Divestment is the nuclear option for ethical fund managers

We examine the red flags that lead the pros to divest from a company and name examples of companies that have been ditched. 

Investors keen for their money to be put to good use may be surprised to find ‘toxic’ areas such as oil and gas in their portfolios.

This isn’t fund management companies being duplicitous - or at least, not often. Many believe that they can achieve far greater change by engaging with a company than they can by not holding it at all. If this ‘engagement’ succeeds, there is a compelling double whammy – the company improves its environmental, social and governance (ESG) footprint and its share price appreciates.

The problem is that engagement doesn’t always work. Company management teams may be intransigent, the business challenges too great, there may be fraud, deception or other nefarious activity. In these cases, fund managers may be forced to admit defeat and sell the shareholdings. 

Divestment remains relatively rare. Fund managers would rather give management teams the benefit of the doubt and sufficient time to make changes. Equally, given that ESG is a relatively new phenomenon, many fund managers are often still in the process of allowing company management teams time to get their house in order. As such, divestment hasn’t been commonplace, but where it happens it is usually a sign that things have gone very wrong.

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It is worth noting that divestment is distinct from companies that are uninvestable in the first place. Managers of sustainable funds are increasingly avoiding areas such as tobacco altogether. After all, while it is possible to make an argument that oil and gas are necessary evils while the world transitions to renewable energy, it is difficult to make the same case for smoking.    

Two key reasons to divest on ethical grounds

There are two main cues for divestment on ESG grounds. The first is that the company has become embroiled in controversy. Peter Michaelis, head of the sustainable investment team at Liontrust, says: “As soon as we are aware of any controversy, the next stage is to analyse the situation in more detail, digging behind the headlines to ascertain the true involvement of the company in question, the seriousness of any allegations made and how the business is responding to the issue.

“This gives us the context with which we can engage with the company and we will then look to speak to senior management or non-executive directors as well as other interested parties such as non-governmental organisations (NGOs) or industry experts. Foremost in all of this is the question of the company’s response.”

If the company isn’t working to resolve the problem, Liontrust’s sustainable team will exit, but if they feel the issue is being addressed, they will continue to hold while engaging with the company to ensure its resolution.

EdenTree, another fund manager with a strong heritage in the ESG space, approach is to divest from companies with poor records in fines, incidents, high health and safety accident rates or pollution. In 2020, it divested from DWS, where multiple scandals raised concerns about the group’s culture. It has also exited G4S on allegations of abuse at its Medway Young Offender Unit. Its exit from Samsung was based on allegations of corruption.

The other main reason for divestment is that a lengthy engagement has failed. This will apply to companies consistently failing to make progress in improving their performance in key areas such as climate change. Yasmine Svan, senior sustainability analyst at Legal & General Investment Management, says: “We make our expectations of companies very clear. We will act as a sounding board and supportive partner. If after a period of engagement, we don’t see a willingness to move, we will apply consequences – voting or disinvestment.”

Slow progress on climate change leads to divestment

Its highest profile example was Exxon Mobil (NYSE:XOM), where it divested because of slow progress on climate change. However, Svan adds: “Divestment is not the end of the conversation. In 2020, we disinvested from carmaker Subaru, but it made good progress on electric vehicle sales and targets and it’s now back in our portfolio.”

Svan said the biggest culprits aren’t in the areas investors might expect. “We have been engaging with oil and gas and the automakers for years and most have well-established strategies in place. The problems tend to be in those companies that have been able to fly under the radar. Our clients don’t tend to think of companies such as the major food retailers as important for climate change, but they are. We are currently disinvested from four companies in the food sector across the globe, for example.”Those five companies were: Kroger (NYSE:KR), Sysco (NYSE:SYY), Hormel (NYSE:HRL), Loblaw (TSE:L) and China Mengniu Dairy (SEHK:2319). In June, following positive engagement, Kroger was reinstated into the funds.

Fast fashion is the ‘antithesis of sustainability’

Fashion retail has been another area thrust into the spotlight. Last year, it was reported that global fashion brands had refused to pay for over $16 billion (£11.7 billion) worth of goods since the outbreak of Covid-19, pushing the risk down the supply chain with devastating consequences for factories that had already paid for fabrics. Edentree has engaged with companies to understand their position. It also avoids ‘fast fashion’ names such as Primark (owned by Associated British Foods (LSE:ABF)), believing their business models are the ‘antithesis of sustainability’.

There is a real difference in whether fund management companies are willing to do this publicly. Some feel that public sanctions are the best approach and can help persuade companies to change. However, others prefer to keep their engagement under the radar rather than shame offending companies.

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Fund managers don’t divest enough

Stuart Forbes, director and co-founder of Rize ETF, believes divestment isn’t used enough saying that unless engagement has real force and carries a real threat of divestment and/or public rebuke, then it is not enough to compel companies to evolve: “The minimum hurdle for divestment is, in our view, not low enough. Many large asset managers talk about engagement as if it is a panacea for the sustainable transition but the reality is, ’engagement’ in its current format is achieving nowhere near enough, quickly enough. You only need to look at the fact that the world’s climate is changing more rapidly than ever and deforestation in the Amazon and other biodiversity hotspots continues unabated to know that.

“It's high time the asset management giants step up and demonstrate their true firepower through a more activist approach to engagement and, failing that, public rebuke and divestment. Otherwise, we're facing a case of too little, too late.”

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There are signs that fund managers are showing their teeth more often with public and high-profile divestment from companies. Abrdn publicly divested from Boohoo (LSE:BOO) last year, saying its response to allegations of slavery and poor conditions within its supply chain as “inadequate in scope, timeliness and gravity”. Legal & General Investment Management publishes its engagement record and any divestments. It also makes public its climate change score for all major global companies. Schroders publishes all its engagements and gives an aggregate score for their efficacy.

Government debt is problematic for ethical funds

A final problem area is government debt. After all, some of the most egregious harms to the environment come from government action. The engagement path is not easy and divestment may be the only option. Thede Rüst, head of emerging market debt team at Nordea Asset Management, says fixed income managers have an important role in key issues. “Deforestation is a vitally important issue…It is relevant to every investor, because it threatens the value of assets they hold and affects the assets they might choose to buy in the future.

“Fixed income managers can play an important role in the fight to curb deforestation in the Amazon, due to the ability to hold governments responsible by applying pressure….We decided in 2019 that we would no longer buy Brazilian government bonds for any of our internally managed emerging market debt strategies.” The group is still in talks with Roberto Campos Neto, the president of the Brazilian Central Bank, and Brazilian vice-president Hamilton Mourão, but insufficient progress has been made to date.

Divestment is the nuclear option for fund managers if they have failed to bring about change through other means. This can put downward pressure on share prices, but also means that the voice of responsible fund managers may no longer be heard. It is a fine balance.