InvestSMART's ethical investing philosophy

Nathan Bell is the Senior Portfolio Manager at InvestSMART and manages their Ethical Share Fund. Alan Kohler spoke to Nathan to find out more about it.

The Initial Offer for our Ethical Share Fund is open! Click here to invest now. 

Hello I'm Alan Kohler, Editor in Chief of InvestSMART and I'm talking to Nathan Bell, Senior Portfolio Manager, about our new ethical share fund called INES.  G’day Nathan.

Hi Alan.

It's an active ETF.  Perhaps we better start by explaining what is an active ETF?  How does it differ from a normal, inactive ETF?

So, basically the difference is that the portfolio in the background will be actively managed by myself and so I should be moving shares around depending on the value and what looks good and what doesn't. Compared to a normal ETF, a normal ETF would just copy essentially an index or an industry perhaps, so it's what we call a passive ETF.  But we're actively - and with a passive ETF you're really just trying to mimic the return of a certain index or industry.  Whereas we're actually trying to outperform the market so that's why we actively manage it. Our investors don't have to worry about any of that stuff. 

I take it it's different to a listed investment company as well?

Yeah, it's a different structure.  But it's still the same orientation I think with most LICs they're normally listed by active managers but we have a much lower fee structure which I'm sure investors will be happy about. 

Also, LIC's do trade at a premium or discount to net asset value but an ETF does not, I guess that applies to yours?

Yeah, that's exactly right.  So, we've got people in the background working to make sure that people are buying in at net tangible asset value so unfortunately you can't get those big discounts that occasionally come, but at the same time you won't be paying a premium for the portfolio either. 

Let's talk about what you'll be buying in the fund, ethical share funds, does it mean simply a screen that there are things that you don't invest in, or is it more positive than that?

We've taken the approach of applying a negative screen, basically to the ASX 300 stocks.  This is not where the secret sauce in our investment process is, we're essentially just trying to mimic what the industry does, and that's just look at those 300 stocks, take out what's widely agreed to be the unethical stocks, or the stocks that don't pass the ESG filters, that's Environmental, Societal, and Governance risk factors.  Then we're left with a number of companies, let's call it 200 or 220 stocks from the 300, and then we apply the same Intelligent Investor investment process that we've had for nearly 20 years now, which is a value investing-based process, and we apply that to the stocks so we can come up with a portfolio that hopefully is almost completely free from the risk applied to those ESG factors. 

Now take us through the screen that you use, what are the things that you don't invest in?

Yeah, in Australia it's mostly the gambling and casino companies, we've also got some alcohol exposure like Treasury Wine Estate so that clearly that won't pass.  We've got the gambling, we don't have any tobacco stocks in Australia but they're a common one overseas and any of the pokies’ companies, Aristocrat Leisure, these types of companies simply don't pass the filters.  I think where it gets a little more interesting is where a company like Coles for example, has say 7% of its operating earnings come from alcohol sales, now theoretically that would be open to be invested in with the fund because we've basically kept it fairly loose and said when a company makes most of its profits from these non-ESG sources then we won't invest in it. 

But in reality, we've been running a portfolio in the background now for a few months and there's essentially zero exposure to any of these factors.  Part of the reason is that it's a growth portfolio as opposed to an income portfolio, it's trying to invest in sunshine industries rather than sunset industries. It typically is a lot of resources companies, for example, coal companies that are on the nose with the government, and these are the types of business tend to be in those sunset industries, which are the ones that we'll be avoiding. 

You don't invest in any resources stocks, I guess Intelligent Investor doesn't really invest in resources stocks anyway does it? 

No, so the way when I first got talking with our CEO about running this fund 6 months ago, I was trying to look for a unique way to actually convince not only investors but myself that we weren't going to be giving up returns by taking on this process, and so I went back through the 420 buy recommendations for Intelligent Investor that go back to around 2001, and I applied the ESG negative screen to it and worked out that the average return from the companies or the recommendations that had passed the ESG screen was 14.8% annualised.  I compared that to those stocks which was about 60 of the 420 that didn't pass the ESG screen and the returns from that group of stocks was 10.1%.  It was an almost 5% gap between the two groups of companies, which tells me that it's not just about ESG factors or the risk factors, but generally the really good businesses are not resources companies they're the ones that can produce consistent profits over long periods of time, they can control the pricing of their products, and I think that's as much as anything of why we've made such good returns.  But had we applied these ESG filters to our recommendations over that 20-year period we would have done even better for our investors. 

Well that's really counter-intuitive I think the conventional wisdom would say that ethical investing costs you money, or at least costs you return, your research suggests that that’s not the case?

I think any time you diminish the amount of stocks that you can choose from, so you limit your choices with investing, and you take away that flexibility, I think almost always the outcome is that reduced choices means lower returns.  But, in this case what I think this actually does is remove a lot of risks from the business and we've seen the Hayne Commission come out and basically go through the financial services companies looking for businesses doing the wrong thing, but it's just not governments coming for these types of businesses that are seen to be doing the wrong thing. 

But if you look at companies like Coca-Cola, which Warren Buffett always used as an example of the best company in the world because every year you could put up the price of a can of Coke by one or two cents and no-one would care.  Then all of a sudden people started worrying about sugar and diets so we started seeing sugar taxes around the world.  That put pressure on selling soft drink, so Coca-Cola was very smart and got ahead of this and started selling bottled water which we pay a fortune for.  But now what's happened with bottled water is that the actual bottles, the plastic bottles are causing an environmental impact so again, people are looking to use less plastic bottles.  I think it's a really key point that these ESG factors, it's not just environmental but it's about societal standards and also governance. These risk factors are becoming increasingly important because they're essentially lowering the profits and dividends of companies. 

Would a plastic packaging company pass your screen at the moment? 

Amcor is one we hold in our growth and income portfolio's but it won't be in the ethical portfolio.  I know they're looking at trying to do a lot more recycling and making products from old materials, but it makes most of its money from new plastics and it's certainly something that going to be cracked down on and, for anyone whose been around probably Sydney or Melbourne or Brisbane and gone into a bar recently you've probably had to drink your cocktail with a steel straw which shows you that this is a real thing and is going to become much more important

Yes, indeed and I suppose what you're saying also is that the risks are greater in the future.  For example, I wonder whether the banks and AMP would pass your screen?

Technically there's actually nothing wrong with banks or insurance companies, for example it's really the culture that's really bad and rotten in those companies and we've seen CEOs get kicked out of the companies and we're seeing huge management change at AMP so they would actually be potential candidates.

The problem with the banks is that they're purely just yield vehicles and they're definitely not growth companies at this point in the cycle so technically they could be invested in, but one thing I think which really shows how important this governance stuff is was that the CEO, Andrew Thorburn of NAB, basically got the boot for the way it handled the Hayne Commission which was very poorly. I thought the greatest thing, because I hadn't actually seen this in my career so far, was that he had a potential $22 million share payout that he supposedly earned for his four years at the company, and yet we always see these managers leaving with a golden handshake even if they've performed really poorly as Andrew had done.  The NAB share price had suffered and so had its returns for shareholders, and yet this was the first time I recall that the company said "you're not getting the $22 million, you just need to leave".  This shows you how important this governance thing is, because once these items start affecting CEO pay packets, to me that's when you're really going to start to see change

Some of these companies, like NAB, could be up for a second strike on their remuneration report at this year's annual meeting. 

Well it's a great point because are you really surprised when the Chairman and the CEO of NAB are both gone after, in December there was a shareholder vote of 88%, I think was the number, against the remuneration report.  I thought this was absolutely wonderful that shows that institutional shareholders are helping and leading smaller shareholders to actually have an impact on who’s on the board and who is running these companies which is a great thing and it should have been happening for a long time, but it finally feels like, as a small shareholder, you can actually get some change. 

What is the fee for the new ethical fund

There's absolutely no performance fee which for anyone who attended our recent roadshows will know that's a big part of what takes away your returns over time and there's a fixed management fee of 0.97%. 

When will the offer open? 

The offer opens on 29th of April, so we're only a couple of weeks away so hopefully people have got their expressions of interest in, and if they invest through the initial process then you'll save on brokerage fees. 

Well there you go everyone, get in your expression of interest and you'll be kept informed.  The offer opens on 29th of April.  Thanks very much Nathan, great to talk. 

Thanks, Alan, and I'll just tell people that I will be investing in the fund which is probably the most common question I've been asked so far

And so will I, as a matter of fact.  That's good, so part of my wealth is in your hands Nathan.

I appreciate it.  I appreciate the support and no pressure.

That's right, no pressure, thanks a lot.

Thanks Alan.

If you're interested in investing in our Ethical Share Fund, click here to register your interest and to be notified once the Initial Offer opens on Monday, 29th April 2019. 

Please note all information given is general advice only, and may not suit your current financial situation.  For more information please visit www.investsmart.com.au


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