Company ethics under pressure

Summary: How fund managers use positive and negative screening tools to determine company ethics by flagging environmental, social and governance (ESG) issues.

Key take-out: Ethics is still a 'shades of grey' area in investing, and different combinations of positive and negative screens can complicate the picture. 

It's routine for fund managers to dump companies based on environmental, social and governance issues, but never before have these motions warranted greater attention.

A recent high-profile example is ETF issuer BetaShares booting Facebook from its global ethical fund amid the Cambridge Analytica scandal, some questioning why it was ever included in the first place. And even more recently, closer to home, we've seen Australian Ethical divest from AMP. 

Ethics is still a ‘shades of grey' area, and applying both positive and negative screens to determine the integrity of a company may leave room for error. There's also the input-output dilemma, where results indicate poorly-run companies are doing the right thing.

ESG principles held by companies, and endorsed by fund managers, are increasingly under pressure. For a growing majority of institutional and retail investors, a good investment isn't just one that's fundamentally sound, but one that ticks all three ESG boxes. 

Fund managers sometimes wear ‘light green lenses' when selecting ethical investments. Our Big Four banks don't make the cut of most Australian ethical funds, neither payday lenders, but regional banks often do. Suncorp, for example, is the fifth-largest holding of FAIR, the BetaShares ETF focused on Australian leaders in sustainability, and Australian Ethical does invest in Westpac and NAB.

Screening ethics 

Australian Ethical's Head of Ethics Research, Stuart Palmer, says the ethical charter at his fund hasn't changed since 1986. Australian Ethical considers every investment through the screens of 12 positive principles and 11 key harms. 

Positive screens include the production of high quality and properly presented products and services, and activities that contribute to human happiness, dignity and education. 

On the flip side, companies that destroy non-recurring resources, engage in arms manufacturing, or deceive and exploit people, are banned from investment.

“When we look at any company, it's first looking at what product or service they deliver, if that's part of a positive future, and secondly, looking at how it is delivering that in a sustainable, ethical way,” says Palmer. 

“There are revenue thresholds that apply, so if you are earning 5-10 per cent of revenue from something considered positive, but the balance of what you are doing is neutral or negative, then you are obviously not going to get across the line.” 

AMP unravelled in the banking Royal Commission to come within breach of at least one-quarter of the negative screens. The company has since lost its chairman, CEO, chief legal counsel and three other directors. 

Australian Ethical cited systemic prudential and cultural issues, serious breaches of duty to clients, including fees for no service, failure to reprimand dishonest advisers and remediate clients, and keeping clients in expensive and inappropriate legacy products and platforms, as key reasons to sell down its AMP positions. 

Misleading regulators was another nail in the coffin, says Palmer, and AMP leaders broadly acting unethically to prioritise short-term profit at the expense of clients and compliance with the law.

Handshake gestures

Australian Ethical still invests in around 70 financial services entities, including residential mortgage-backed securities and retail banks. Financial services makes up the majority of the fund, however, Australian Ethical's investment in financial services is still underweight compared to the benchmark. IT, software and professional services also make up a large part of the fund.

“Governance is crucial and the engine that delivers on the objectives of the company,” says Palmer. 

“How teams manage environmental and social impacts, and indeed the financial parts of their business, that's where you can see they are thinking broadly about the license of their company and impact on stakeholders — and that is usually strong evidence about the governance of the company.

“But there's the challenge. And to actually identify good governance by shaking someone's hand, or reading the chairman's report, that can be very difficult.”

Governance matters

Up for the challenge is proxy advisory firm Ownership Matters, which has recently been raising its profile. Recently it revealed flaws in Afterpay's payment processes which prompted company action, and it was integral in flagging grave concerns about crash-and-burn startup Big Un. 

Ownership Matters identifies risk to engage with ASX 300 company directors on behalf of shareholders and hold boards accountable.

‘Pay for value' models are currently on its radar, involving the examination of bonus deferrals and clawbacks, the gaming of performance hurdles, and accounting values used for equity incentives. On that point, rich valuations attached to unlisted investments by private equity and venture capital firms are increasingly being brought into question.

Monitoring ‘the gene pool' of board appointments to better identify member skill sets, and working to improve the visibility of non-executive directors to institutional investors, is also a priority. All points that could help prevent another AMP-like situation.

More transparency

When it comes to governance, there's always more bubbling behind the scenes at some companies than retail investors are privy to. 

Why institutional investors vote a certain way at shareholder meetings, or even how they simply cast their votes, often isn't made known to the public, or at least until a much later date. This lack of transparency can make it hard for mum and dad investors to get the full picture of their investments. 

But things could be changing.

Considering the recent flurry of board activity across corporate Australia, there seems a greater chance that institutional investors will start flexing more muscle. This would help safeguard against further public spillovers, which would certainly be in the best interests of retail investors, either invested directly, through managed funds, or super funds. 

For some institutional investors, their wounds would appear much too fresh, and far too big, for them to do otherwise.