Investment returns Vs principles: and the winner is…

Back to the real, post-Olympics, world now, which is such a shame, since it was great living in a bubble where the daily news was led with positive stories of athletic endeavours, national pride and unity, which really made you feel good. Being constantly in the mood to celebrate was fantastic and very uplifting, and wasn’t it so nice to have escaped from the normal ‘bad news’ approach to reporting. Oh well, I guess we all knew it couldn’t last.

Olympics aside, there have been two news stories in the last couple of weeks that were higher profile than most – the Pussy Riot trial in Russia, essentially dealing with freedom of expression, and the trial of Gu Kailai in China, for the murder of British businessman Neil Heywood. I expect most people will be familiar with each story, and so won’t spend time going over them – you can always go to the BBC website if you want to read more on each.

Why am I highlighting these in an LGPS investment blog? Simply because they serve to remind us of the significant political/reputational/societal issues and risks that can, and do, exist in some ‘emerging market’ countries – indeed, these two trials reflect poorly on two key ‘BRIC’ countries!

Would it be fair to say that such risks have been, to date, pretty much glossed over by the vast majority of mainstream institutional investors and their agents, investment managers, in the pursuit of investment opportunities? If so, the question I now pose is – is that the right approach to be taken by long term investors?

Over the years I’ve occasionally (in all honesty, not that often) thought about the conflict between securing a decent investment return for the pension scheme members, versus the various potential risks of making any investment – and for the most part, it hasn’t bothered me too much. Let’s take tobacco as an example. Well, I might have said – on the face of it people choose to smoke, and as a sector it generates a significant dividend yield – something which funds may find even more attractive if they enter a cashflow negative world, and they need investment income to pay benefits. So, as long as the tobacco companies governance standards are high, and they are not permitted to sell cigarettes to minors, and stay away from underhand advertising in developing markets, etc etc etc, tobacco shares seem a reasonable investment opportunity.

Most people will be familiar with the standard line, supported by court rulings to date, that scheme trustees primary concern is to try to secure decent investment returns on behalf of the scheme members, with all other considerations being secondary. I’m beginning to form the view that, in this new age of globalisation, this has been too narrow an interpretation of fiduciary duty, and that such a line of defence will not – and surely cannot – hold for that much longer.

As the globalisation effect on financial markets has progressed over the last 20 years, most LGPS schemes have overseen a corresponding expansion of the list of countries in which their agents invest on their behalf. However, how many schemes have considered the overall ‘appropriateness’ of some of the countries in which they now invest?

For example – most LGPS funds will have some exposure to emerging market equities, or indeed debt, either on a passive or actively managed basis. Here’s a list of the constituents of the MSCI Emerging Markets index, with each country’s corresponding rank from Transparency International’s 2011 Corruption Perceptions Index*. The BRIC countries are highlighted:

*The Corruption Perceptions Index ranks countries/territories based on how corrupt their public sector is perceived to be. A country/territory’s score indicates the perceived level of public sector corruption on a scale of 0 – 10, where 0 means that a country is perceived as highly corrupt and 10 means that a country is perceived as very clean. A country’s rank indicates its position relative to the other 183 countries/territories included in the index.

As can be seen from the information in the table, Brazil has a marginally less corrupt public sector than China, which has a marginally less corrupt public sector than India, which has a marginally less corrupt public sector than Russia, which has a pretty corrupt public sector. The public sector, by definition, is run from the very top of the political structure in each country, and so what does that say about governance standards in investors’ supposed favourite emerging markets?

Are we all aware that, in seeking investment returns from across the globe, we seem to be unconditionally financially supporting some questionable regimes? What about the citizens of the developing nations around the world? Are their best interests served by this seemingly unconditional flow of capital into their respective countries? Are their living standards improving? And by that I don’t just mean with access to clean water, sanitation, healthcare, education etc…

Oh, just by way of comparison, here’s some familiar names:

There are of course other statistics and indices out there which measure the various components of each country’s ‘national character’, as it might be described. But does your fund, or your agents, make use of them, or indeed take them into account in any way? Is it defensible in the long term that public sector pension funds seek to make investment returns in overseas territories, regardless of how each country is governed? Regardless of how it treats its citizens? How much freedom it allows its press? How little it does to enshrine the rights of its citizens?

Is there an argument that we should collectively and individually put a bit more thought into where we invest our members’ hard earned and well deserved retirement assets, so that they have a decent income in retirement without negatively impacting the lives or destroying the rights of others, and feeding political corruption around the world?

Just a daydream? Many, I suspect, will say so.

Having reread this latest blog, some might say it comes across as ‘left leaning’, which may or may not be a bad thing, depending on your political persuasion. One good thing I’ve just thought of is that I won’t be put in prison for publicly criticising the UK for having the 167^th most corrupt public sector in the world. Another good thing is that you won’t be put in prison for reading it.

David Crum spent 11 years working in the LGPS for the Lothian and Strathclyde Pension Funds, and 5 years as an investment consultant with Aon Hewitt. He is now the founding Director of 330 Consulting Limited

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The Local Authority Treasurers’ Investment Forum September 25th, 2012, London Stock Exchange
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