Legal Sins – Is There Value in Vice?

Untitled design (34)


Responsible investors often grapple with drawing the line in the sand when it comes to legal sins in investment portfolios – CAER’s Duncan Paterson offers a conceptual framework to assist with values-based discussions.


I think we can finally call it – responsible investment has gone mainstream.

According to the Responsible Investment Association Australasia (RIAA)’s most recent Benchmark Report, over 50% of professionally managed funds in Australia now have a clear responsible investment process in place.

The bulk of these funds are categorised as ‘broad responsible investment strategies’. In other words, funds that are managed with overt integration of environmental, social and governance (ESG) issues, but that are yet to actively take a stance on controversial activities.

While mainstream financial players have clearly discovered the language of ESG integration and the potential for environmental and social factors to impact on portfolio returns, they still face challenges communicating about values. There are enthusiastic explanations of how far ESG integration has evolved from ‘ethical investment’ and ‘negative screening’, however the mainstream of responsible investment still grapples with a core problem: the punters (their members, stakeholders) still find values important.

The argument goes like this:

Fund manager to the punter: “If I restrict my investment universe, I restrict my ability to maximise returns for my clients by reducing the investment opportunity set. Sector-based and activity-based exclusions restrict my starting investment universe, and therefore reduce my returns over time, all things being equal.”

Punter to the fund manager: “You call yourself a responsible investor, but you hold tobacco stocks? WTF?” *switches fund*

To date, the solution for most asset owners and managers has been to hedge their bets. There are few responsible investment offerings currently out there that are dogmatic about portfolio diversification. And of the screened funds, the RIAA Benchmark Report (p.13 of the full report) notes that 100% exclude tobacco and controversial weapons stocks. This is despite the challenge of making a clear case for an activity like controversial weapons manufacture posing a risk to portfolio returns.


Playing Devil’s Advocate

This does however lead to an inevitable communications problem. It’s the thin edge of the wedge conundrum that is often cited by asset managers who are cautious about joining the responsible investment club:

Sceptical portfolio manager to the product sales team: “Where will it all end? Sure I can screen out tobacco stocks, there’s only a few of those – but what are you going to say when the activists start asking you to do crazy things like screening out fossil fuel stocks?”

Business development manager to portfolio manager: “…”

Having a clear understanding of why you are choosing specific portfolio exclusions (or inclusions) is an important part of the communications process around your responsible investment implementation framework.

The classic example here is the exclusion of ‘sin’ stocks. This term is usually used to capture those activities considered moral transgressions in Western religious tradition (tobacco, alcohol, gambling), and so it is natural that progressive investors might tend to push back against their exclusion. The soliloquy may go something like this:

Progressive Investor: “Alcohol is legal, I drink alcohol and I think of myself as a moral person, why should I exclude alcohol from my portfolio on moral grounds?”


Legality vs Community Acceptance

This question of legality and community acceptance lies at the heart of fruitless discussions that have held up the implementation of responsible investment processes at various fund managers.

In order to move the discussion back onto productive grounds, it is best to draw a distinction between micro and macro societal impacts. So for instance, if we look at things at the micro level, one might think:

  • Tobacco is legal, and while nicotine is habit-forming, as long as I am careful in my consumption I am doing no harm to others.
  • Alcohol is legal, its consumption is an accepted social practice, and while it can become addictive, in most case it tends not to be. So long as I consume alcohol responsibly, I am doing no-one else any harm.
  • Gambling is legal, gambling supports my favourite sporting code, and indeed if I have a bet with a mate, who’s to say that’s wrong?

These are all valid points – one can imagine a case where home-grown tobacco is smoked away from others, we all likely know a home-brewer or local winemaker who produces and consumes their favourite tipple responsibly, and many Australians get together to play two-up each year to mark Anzac Day. These activities are not inherently ‘wrong’.

The situation changes however when we look at the industries these activities support at a macro level. Using a wide-angle lens:

  • Tobacco: The World Health Organisation (WHO) reports that more than 7 million people a year die from tobacco-related causes, with almost 1 million of those deaths being the result of indirect tobacco exposure. 80% of smokers live in low- and middle-income countries.
  • Alcohol: Again, the WHO notes that harmful alcohol use is associated with 3.3 million deaths every year globally, representing 5.9% of all deaths. In addition to the 200 disease and injury conditions that harmful use of alcohol causes, it is also responsible for “significant social and economic losses to individuals and society at large.”
  • Gambling: The Australian Gambling Research Centre (AGRC) notes that of the 6.8 million Australians who gamble regularly, almost 1.4 million experience problems with their gambling habits. Gambling hits low-income households the hardest, with unemployed and low-income men among the country’s biggest gamblers.

For each of these activities, there are large listed companies who facilitate them and are aware of the harm their products are doing to individuals and to society in general. Most of these companies are taking steps to mitigate those harms that aren’t inherent to their products. Some of them are actively working to hide the harms and dissemble with consumers and regulators about the appropriate steps that society could take to reduce the risks of consumption of their products and services.

It is this question of choice, as well as the informational disadvantage that exists between a large company and the consumer of its products, that lies at the heart of the debate. While at a micro level an individual can make the choice to consume a product that is harmful, at a macro level consumers as a group may be unaware of the full range of harms they face regarding that product. They are not necessarily equipped to combat the way a product or service is advertised, and the broader costs to society are rarely considered relevant to the individual consumption choice. But it is at this macro level that most investors should be considering the impacts of their investments.


The Role of the Shareholder

Shareholders in these companies have an opportunity to apply their analytical skills to a range of questions that arise from investment in activities that result in harm – some examples:

  • To what extent is the company responsible for the consumption of its product/service, and how much responsibility needs to be borne by the individual?
  • What is the balance of the product/service’s risks to society at large vs to the individual?
  • Does the product/service have inherent or egregious problems, or can the risks be managed?
  • Is the company taking all appropriate steps to manage the risks associated with their product/services?
  • Are consumers properly informed about the risks of consuming the product/services in question? For example, are specific at-risk consumers responsible for a high proportion of the product/service sales? This might go to the question of the capacity of the consumer to make informed choices about things like health impacts or the actual odds of winning a bet.
  • What is the right approach to materiality for the activity under analysis? This is the question relating to percentages of revenue associated with the activity of concern.
  • There is a growing consensus that superannuation funds have scope to consider the attitudes of their members on values-based questions – are these views likely to be reasonably consistent across the member group?

As noted earlier, many large Australian asset owners have already taken a strong stance on the tobacco industry, thanks in no small part to the hard work of Dr Bronwyn King and her team at Tobacco Free Portfolios. The issue of gambling has had less penetration, although Woolworths has faced pressure at recent AGMs for its position as one of Australia’s poker machine operators. Interestingly, alcohol companies have not to date faced organised pressure from investors concerned about the social harms associated with alcohol consumption.

There is also an emerging area of risk that responsible investors will need to be mindful of in the near future – recreational cannabis use. While not front and centre in Australia, changes in legislation in Canada and a number of states in the US mean that there is rapid growth in the industry in those markets. Indeed, many Australian asset owners with international holdings are likely to be exposed to cannabis companies. Recreational cannabis use has most of the negative characteristics of tobacco and alcohol consumption and while the industry is currently in a honeymoon period, cannabis is likely to be an addition to future screening discussions for asset owners around the world.


Questioning Sin

This article is not advocating a particular stance on any of these issues. Rather, we are encouraging investors to take more time and care when developing policy on values-based investment questions.

The approach outlined above can be applied to a range of different questions that regularly arise in responsible investment, and is particularly relevant to those questions where a clear investment (read financial) case for screening is difficult to construct. For instance, controversial weapons are clearly something that investors are concerned about, but there is little evidence that divesting these stocks will reduce portfolio downside risks. Utilising the above approach can assist to frame the discussion about potential screens or engagement on these sorts of issues.

As responsible investment becomes the mainstream, investors are naturally starting to express interest in the issues that get them excited, beyond bland discussions of risks and returns. The finance sector has some of the strongest analytical capacities in our economy. There is an exciting opportunity for these skills to be applied to some of societies’ more intractable problems, but first we must maintain the discipline of considering them at a societal level rather than dismissing their harms as the failures of weak individuals.


Interested in discussing this issue further? Feel free to get in touch.

CAER is able to work with clients to determine the responsible investment (RI) approaches best suited to their business.

You may also like: My Portfolio is Going to Pot!

Duncan Paterson

Author: Duncan Paterson

Duncan Paterson
Executive Director