Some of Local Government Super’s ideas on ESG arise from a requirement that even its most red-blooded active manager must research it as part of their investment process.

Chief investment officer, Craig Turnbull, says: “We will only use managers that think about ESG factors when making their investment decisions, so that it is making a difference to their portfolio. We like them to report those issues to us too.”

The fund has been using this research since 2004 to short out Australian companies with poor ESG practices that sit in its equity manager portfolios. This practice that has gained a return of 10 basis points. This is more significant than it looks, in that it is derived from shorting only a small number of stocks.

It is part of a two-pronged approach to its environmental, social and governance strategy. The first step is to instruct its managers not to invest in companies that produce tobacco, armaments, nuclear power, old growth logging or in those that derive their income from gambling outlets. The second is to short the value of stocks held in companies that sit outside of these proscribed sectors, where research shows them to have a high risk of involvement in polluting the environment, unethical treatment of employees or the public, or from poor management structures or ethics. This shorting is done through a prime brokerage account which allows the Local Government Scheme to track profit and loss.

Turnbull says: “In this way we can measure the impact in terms of whether it is helping or hurting us.”

He describes the 10-basis-point return on shorting bad-practice Australian companies over nine years as “quite healthy” and has seen enough proof of success to extend the practice to international shares, where it has also seen a positive return after two-and-a-half years.

The overlay activity used to be a bigger operation, but with fund growth it has moved towards mandates where it can tell the fund managers to avoid certain stocks. Its depth of experience means that even when State Street runs a passive mandate with an ESG filter, Local Government Super can impose ideas based on research supplied by the super-fund-owned, ESG specialist Regnan.

“They might say ‘we really think a company is a high risk because of poor governance or board composition’; and if it rates very poorly under our policy, we take that stock out as well. In State Street’s research, they might think the company was fine,” Turnbull says.

The process of deciding which company to short follows a decision tree.

“We have set it up so there is no one person making these moral and ethical judgments,” he says. “It is either based on the activities the firms are in or in the case of the ESG research, it has to rank to a certain level; then it is just taken out.”

Currently more than half of the $7.5 billion fund is invested in responsible strategies, across the asset classes of Australian and international shares, property, absolute return, private equity and fixed interest.

Decision making

One might argue that while these shorting strategies make a profit for the fund, they do not change the world. The response from LGS is that where it sees companies taking high-risk strategies, then the board is also happy to vote against particular directors or remuneration reports.

Following the international outcry over conditions for garment factory workers in Bangladesh, the fund explored what potential exposure it had and decided to target supermarket companies selling the clothes. It became the first Australian super fund to sign the ‘Investor Statement on Bangladesh’, joining over 190 global shareholders and investors, representing more than $US1.5 trillion, in calling on brands and retailers to implement an internationally recognised core labour standard.

Turnbull says: “We not only supported a global initiative to raise awareness and lift the standards, we became a signature to that. We also wrote to Wesfarmers and had a dialogue with them. From time to time we will do that.”

The fund’s shareholder activism extends to being a shareholder in Regnan and having a high level of interaction with the Australian Council of Superannuation Investors, for whom Bill Hartnett (LGS’ sustainability manager) sits on the management committee.

Limits to the strategy

There are limits to the faith of the fund in pursuing this strategy. There have been years when it has underperformed – there is a recognition that companies with poor practices may still have bursts of outperformance – though this has not yet happened for two consecutive years.

“If it did get that far then it would get reviewed by the investment committee,” Turnbull says. “We do not want to do this if it is going to hurt returns, we are looking for a win-win situation, where, yes it is reducing our risk, but it is also contributing to the performance. This is not done just for the sake of saving the world, it is done because we are expecting to reduce our risk and to help our returns. If it looks likes it is not working it will be dropped or revised.”

Origins

The strategy came at the behest of two LGS directors, including Ian Robertson. It started with the exclusion of tobacco stocks, following a report to the board by Robertson in 2000, and then spread incrementally to gambling and armament stocks. That is not to say all on the board think alike. The debate about the effectiveness of the strategy still continues.

“Within the board there are some passionate believers who think this is the right thing to do on investment and moral grounds,” says Turnbull. “There are others who are saying ‘we can see it is reducing our risk but we do
not want it to cost returns, because that is not what the members want’.”

“It is hard to get everyone to agree, but if we are making returns it is a win-win situation; then it is hard for anyone to feel bad about it.”

The fund’s constant championing of its own ethical investing has won over members and employers and brought kudos. Turnbull cites support from councils and members for the policies. At the time of writing it was ranked second globally for its sustainable investment practices by the Climate Institute’s Asset Owners Disclosure Project.