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Australian Ethical making returns from a third of the market

David Rowley




Australian Ethical’s beliefs restrict it to a third of the companies in the ASX200, but the fund’s chief investment officer, David Macri, makes a strong defence for why it is actually better diversified than other investors.

Every company Australian Ethical invests in has to be actively contributing to the common good. Additionally, it must not pollute the atmosphere, nor exploit its workers, do harm to wildlife or make unsustainable use of the world’s resources.

Such principles means the $1.4 billion Australian Ethical fund can only invest in 76 of the stocks in the S&P/ASX 200, representing just a third of the index by market cap.

Coal, tobacco, and arms manufacturers are clearly off limits for the fund, but the business of choosing other companies is more complex. A company might, for example, be guilty of a certain amount of environmental damage, but if the bulk of its activities are for the common good then it could be investable. A borderline company that has a credible commitment and a framework for improving its ESG rating framework is better than a company with poor leadership on this issue.

It is such debates that have led the fund to invest in Westpac, but not CBA, ANZ and NAB.

The screen run over the activities of the big four banks determines whether the fund can invest in them. This breaks down the banks’ revenues between mortgage and corporate lending, as well as other sources of income such as corporate advisory, derivatives and funds management. The fund also asks how the banks include social and environmental factors in their corporate lending decisions, and how they treat customers across all their business lines, including insurance and financial planning.

David Macri, chief investment officer at Australian Ethical, says: “You can clearly see that Westpac has a genuine agenda for environmental and social considerations. We are convinced it comes from the board and senior management and it is ingrained into how they operate, whereas with CBA we have not found that to be the case. We want to see some practical implementation of the banks doing that.”

Another category of company that Australian Ethical will not choose to invest is one that is simply classified as neutral.

“It happens regularly that we do not invest in something that looks good from an investment perspective, because it does not meet one of our positive tenets of our Ethical Charter,” says Macri. “People would argue Dominos pizza [is a good investment], but we just do not see the positive in takeaway pizza.”

Where the fund’s process is more familiar is where the fund will not invest in a company that has actually passed the screen. Macri says a particularly successful decision here was not to invest in cloud accounting software firm Xero, because it could not justify share price relative to the fundamentally driven fair value of the company.

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    The fund’s starting point for its unique investment process is its 23 principles, 12 of them positive and 11 negative, which it initially wrote in 1986 (see box).

    How the principles are employed in sector and stock analysis is worked on internally by the ethical advisory group consisting of Dr Stuart Palmer, the fund’s head of ethics research; by Macri, and the fund’s chief executive Phillip Vernon. This work is supported by a full-time ethical analyst Ella McKinely and by third-party ESG research providers CAER and EIRIS.

    One of the consequences of eliminating two-thirds of the investable universe is that the fund takes a much harder look at small companies compared to other funds, with over 25 per cent of the Australian Equities allocation of the $900m superannuation fund invested in small caps. Given the greater amount of analysis needed in this part of the market, Macri goes as far as to call his five person Australian Equities team, which invests directly, as a small cap team.

    There are fewer internal resources used on picking global stocks. Until recently, the international shares portfolio was themed around the supply and demand of energy, and benchmarked to the MSCI Global Climate Index, but it will now be tailored to provide a return similar to the MSCI World Index.

    Aware of how unorthodox Australian Ethical’s portfolio looks, Macri is quick to point to results that justify the fund’s position.

    Firstly, he states that the fund’s Australian small cap portfolio has consistently delivered alpha. Secondly, he points out more conventional Australian equity portfolios are unhealthily skewed to mining and financial services companies. By contrast, the Australian Ethical Australian shares portfolio is more evenly weighted, and is a much more balanced portfolio when compared to the index.

    Macri is also a firm believer that detailed ESG research is one of the best ways of spotting long-term investment risk, so it can act on trends before other funds, notably on global warming, but also the ageing demographic. “A lot of the issues that we deal with, pretty much hinge on what the world needs to do or the way the world is going to be,” he says.

    At the end of 2015 Australian Ethical divested from companies exposed to conventional natural gas on the basis that advancements in energy storage solutions are making low-carbon energy sources unnecessary. The fund had long invested in domestic company DUET and international giants such as Tokyo Gas and Osaka Gas, on the basis that a greater use of gas would help lessen the reliance on higher-carbon emitting coal fuel power stations.

    Macri speaks of a tipping point being reached. “The amount of time and resources needed to make the transition from coal to gas might as well be spent on making the transition from coal to renewables. The amount of capital expenditure flowing to energy storage solutions has given us a high level of conviction that the timeframes for both scenarios are very similar. Advancements in technology always surpass expectations and indeed mostly follows an exponential curve,” he says.

    The Paris agreement between developed nations in November to limit a rise in climate change to 1.5 per cent was significant, as the fund believes the agreement will be a catalyst for capital markets to fund more investment in clean technology.

    “A 1.5 degree scenario is a dramatic change to the energy supply of the world,” says Macri. “It will be a fundamental change in how you measure risk.”


    Fiduciary duty

    Macri backs the radical view that not only do pension funds have an obligation to provide an optimal retirement income, but an obligation to recognise that as universal owners they will also shape the society that their retirees will enter.

    “We can direct corporates to do things in a different way, and we have to, because we are going to ‘own’ the global economy in 20 years or so, if the pension industry continues to grow,” he says.

    Hand-in-hand with this view there is a disavowal of the common belief that a maximisation of returns is the only imperative for a fiduciary investor and anything less is a breach of duty. He notes that the famous Scargill vs Cowan legal case (1985) between the trustees of the UK coal mining pension fund, which set a precedent for fiduciary investors, was effectively overturned by the UK Law Commission’s finding that a maximisation of returns should not preclude trustees from taking into account ESG factors when making investments in 2014.

    The Scargill vs Cowan case, he believes, played into the hands of chief investment officers that wanted to keep their roles as simple as possible.

    “Chief investment officers are making investment decisions, so they do not want to be distracted or clouded by other things, they see the integrity of the investment process as being paramount,” he says.

    Australian Ethical Charter

    The Australian Ethical Charter is a series of statements that guide both the positive side(investments we seek out) and the negative side (investments we avoid) of our ethical approach.

    Australian Ethical shall seek out investments which provide for and support:

    • the development of workers’ participation in the ownership and control of their work organisations and places
    • the production of high quality and properly presented products and services
    • the development of locally based ventures
    • the development of appropriate technological systems
    • the amelioration of wasteful or polluting practices
    • the development of sustainable land use and food production
    • the preservation of endangered eco-systems
    • activities which contribute to human happiness, dignity and education
    • the dignity and wellbeing of non-human animals
    • the efficient use of human waste
    • the alleviation of poverty in all its forms
    • the development and preservation of appropriate human buildings and landscape


    Australian Ethical shall avoid any investment which is considered to unnecessarily:

    • pollute land, air or water
    • destroy or waste non-recurring resources
    • extract, create, produce, manufacture, or market materials, products, goods or services which have a harmful effect on humans, non-human animals or the environment
    • market, promote or advertise, products or services in a misleading or deceitful manner
    • create markets by the promotion or advertising of unwanted products or services
    • acquire land or commodities primarily for the purpose of speculative gain
    • create, encourage or perpetuate militarism or engage in the manufacture of armaments
    • entice people into financial over-commitment
    • exploit people through the payment of low wages or the provision of poor working conditions
    • discriminate by way of race, religion or sex in employment, marketing, or advertising practices
    • contribute to the inhibition of human rights generally