Ethical considerations aside, the call to exclude weapons companies reflects an issue ESG investing has caused both active and passive investing.
Stockmarket indices should automatically exclude companies involved in the production of “controversial weapons”, according to an open letter signed by 140 asset and wealth managers, published by Swiss Sustainable Finance.
The letter calls upon market index providers such as FTSE Russell, Morningstar, MSCI, S&P Dow Jones and Stoxx to no longer include “controversial weapons” companies in their main indices. Signatories of the letter represent a total $6.8 trillion worth of assets and include big names such as Pictet Asset Management and Credit Suisse.
According to the letter: “There is a growing consensus among financial regulators, asset managers and end investors to invest responsibly. Excluding companies with any involvement in the production of controversial weapons is a key part of that.”
These weapons include cluster munitions and anti-personnel mines, as well as chemical, biological and nuclear weapons. Such weapons are deemed to cause “indiscriminate or disproportionate harm”, with their use often banned by international conventions.
Inclusion of “controversial weapons” companies in large indices contributes to their financing, the letter says, adding: “The financial industry is in a position to make a huge difference to responsible investing, and that should include making funding less easily available for such companies.”
“We therefore call upon index providers to remove companies involved in controversial weapons from mainstream indices, and to engage in dialogue with asset owners and asset managers on using these indices for benchmarking and investment solutions.”
What’s in it for fund managers?
These ethical considerations aside, the call to exclude such companies reflects an issue for asset managers caused by the rise of ESG (environmental, social and governance) investing.
Passive funds that replicate the market index will, by default, have a holding in companies deemed to fall foul of ESG rules so long as they remain on the indices. This inclusion of supposedly “unethical” companies in market indices, and therefore their inclusion in passive index-tracking funds, has stoked controversy before.
Following a number of high-profile mass shootings in the US, the world’s two largest index fund providers, Vanguard and BlackRock, were criticised for the large gun manufacturers both were invested in through their passive fund products. Both offer index-trackers that exclude gun companies.
Active fund managers, though, have the choice not to include such companies. They use indices as a benchmark from which they can deviate.
However, in reality, many managers don’t like to stray too far from their benchmark. Too much deviation leaves them at risk of underperforming their benchmark. As the letter notes: “for active investors using standard benchmarks, excluding these companies means exposing portfolios to extra tracking error.”
Of course, fund managers could always instead opt for ESG-friendly benchmarks which screen out “unethical” firms. Indeed, increasingly investment companies have started to talk of ESG considerations being baked into their entire investment process, whether for ESG-specific funds or not.
The line being taken by many investment firms is that ESG acts a form of quality control, with companies that stack up best on ESG metrics also exhibiting quality and robustness in other traditional measures. But such investment funds may not wish to be benchmarked with an explicitly ESG-focused index for fear of being seen as a fund overly focused on green investments.
So instead such funds have to benchmark against an index that includes companies they are not allowed to invest in. If a group of companies that the fund cannot invest in end up outperforming other companies in the benchmark (depending on weighting and extent of outperformance), the fund’s portfolio may end up underperforming the general benchmark. With fund managers paid fees to outperform their benchmark, such an outcome is likely to make for disgruntled clients.
Currently, the “controversial weapons” companies only constitute a small part of most indices, making such an outcome less likely. However, if ESG investing continues to gain traction it is likely that both the definition of what constitutes an “unethical” company will continue to expand while the number of funds restricted from investing in such companies will continue to grow. And with that, so too with calls from the exclusion of such companies from the indices.