Is 'not so bad' a good investment?
Some activist funds buy 'good' firms in 'bad' industries to push for change from within. But critics say the strategy, called 'best in class,' makes it hard for investors to properly diversify and doesn't generate much change within the companies.
For three decades, investors keen to build a better world have grudgingly held stocks in less-than-perfect industries. Owning shares, they've hoped, would afford them two good things: solid performance via diversification and an insider voice to encourage best practices at firms that just might listen.Skip to next paragraph
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But activists say too little has come of this "best in class" approach, which supports the least-bad actors in a range of industries from oil and gas to mining. New portfolio research suggests the strategy might be overrated.
"There is more of a challenge being applied to best in class" as a strategy, says Ominder Dhillon, head of distribution for Impax Asset Management, a London-based firm. "In a low-growth world, are all sectors going to generate growth in similar amounts? I don't think so. So we have to focus our efforts on those areas that have the best prospects."
As best in class faces fresh scrutiny, a longstanding pillar of socially responsible investing (SRI) is being questioned. Stakeholders are asking whether investors need exposure to all major sectors, even problematic ones, and what difference those investments really make.
Among the factors driving this reexamination is a new push for divestment from environmental activists. Nearly 500 local campaigns have cropped up to urge governments, religious institutions, and other institutional investors to phase out their fossil-fuel holdings, including equity shares and bonds issued by some of the world's largest blue-chip companies.
Proponents of best in class say the method is as effective and important as ever. It's commonly used in SRI mutual funds. The Legg Mason Social Awareness Fund, for example, has had at least six oil industry holdings this year, including Apache Corp. and Schlumberger Ltd., among its top 20 holdings. The fund has latitude to invest in any industry, even weapons manufacturing, as long as analysts deem a stock ranks higher than its peers on social or environmental benchmarks.
Best in class has a financial raison d'être: performance. Portfolio theorists agree diversification helps mitigate risk. A portfolio that shuns particular sectors in the name of social responsibility theoretically runs higher risks – though not necessarily much higher – than one with broad market exposure for weathering ups and downs.
"The basic story that one needs to have a well-diversified portfolio hasn't changed," says Christian Lundblad, a finance professor at the University of North Carolina at Chapel Hill. "People still buy in deeply to that argument, and the research hasn't altered at all."
New studies suggest, however, that the upside to owning all sectors can be small and is sometimes offset by sector-specific risks. For example, dropping exposure to small controversial sectors – such as tobacco – doesn't devastate portfolios, according to research from Aperio Group, an investment management firm in Sausalito, Calif.
It's riskier to eliminate large sectors of the economy, such as energy or financials, according to Aperio Group's chief investment officer, Patrick Geddes. But many risks can be managed, Mr. Geddes says, by overweighting elsewhere to compensate for what's been removed, such as by increasing exposure to comparable large cap international stocks in other industries. Hence investors need not assume they must have exposure across the board.