The public response to the February 14, 2018, mass shooting at Marjory Stoneman Douglas High School in Parkland, Florida, which left 17 students and teachers dead, has been swift, passionate and widespread. For many retirement plan participants and advocacy groups, the appropriate response to dealing with firearms-related investments has been to pressure their pensions and other institutional investors to divest; however, for the fiduciaries charged with making prudent financial decisions on behalf of beneficiaries, the issue is not so straightforward.

Many institutional and retail investors have responded to this tragedy by scrutinising their portfolios to assess whether they are invested in firearms manufacturers or other elements of the firearms supply chain, and to what extent. Identifying the owned securities of firearms and ammunition manufacturers is a fairly simple exercise, as these companies typically make up small portions of portfolios. However, there is the related consideration of whether a client believes firearms distributors, such as sporting goods stores, should be considered part of this analysis and what appropriate screening thresholds should be used.

Divestment as a strategy has been much discussed in recent years, particularly in relation to climate-change risk. Investors controlling more than $6 trillion in assets have divested from some form of fossil fuels to date. Investors looking to address divestment pressure or develop a proactive strategy should undertake a full-spectrum assessment of the impact of the relevant issue on the “three Rs” — risk, return and reputation.

For example, assessing risks and returns by backtesting a portfolio’s performance against various divestment scenarios can provide useful quantitative guidance regarding historical under- or outperformance trends for a given industry. However, the backtest tells only part of the risk-and-return story.

Questions to ask include whether the organisation believes an investment’s historical return patterns will continue based on current trends, and whether there are long-term systemic risks an industry might be facing that markets are not pricing into valuations. If so, divestment could serve to insulate the portfolio from abrupt policy or market shifts with potentially severe consequences and unpredictable timing. On the other hand, if the investor believes markets are efficient and unlikely to misprice systemic risks, or that these systemic risks are overstated, divestment may not be palatable.

In addition, investors may face material reputational concerns around continuing to hold an investment and may be under pressure from internal or external stakeholders to act. Such reputational risks can be significant and may warrant divestment – regardless of the potential performance impact – depending on the investor’s type, mission or strategy. For instance, foundations or endowments may determine that their future donor base or student engagement will be negatively affected if they continue to invest in sensitive industries.

If, after thorough consideration, the decision is made to divest or not divest from a sensitive investment area, a range of other questions may well arise:

If divesting

Will investment managers support a divestment request for a specific range of securities, or will such a request impede their ability to meet their investment objectives?

Large investors with custom separate account mandates should be able to implement exclusions relatively easily.

However, investors taking part in commingled investment options will first need to engage with the manager to encourage it to divest from the investments in question. The manager will have to balance that request against other considerations across the strategy and investor base.

If an investment manager is unwilling or unable to accommodate a divestment request, then seeking a new manager that excludes the investments in question may be the best approach.

In the wake of Parkland, both State Streetand BlackRockhave announced gun investment and engagement strategies in response to growing client interest in this topic.

Mercer’s long history of ESG investment strategy ratings, and access to holdings-level ESG data to support portfolio screening, can be leveraged to support any changes investors may consider. After divestment has been achieved, subsequent consideration of a broader strategy to address the sensitive issue may be warranted.

 

If not divesting

If divestment is not deemed prudent, decision-makers should consider whether other means of addressing the issue should be pursued, including:

The development of an engagement strategy that uses the investor’s access and rights as a shareholder (or debt provider) to influence the management practices of select companies or the regulations policymakers set

A program of positive investments in solution providers looking to address the issue with technology or novel business models

A hedging strategy that may result in lessening (but not eliminating) exposure to the sensitive sector

Additional approaches; for example, US-based foundations may decide to use program-related investments or grants to address the issue

Post-Parkland policy shifts by Kroger, Dick’s Sporting Goods and Walmart show that companies are listening to a range of stakeholder voices when it comes to sensitive topics – certainly including those of shareholders.

With our experience helping investors of all types and sizes develop voting and engagement policies to affect investment solutions, Mercer can assist with the design and implementation of a more holistic strategy to address the long-term management of sensitive issues[1].

 

Although firearms may be the current topic in the spotlight, a variety of stakeholders can be expected to continue to raise questions around divestment from sensitive industries. Heightened awareness, driven by social media, a rising generation of socially engaged Millennial investors and beneficiaries, and civil society’s increasing sophistication in engaging the financial services industry on ESG topics, allow scrutiny and pressure to arise more quickly than ever before.

There is no panacea for these challenges, but taking a thorough approach to analysing and debating the relevant issue can help facilitate productive and positive resolution. Even if no action is ultimately taken, thoughtful consideration of the risk, return and reputation effects of various courses of action aids fiduciaries in both making sound financial choices and proactively communicating those choices to key stakeholders.

Max Messervy is senior responsible investment consultant at Mercer.

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