How can trustees balance ethics and returns?

Take a cursory glance at some of the past year’s best performing sectors – oil and gas, tobacco, mining, armaments – and it’s not difficult to understand the challenges faced by charity investors with some of the most commonplace ethical restrictions, argues James Flett.

These headwinds have been compounded by the precipitous drop in portions of the market, including valuation-rich technology stocks, consumer discretionary stocks and even renewable energy investments; these tend to score well on environmental, social and governance (ESG) metrics, and it would be unusual for even the more restrictive investment policies to exclude them. The nature of market leadership so far this year, and indeed its narrowness, is a reminder that restricting large swathes of a charity’s investable universe is not necessarily without cost. At a time when inflationary pressures are already having far-reaching consequences for many charities and their beneficiaries, this will no doubt be giving trustees pause for thought.

However, with the ethics of charitable investment under increasing scrutiny, trustees may feel they are between a rock and a hard place. Despite an undoubtedly febrile political and moral backdrop, where reputations can be seemingly dismantled in one tweet, trustees are under pressure to develop bulletproof ethical policies, while delivering attractive returns. More than ever, trying to weigh the uncertain financial implications of an ethical policy against a charity’s values, purpose and the interests of its stakeholders is an unenviable balancing act. So what information can investment managers provide to help trustees in their quandary?

Screening tools

Clearly, trying to predict the precise impact an ethical policy will have on returns is an impossible task. However, investing is often less about predicting the future than it is about balancing risk. Furnished with a better understanding of these risks, trustees can ensure they are better positioned to make more informed decisions.

As a first step, it pays to understand the proportion of a charity’s investable universe which would be excluded by a given restriction. Using screening tools, the remaining universe can then be compared to the charity’s chosen benchmark to understand how performance might differ over time and in different market conditions. It will in turn help trustees understand whether they are restricting, for example, significant income paying sectors and the likely impact this will have on the portfolio yield. More generally, it can help trustees assess the extent to which the applied restrictions would limit diversification by sector, style or region.

Screening tools can additionally show trustees the specific companies which are being restricted and those that are not, and this will vary depending on how the restriction is formulated. Using this information can allow trustees to calibrate restrictions more precisely and avoid unintended consequences.

Let’s take the relatively straightforward example of a charity which wishes to exclude tobacco stocks. There are a variety of ways this could be formulated. If the charity takes a zero-tolerance approach to tobacco, then as well as excluding the major manufacturers, it would also exclude supermarkets like Tesco or Sainsbury’s which stock tobacco, oil majors whose petrol stations sell cigarettes, and even Amazon. One might instead apply a revenue threshold to ensure only the major tobacco manufacturers are excluded. In other more complex areas, the difference between a 5%, 10% or 25% revenue threshold might look profoundly different. Understanding how a given restriction translates in practice can therefore be an invaluable exercise in evaluating the financial implications of your ethical policy and how this impacts diversification and risk.

Managing conflicts

The other side of this balancing act is no less complex. Determining which stocks and sectors may conflict with a charity’s values, purposes or stakeholders can be a difficult exercise. The recent case of Butler-Sloss and Ors v Charity Commission for England and Wales and Anor served as a reminder that the overriding duty of trustees is to further the charitable purposes, and that this ordinarily means “maximising financial returns” ¹. This principle simply emphasises the importance of prioritising the specific ‘good’ of furthering the charity’s defined purpose, over more nebulous, subjective concepts of investing in the ‘right’ companies. However, the judgement also reconfirmed the wide discretion trustees have in making non-financial or ethical investment decisions.

Of course, for many charities, the red lines on investment are entirely straightforward and periods of short-term underperformance should never be an invitation to throw the baby out with the bathwater. Where there are grey areas, it is imperative that trustees leave subjective views to one side and look objectively at the charity’s purposes to identify direct conflicts, or clear reputational risks.

Indeed, the Butler-Sloss judgement urged considerable caution when making decisions on purely moral grounds. Given the scale of many multinational, publicly traded companies, the breadth of their operations and the complexity of supply chains, the issues are rarely as black and white as they may seem. Fossil fuel companies are some of the biggest investors in green energy; weapons manufacturers supply countries like Ukraine to defend themselves; miners, despite their enormous carbon footprint, will be an essential player in the global energy transition.

Understanding your portfolio at a more granular level can help trustees decide whether companies are behaving in a manner that is consistent with their values and those of their stakeholders. Investment professionals can provide ESG screens, for example, which can be a useful starting point in understanding the behaviour, policies, controversies, and commitments of certain companies. Charities may look only to invest in ‘best-in-class’ investments, or even seek to influence behaviour through a policy of active ownership, by engaging with companies directly or via their investment manager, rather than imposing outright restrictions.

These are thorny issues, but with a deeper and more nuanced understanding of existing or prospective investments, trustees will be in a stronger position to decide how comfortably specific corporate activities sit alongside the charity’s values.

Conclusion

Ultimately, there is no right or wrong in balancing the equation and no playbook which will ever guarantee the perfect investment policy. However, with the right advice, trustees can at least ensure better and, crucially, more defensible decisions are taken. Maintaining a robust and comprehensive ethical policy is not always the easy thing to do, but it is always the right thing to do.

¹ http://www.bailii.org/ew/cases/EWHC/Ch/2022/974.html

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