Jeremy Glaser | 01-18-2018 02:00 PM

Alternatives to Divesting When Investing for Impact

Large investors can also consider focusing on best-in-class investments or engaging management for change.

Jeremy Glaser: For Morningstar I'm Jeremy Glaser. The New York City pension funds have announced that they are going to be divesting from fossil fuels. I'm here with Jon Hale, he's our director of sustainable investing research. Let's see what this could mean for investors who are thinking about making an impact with their portfolios.

Jon, thanks for joining me.

Jon Hale: My pleasure.

Glaser: Let's take a quick look at this announcement about this divestment from fossil fuels. Is this the continuation of a trend? We've seen a lot of pension funds take these kind of steps.

Hale: Definitely we're seeing a lot of pension plans doing this, and if not going fully into divestment there are some other areas that they are exploring as well, like best in class investing or just even engaging with the companies that they do own in their portfolios.

Glaser: Let's take a look at some of these options, it could be illuminating for people who are thinking about their own portfolios. The first is full divestment. What is the case that's been made to walk away from these companies?

Hale: First of all it's probably interesting to talk about divestment in terms of the criticism that is made about divestments, which is basically that if you take something out of your portfolio for sort of noninvestment related reasons you risk it's said underperformance. What it really is is tracking error. You risk tracking error, you could underperform, you could outperform over time. It is very interesting I thought that GMO recently came out with a quick study that they did, where they took the S&P 500 and they took it out sector at a time and looked at what the S&P 500 ex-energy looked like, ex-financials, ex-healthcare. Went back 20 years, 50 years, 90 years--what they found was that it really doesn't make a lot of difference in return.

The primary case I think against divestment that you are risking a lot of tracking error, not that big of a deal. I think in addition to that we've seen over the last few years an investment case developed for divestment which is basically that, your large fossil fuel companies, especially the major extractors of coal, oil, and natural gas, are companies that are going to find it much more costly to operate over the not too distant future. Divestment in fossil fuels really is saying we don’t think these are great investments going forward. We have some evidence certainly in the last few years that that's been the case despite the natural gas boom of last few years. The MSCI All Country World Index ex-fossil fuels has outperformed the base index over the last seven years by about a percentage point annually.

Glaser: Another option is just looking at best in class investments. Instead of saying I'm not going to own fossil fuels you own the least polluting or the ones that are the best stewards. Why would people gravitate toward this option?

Hale: Best in class is really saying we're not going to take out everybody. We're going to just focus on those in the sort of transition to a low carbon economy, are handling that better than their peers and are sort of improving their sustainability performance in areas like managing their carbon footprint, energy, efficiency, maybe even investing in renewables. That's definitely a way to go as well.

Glaser: And then finally there is engagement. We hear a lot of this particularly from the passive index providers who have to own everyone. What's the case for owning them but then engaging with management to try to make a change?

Hale: Engagement is having a seat at the table with shareholder. We are seeing quite a lot of action on that front. Recently in the engagement world just last year for example 63% of the shareholders of Exxon, including their largest fund company shareholders like BlackRock and Vanguard and State Street, all voted to encourage the company to release regular reports to investors about the risk they face from climate change. BlackRock just announced they were indeed going to do that, just last month.

In addition, there is a group of investors called the Climate 100 Task Force that have bound together this year and said, we're going to coordinate our engagements with the 100 companies that have the heaviest carbon footprint globally to talk to them about how to reduce that footprint and what their plans are for the future. Certainly, engagement can be effective I think tilting portfolios toward best in class can be effective but so can fossil fuel divestment. They are not as mutually exclusive as they might seem. You can do sort of combinations of all three. I think investors have a choice here of paths they want to take. It's just really not that productive to say, one's good, one's bad-- I think they all can serve a purpose.

Glaser: Jon, thanks for walking us through that today.

Hale: My pleasure.

Glaser: From Morningstar I'm Jeremy Glaser. Thanks for watching. 

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