Heather Lamont describes how schools can ensure they are responsible investors as well as protecting their portfolios

Most investors and the investment industry no longer feel the need to ask “Do we want to invest ethically?” It should be reasonable to assume that we aim to act ethically in all aspects of our conduct, including managing investment portfolios. But the debate hasn’t stopped, it has just moved on. What’s changed, and what are school and charity investors talking about now?

There was a time when ‘ethical investment’ was shorthand for avoiding investment in certain companies because of the nature of the business they carried out. Tobacco companies have long since been excluded from most charitable portfolios, and some organisations would also have concerns around activities including alcohol, armaments or gambling for example.

However equating this approach, which is often known as negative screening, with a definition of ‘ethical investment’ has created a number of problems.

 From the start

First, some school boards would struggle to agree on what types of company should be excluded from investment. The question “Who’s to say what’s ethical?” has echoed down many a corridor. Admittedly it would often be asked by the most sceptical governor in the room, whose view was really that you shouldn’t be considering the ethical aspects of investing in the first place, and who hopes that pretending the topic is just too complex might help to close the conversation down altogether.

In fact, it shouldn’t be that difficult to identify the types of business activity you might want to avoid on the basis that they conflict with your school’s aims or because holding them would pose too great a risk to the school’s reputation. The trick is to ensure that individual trustees/governors remember they are thinking here about the school’s mission and values, not any other views or values that they might hold personally.

But it can be more of a challenge to ensure that your policy has the intended effect of protecting your reputation without excluding such a large chunk of the investment universe that your manager can’t find enough opportunities to put together a well-diversified portfolio. For example, it’s common for schools to want to avoid investing in tobacco, alcohol or gambling companies, but you wouldn’t necessarily want to rule out supermarkets or hotel and travel companies even though they also sell such products. The most common approach is to define the screen with reference to a ‘revenue threshold’ meaning that any business will be screened out if it derives more than (say) 10% of its total revenue from the activity in question.

Another practical issue to be aware of, as some high-profile charities have occasionally discovered to their embarrassment, is that it’s no longer safe to rely on any screening policy which applies only to direct holdings in individual company shares or bonds.

Almost all schools’ portfolios are in fact invested largely, if not entirely, through pooled investment funds. In recent years more attention has been paid to this area, including sometimes by campaigners who are keen to highlight any exposure that investors may have to the activities that concern them, even if only through indirect holdings within pooled funds. It could be hard to describe your approach as ‘ethical’ if your policy basically says that you’re happy to turn a blind eye to what goes on in the funds that you hold. So if you do have exclusion criteria, you will probably want to ensure that these are being applied consistently across the portfolio, or at least acknowledge the reputational risk that you face if pooled funds are not screened according to the criteria set out in your policy.

It’s not what you do, it’s the way that you do it

Among other changes in the investment landscape has been an increasing focus by regulators and other stakeholders on standards of company policy and behaviour across a range of environmental, social and governance (ESG) practices. In other words, this isn’t primarily about what sort of business a company is in, but about how it goes about that business.

Depending on how large they are and where they are listed, publicly quoted companies have to report on an expanding range of topics such as board and employee diversity, environmental impact and supply chain issues like modern slavery. Another reason why the term ‘ethical investment’ has fallen out of use is because it is now widely understood that it’s important to assess these factors, which reflect a company’s values rather than just its financial characteristics, when making investment decisions for all investors – not just those who may want to screen out certain business activities. When everyone is taking these behavioural values into consideration, it doesn’t really make sense to think of ethical investment as a distinctive approach.

Why do these non-financial issues matter? There’s something of an overlap here between managing your school’s reputational risk – nobody wants to see a company in their portfolio hit the headlines as a result of a major scandal, for example – and managing financial risk. Companies which have very poor standards of behaviour tend to underperform over the long term. They are also more prone to financial shocks and sudden reputational damage which can destroy shareholder value.

Assessing these issues is therefore a key element of responsible investment management and good fund managers will do so as an integral part of their process.

Action, not transactions

Schools and other charitable investors are increasingly aware that investment markets and portfolios can only be as healthy as the environment and communities in which they operate, and indeed that the long-term sustainability of returns depends on there being some mitigation of systemic risks such as those arising from climate change, soaring global rates of obesity and poor mental health.

You can think all day about what’s allowed or not allowed to be held in your portfolio, but that won’t help to address wider real-world issues like these. Most investment decisions involve buying shares or other assets from other investors, or selling to them. These transactions don’t change the amount of capital that is allocated to the companies in question, whether you think they make a positive or negative contribution to the issues you’re concerned about. Even policies that aspire to include ‘positive’ investments in the portfolio tend to have very limited impact on how the world works.

Many investors and regulatory bodies have come to recognise the importance of active stewardship – using the power of asset ownership to promote positive change in standards of corporate behaviour – to help reduce the threat from these systemic risks. A number of industry-led initiatives have already demonstrated that commitment and collaboration by investment managers who engage with companies, legislators and regulators on behalf of the investment community can indeed have a positive influence on company behaviour over time.

These challenges aren’t of concern only to a self-defined subset of ‘ethical investors’ – they need to be on the agenda of every responsible long-term investor, in the interests of protecting their portfolio for the future.

Heather Lamont is a client investment director at investment company CCLA.

Heather Lamont