The only ones to suffer will be colleges that earn less money for research, services and student scholarships.
Global Divestment Day will kick off on Friday. In the run-up to this two-day event, college administrators are coming under increasing pressure to accede to climate activists’ demands and sell off the fossil-fuel-related equities in their endowments. Should they?
Any rational investor should make a clear-eyed comparison between the potential benefits and costs of a divestment strategy. A new study that I and my colleagues at Compass Lexecon released on Tuesday indicates that fossil-fuel divestment could significantly harm an investment portfolio.
No single piece of financial advice is more widely accepted by academics and savvy investors than portfolio diversification to increase returns and manage risk.Divestment advocates typically assume that investors can exclude fossil-fuel stocks with little or no loss. One California-based investment manager, for example, was quoted in a recent Rolling Stone article as saying that divestment would have “very low impact. If you take the fossil-fuel companies out, you’re still very well diversified.“
Our research shows the opposite: Of the 10 major industry sectors in the U.S. equity markets, energy has the lowest correlation with all others–which means it has the largest potential diversification benefit. The sector with the second-lowest correlation with others is utilities, which includes many fossil-fuel divestment targets such as Southern Co. and Duke Energy.
How does divestment affect portfolio performance? To get at this question, we constructed a model to track the performance of two hypothetical investment portfolios over a 50-year period: one that included energy-related stocks, and another that did not.What we found is that the optimal portfolio, which included energy stocks, generated average returns 0.7 percentage points greater than portfolios that excluded them on an absolute basis. In other words, the “divested“ portfolio lost roughly 70 basis points compared with the optimal one–70 basis points for each year over the 50-year period in which the portfolios were active.
A lower return is only one cost that institutions considering divestment should evaluate. Another is the costs associated with complying with such a policy, including the fees required to actively manage the portfolio to ensure it remains fossil-fuel free. The question of which companies have unacceptable “fossil fuel exposure“ is not simple in most cases. For instance, what about an oil-andgas company that also performs substantial “green“ energy research? What about an automobile manufacturer? What about a bank that holds the debt of an oil-and gas firm? What about index funds?
Precisely because these questions are hard, management fees charged by mutual funds with an environmental focus appear to be, on average, greater than those funds without such a focus. Our research indicates that the largest “green“ funds have average expenses three times greater than those of the largest mutual funds that invest in energy firms. This may be why, in announcing their decision in November not to divest from fossil-fuel related stocks, the board of trustees at American University in Washington, D.C., indicated that divestment would “cause manager fees to double.“
The potential for lower investment returns after divestment is real, and substantial. The National Association of College and University Business Officers (Nacubo) has estimated the assets in university endowments to be $456 billion. A 0.7% decrease in the collective portfolio performance of these endowments would decrease annual growth by nearly $3.2 billion annually. Nacubo has estimated $22 billion in university endowments are invested in energy stocks. An increase in compliance or management costs of 1% to maintain a fossil-fuel-free endowment would further decrease annual growth by an additional $220 million. A reduction in wealth of this magnitude could have a substantial impact on the ability of universities to achieve their goals, such as the research, services and scholarships that they offer.
What benefit would investors serve by incurring these losses?
Divestment activists claim that fossil-fuel stocks are certain to decline as regulatory or consumer behavior changes. The problem here is that current stock prices already incorporate broad market expectations about the future of the industry–expectations that include knowledge about possible political or consumer changes. In short, assertions about the future valuations of fossil-fuel (or any) companies are about as reliable as your Uncle Ernie’s latest hot stock tip.
Can divestment make fossilfuel-related companies change their ways? Even activists acknowledge that divestment is more about stigmatizing fossilfuel companies and might not have a direct financial impact on them. On this point, at least, they’re right. Over the long run, stock prices are primarily driven by fundamentals, not the decisions of particular investors to hold or sell. Moreover, the vast majority of institutions currently attempting to implement fossil-fuel divestment policies hold a very small share of stock in the companies that are targets of the campaign.Divestment would have little or no effect on company share prices.
Every bit of economic and quantitative evidence available to us today shows that the only entities punished under a fossil-fuel divestment regime are the schools actually doing the divesting–with virtually no discernible impact on the targeted companies. Students and universities may nevertheless wish to make a symbolic or political statement, but they should know it will come at a high price.Talk is cheap, but divestiture is not.Mr. Fischel is chairman and president of Compass Lexecon, an economic consultancy firm, and emeritus professor at the University of Chicago Law School. The report discussed in this op-ed, “Fossil Fuel Divestment: A Costly and Ineffective Investment Strategy,“ was financed by the Independent Petroleum Association of America.
Source: AWSJ, Feb 11, 2015