By Julie Fox Gorte, Senior Vice President for Sustainable Investing at Pax World Management LLC, and Steve Falci, Chief Investment Officer of Pax World Management LLC | 3 March 2015
The New York Times Business section article entitled “Study Claims Oil Divestiture May Hurt College Endowments” on February 9 reported on a new paper, financed by the Independent Petroleum Association of America, claiming that universities that divest from fossil fuel stocks could hurt the value of their endowments. The author had to take a very precise and extremely circuitous route to reach this conclusion. We believe that there is plenty of room to achieve competitive returns while also divesting fossil fuel companies from investment portfolios.
There have been several studies over the past three years, since the beginning of the Divest Fossil Fuel campaign, that have found that fossil fuel-free or low-carbon portfolios either outperformed or performed similarly to benchmarks on a risk-adjusted basis. For example, Standard & Poor’s produces a Fossil Free Index US, which has outperformed the S&P 500 over 1, 3, 5 and 10 year periods, according to S&P1. So maybe that’s an only-in-America result? Not really. Impax Asset Management analyzed various fossil fuel-free investment options compared with the MSCI World Index, and found that all of them—including simple exclusion of all fossil fuel stocks—outperformed MSCI World2.
At this point one has to ask what route the author of this new paper had to travel to make his case. The factors that the author claims diminished the returns for endowments that divested fossil fuel stocks include: (1) diversification costs, (2) trading costs and (3) compliance costs. These are all costs factors that apply to every portfolio and every security, every day. Portfolio managers weigh these costs in every investment decision making process.
Let’s take these one by one. The performance and diversification cost arguments the author makes rely on data from 1965 -2014. On the surface what gives the appearance of a robust data sample actually provides the grounding for the central misleading arguments. That time period is dominated by the Halcyon days of oil which included explosion in demand for energy, oil shocks, little competition for fossil fuels and minimal concern (until recently) regarding carbon emissions. Does anybody believe the next 50 years or even the next 5 or 10 will look like the last 3.5 decades of the 20th century? During much of the study period, there was little opportunity to diversify into cleaner energy. In the last ten years, and certainly going forward, there are a growing number of companies providing energy efficiency and renewable technologies where investors can gain exposure to the global demand for energy. Moreover, we would argue that many of these companies providing cleaner energy are better positioned for long term growth and better returns than fossil fuel companies as we transition to a lower carbon world.
Prudent management of trading costs involves a thoughtful evaluation of the benefits of implementing an investment strategy as well as an approach to executing it in a cost efficient manner. If we are transitioning to a world where there will be increased risk for fossil fuel companies and increased opportunity for investments in cleaner energy technologies, there are positive benefits for incurring trading costs. Moreover, the transition can and should be carefully managed over time to minimize transaction costs. In fact, many portfolios hold fossil fuel stocks in the form of mega-cap companies like ExxonMobil and Shell, stocks whose liquidity is excellent and trading costs routinely low. Portfolios turn over all the time; what matters is the positive benefits that accrue to investors whether turnover is 5% or 100%.
The author’s argument on compliance costs is evidence that he is not familiar with the basics of portfolio management. Here’s what he says about compliance costs: “Investors must identify the specific securities to be divested from an existing portfolio. Moreover, because firms evolve over time and new investment opportunities arise, there will be ongoing compliance costs to ensure that the portfolio continues to meet the desired standards.” This describes what portfolio managers do for every security in every portfolio: they choose what to buy and sell, and then monitor both what is in the portfolio and what to trim, every day. That this is an added burden for a fossil free portfolio is nonsense.
The author also attempts to “prove” that green funds are more costly by comparing the expense ratios for the 10 largest mutual funds with a group of ten “green” mutual funds. All ten of the green funds are actively managed. Of the ten largest mutual funds the author lists, four are index funds, two are money market funds, and one is a cash reserve—all of these types of funds have very low expense ratios, green or not. There are only three actively managed equity funds among those listed. This is a misleading comparison.
The many studies that have been done looking at fossil fuel-free and carbon-managed portfolios don’t “prove” that fossil fuel divestment is a better strategy, any more than this study “proves” that it’s terrible. What is clear is that divestment of fossil fuel stocks and prudent, well managed reinvestment in cleaner and more efficient energy solutions can be a sound strategy for investors looking to avoid climate-related risks and capitalize on investment opportunities that are essential to our 21st century global society.
1 Source: Fossil Fuel Free Indexes, LLC, Performance Analysis, June 30, 2014. As of May 30, 2014, The S&P 500 Index returned 16.27% for the 1-year period, 45.10% for the 3-year period, 112.12% for the 5-year period, and 72.82% for the 10-year period. This is compared to the Fossil Fuel-Free Index US returns, which were 18.98% for the 1-year period, 58.43% for the 3-year period, 144.91% for the 5-year period, and 118.14% for the 10-year period.
2 “Beyond Fossil Fuels: The Investment Case for Fossil Fuel Divestment”, Impax Asset Management, http://www.impaxam.com/media-centre/white-papers/beyond-fossil-fuels-investment-case-fossil-fuel-divestment