Investment market update

November 2014

November 2014

To print this update, download a PDF version.

Australian shares returned 4.3% in October, partially reversing a large fall in September. The Australian market was boosted by its large proportion of yield sensitive defensive shares (such as banks and real estate investment trusts [REITs]) which benefitted from the fall in bond yields.

This month we outline our position on divesting from company shares on the basis of environmental, social and governance (ESG) considerations. We point out that using divestment to drive behavioural change may have its limitations.

Performance of key markets

Returns are for periods to 31 October 2014. Past performance is not an indication of future performance.
* Returns relate to our Accumulation (not Pension) investment options and are published after fund taxes and investment expenses, other than account-based fees. 

• See performance information for all options

October was a tale of two halves for financial markets. At one point, global share markets were down more than 6% and oil prices and bond yields were also sharply lower amid concerns over faltering global growth (especially in Europe), renewed deflation risks and Ebola scares in the US. However, a solid earnings reporting season in the US and valuation support from lower bond yields acted as a catalyst for a bounce in shares, which saw the month actually finish on a positive note.

The efficacy of divestment as an agent of change 

As is the case with all Australian super funds, UniSuper is often called upon by members and activists to divest from certain companies and industries. While the most public example in recent times has been the call to divest from fossil fuels, we’ve also been lobbied on myriad other issues ranging from companies that have any involvement in offshore detention centres to religious denominations, specific countries, and more. Our responses to such requests have been consistent, and could be summarised as follows:

• UniSuper has a legal and fiduciary obligation to our members to aim to maximise their financial outcomes within the constraints applicable to the respective investment options.
• Therefore, for ‘mainstream’ funds (e.g. the Balanced option), investment or divestment decisions are solely based on our judgement as to the financial sustainability of an asset. The decision-making process will necessarily involve a robust investment thesis, taking into account a range of factors including environmental and social considerations.
• However, we also acknowledge that some members demand options that specifically screen out certain sectors. Accordingly, the Sustainable Balanced and Sustainable High Growth options are included on the investment platform, with both options screening out fossil fuels, tobacco, alcohol, gambling, and munitions (see the September 2014 Investment market update for more information). Importantly, both options have sufficient demand to warrant their inclusion. 

This update does not intend to cover old ground defending our position. Rather, it attempts to consider the efficacy of divestment (for non-financial reasons) as a tool to drive change.

Common reasons for advocating divestment

1. The financial outlook for the company or industry is so poor that it is incumbent on the fund manager to eliminate the exposure of Australian superannuants to such financial risk.

Citing a deteriorating financial outlook is definitely the right grounds on which to call for divestment. The problem to date however, has been the inability to translate a general outlook into a robust investment thesis. An investment thesis requires judgement on probabilities in relation to (among other things) the timing of an event and the nature and magnitude of consequences. Simply stating that an asset could possibly be worth zero sometime in the future is not an investment thesis. Take for example our investment in toll road operator Transurban, whereby the value of the company is essentially driven by the tolls it will collect over the life of the concessions it owns. We know for a fact that (at different dates) in the future, the various concessions will be handed back to the respective state governments and at this point they will be worthless to Transurban. This doesn’t mean they are worthless today.

In a similar vein, there is a school of thought that new coal mines will not be permitted to open (i.e. they will be ‘trapped’ assets), which will obviously be bad news for the asset owners. However, many questions need to be answered before simply concluding that such companies are, or will be, worthless. Such questions include:

• What is the probability of a government effectively sequestering assets?
• Even if government policy were to change, when would this likely happen? 
• How much compensation would be paid to the owners to preserve the sanctity of property rights? 
• How much has the market already discounted in the assessed value of the companies that own the assets? 
• How material is the potentially trapped asset to the company’s total revenues? 
• Will the reduction in new supply actually lead to an increase in price of existing supply, potentially increasing the value of mines currently operating?

All of these questions would need to be addressed before simply divesting on the basis that an asset may be worthless in future.

2. Divestment will starve the company or industry of capital.

In relation to trading securities in the secondary market (where the vast bulk of trading occurs), this argument has no validity at all. New funds are only raised when a company sells securities or borrows in the primary market. A fund divesting shares or bonds on exchanges or other markets (the secondary market) has zero impact on the capital structure of a company. It simply results in a transfer of ownership.

3. Stigmatisation of the company/industry will change behaviour; at one extreme possibly resulting in a cessation of offending activities. It may also act as a deterrent to providers of new capital as they seek to avoid being caught up in the stigmatisation.

There certainly appears to be some validity in this argument. While it would be rare for stigmatisation to result in the outright cessation of an activity, given that livelihoods are at stake, corporations are becoming acutely aware of the need to communicate their awareness of the social contract under which they implicitly operate. Where externalities are more obvious such as carbon emissions, progressive corporations are being increasingly transparent with respect to the actions they are taking to mitigate consequences and to deal with community concerns.

However, given the sheer size and global mobility of capital, divestment by one set of investors is unlikely to deter all providers of capital from investing in an industry. For example, the tobacco industry still has a large investor base despite the fact that it is probably the most widely avoided industry in the global market place. Much to the disappointment of many, the widespread investor boycott of the tobacco industry has to date not manifested in a collapse of business models or market capitalisations.

The downside to divestment 

With the exception of regulators and public officials, owners of capital have the best access to company boards and management. Given the range of stakeholders a listed company needs to engage, there is effectively little incentive to actively engage investors who are not current or potential owners. This point needs to be carefully considered by those calling for divestment. Investors have different priorities, and this becomes more apparent when crossing global boundaries. Australian investors as a whole tend to take ESG considerations into account to a far greater extent than investors in many other countries. Indeed there are some regions in which ESG is considered irrelevant and investors in these regions invariably control globally mobile capital. In a free market very few restrictions are placed on foreign investors from buying shares in companies sold by Australian super funds. And some foreign investors may not have the time or inclination to engage the Australian based companies that they partly own.

The point is that, while divestment may entail a ‘feel-good’ element for some parties, it may also imply the relinquishment of a right to engage with a company. In some circumstances the unintended consequences could outweigh the feel-good benefits.

Inclusion of Australian Banks in UniSuper’s Sustainable options 

As is the case with the majority of Australian sustainable (aka ’ethical’ or ‘socially responsible’) funds, UniSuper’s Sustainable Balanced and High Growth options invest in Australia’s four major banks. Australian banks are among the best managed and creditworthy in the world; they have delivered excellent returns for Australian investors over long periods so their inclusion in most of our investment options is warranted on prudential grounds alone. Furthermore, in the course of our numerous engagements with the banks, we have been left in no doubt that their boards and senior management are aware of the implicit social contract under which they operate. All of them have robust corporate responsibility programs in place. However, a few members have queried their inclusion in our Sustainable options given that our major banks also finance companies involved in the fossil fuel industry.

The screening process within our sustainable options ensures that companies directly involved in the exploration or production of fossil fuels are excluded from the portfolios. Such boundaries are inherently subjective in nature, although they were decided after consultation with various parties including knowledgeable members who are also passionate about the subject. During these discussions inclusion or exclusion of the major banks was not raised as an issue. Extending the boundaries to exclude companies involved in the financing of fossil fuel companies would create problems on a couple of fronts. Most importantly, while it is true that the fossil fuel industry couldn’t survive without finance it also couldn’t survive without a number of other supporting industries, the most obvious being the heavy manufacturing, engineering services and transportation industries. Of course the most effective way to kill an industry is to stop buying its product, although we know that is currently impossible in relation to fossil fuels. Exclusion of sectors by definition reduces the investible universe. When managing the life savings of our members, we simply cannot get to the point where widespread exclusions severely compromise sensible portfolio diversification.

UniSuper now offers six investment options, ranging from low risk to high risk, that do not invest in companies involved in the exploration or production of fossil fuels. Of course some of these options (e.g. Cash) do not invest in fossil fuels due to the nature of the investment strategy, as distinct from active exclusion.

We understand that our approach may not appease those members demanding the total exclusion of fossil fuel related companies from all options. However we are comfortable that it represents the right balance. With a membership base as broad as ours, when sensitive issues are involved, trying to please everyone would be a very difficult exercise.