Divest or Engage? Our Advice for Institutional Investors
The recent spate of deadly shootings in the U.S.—especially those involving schoolchildren—has prompted some institutional investors to ask about ways to use their portfolio assets to signal they would like to see meaningful change related to firearms and their role in society. While the notion of wielding shareholder influence to sway corporate policies is not new, it is being considered to a greater degree in the debate around gun violence.
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Much of the coverage on this issue centers on divestment. For some asset owners, divestment may be reasonable, but for many it is neither a prudent nor reasonable course of action. Alternatively, engagement may be an effective means of achieving a social objective while staying true to the fund’s goals.
What Are the Options?
Investors should consider their investment mandate (i.e., the fiduciary duty of the fund to its beneficiaries), fund size, existing investment vehicles and relationships, exposure to gun-related securities, and other factors when assessing their options:
- Use investments in gun manufacturers and related areas to influence their policies through engagement or proxy voting.
- Divest of holdings in gun manufacturers and related areas with a thorough policy on which holdings to exclude and a clear understanding of the implementation challenges.
- Pursue a combination of engagement and divestment.
- Make no changes to current investments and pursue other means to express their views, such as political or regulatory change.
Investors should understand that both engagement and divestment can expose them to “headline risk” from either side of the gun debate, whether from being associated with companies that have a negative public perception or from taking an activist stance in divesting from them. This should factor into their decision-making.
How Can My Fund Engage?
Engagement typically takes one of two forms:
- Communicate to investment managers that this issue is important to the fund, and find out what they are doing and how they are engaging with companies on the issue.
- Use third-party services, such as Institutional Shareholder Services, Glass Lewis, or Egan-Jones Proxy Services, to outline goals and implement solutions around civilian gun violence using proxy voting and other solutions.
What About Divesting?
Divestment is very often a less-than-desirable strategy due to both the financial impact and administrative burden it can bring to an asset owner. In addition, divestment removes the possibility of engagement to try to enact change.
For funds that opt to pursue divestment, they will need to define which companies or industries will fall under the funds’ exclusionary definition (e.g., gun manufacturers, retailers, ammunition manufacturers, suppliers, etc.), and determine what revenue thresholds to use in deciding how central gun sales or manufacturing is to a company’s core business. For example, Walmart is a large gun and ammunition retailer in absolute sales and dollars, but the revenue to the company is small as a percentage of its total sales).
Funds then would need to create customized indices that screen out critical areas by industry, sub-industry, or company (stock). One issue to consider: Privately held gun companies would not be screened out as they are not included in equity index universes, and there are a number of such firms. In practice, gun-related exposure in major indices is extremely small at around half a percentage point (0.5%) for both the MSCI ACWI Index and the Russell 3000, and that is primarily reflective of Walmart; active managers might have more substantial holdings, depending on the strategy. Another consideration is bonds issued by private and public companies.
Investors weighing divestment should also consider:
- Questionable impact: Will divesting certain stocks or sectors have a lasting impact on furthering social goals? Is the size of the investment material, or would the institutional investor have to band together with others to gain materiality?
- Critical scrutiny: Some institutional investors, public pension funds in particular, have faced scrutiny due to underfunded plans and fund management decisions, causing critics to question the appropriateness of factoring strictly non-financial information into investment decision-making. They point out that fund beneficiaries and taxpayers will ultimately pay the cost of any poor and costly decisions.
- Fund focus: Most institutional funds were not created to serve as vehicles for social policy but rather to provide retirement income or fund another explicit goal.
- Fiduciary duty: Laws governing pension funds typically require those overseeing investment decisions to do so to fulfill the purpose of each trust or fund and not for any other purpose.
- Costs: Transaction costs vary depending on how many securities and funds are involved.
- Internal resources: Many funds lack the internal resources to address divestment. This can be outsourced but those costs will need to be considered. Divestment decisions must be reviewed regularly to ensure they are current.
Importantly, any fund considering divestment should start by documenting a policy that includes a consideration process to follow before making a decision. This helps prevent emotional reactions.
Implementation can vary substantially by asset class and vehicle type. Publicly traded securities held in a separately managed account present the most straightforward example, as the investor could work directly with the investment manager to remove objectionable securities from the portfolio. But investments in pooled or 40 Act vehicles make divestment of specific securities extremely difficult, as one investor does not have the flexibility to dictate which specific securities are included in the strategy. In these cases an investor may need to divest of the entire fund to avoid prohibited securities.
For more information about Callan's approach to environmental, social, and governance issues, please see our web page here.