The Skorina Report: Divestment vs. Fiduciary Duty Whose Money is it?

SkorinaWhat the divestment debate comes down to is how boards define their fiduciary duty.

[Spoiler: We don’t think divestment is a good idea]

We’re recruiters in the business of finding chief investment officers and senior asset managers, and our readers worry more about investing than divesting.  So you may be forgiven if you overlooked Global Divestment Day on Friday, February 13.

It was spearheaded by Bill McKibben’s 350.org/Fossil Free group with support from many other Green enthusiasts.  Mr. McKibben is the Pied Piper of the anti-fossil-fuel movement.  He has been barnstorming the nation’s campuses for years rallying local activists and pressuring boards to remove traditional energy investments from endowment portfolios.

We had our say about the divesters a while back in Skorina Letter 50. Today, we think it’s worth another look.

For one thing, an important new paper was published just ahead of Divestment Day and anyone who has to grapple with this issue should take a look at it.

The economic consultant firm Compass Lexecon issued Fossil Fuel Divestment: A Costly and Ineffective Investment Strategy under the byline of its president Daniel R. Fischel, formerly a professor at University of Chicago School of Law.

This is the most thorough dissection of the divestment argument we’ve seen, and it’s most striking feature is its utter banality.  It uses boringly conventional investment analysis to arrive at a conclusion which anyone would expect: divestment from the conventional energy sector would negatively impact returns.  The only question is: by how much?

They conclude that over the 50-year period 1965-2014 a fully-diversified portfolio would have earned a gross annualized 6.3 percent, while a divested portfolio would have returned only 5.8 percent (with both adjusted to the same level of volatility).

That gap of 50 basis points per year means $100 would have grown to $14,600 in the fully-diversified portfolio, but only $11,200 in the divested portfolio.  The divested 2014 portfolio value would have been about 25 percent smaller than the fully diversified one, ceteris paribus.

The energy sector is notoriously volatile over the short run (as the current oil market confirms), so we think taking a 50-year window is appropriate for endowment investors with their theoretically infinite investment horizon.

Their methodology is spelled out so readers can check their math.

There are other negatives associated with divestment, including trading and compliance costs.  They take a hard look at those, too.

Investment professionals usually assume that restricting diversification leads to sub-optimal returns, all else being equal; and the Fischel study bears this out.  But that is exactly what the divesters advocate.

There are really only two ways the divesters can convince anyone to do this.

The first, easiest, and most popular tactic is to simply ignore the economics.  Their cause is too transcendently important for them to be concerned with such trivia.

The second, slightly more legitimate tactic is to concede that divestment may have some marginal negative impact on investment returns in the short term, but only a trifling amount which can be easily recouped by more enlightened investing.  They confidently expect big profits from “alternative” energy investments, regardless of how the market is currently pricing the expected risks and returns of those assets.

Since we’re all about being fair and balanced, we invite readers to consider the divesters’ case.
Patrick Geddes of Aperio Group published a 2013 paper attempting to measure the impact of divestment on portfolios.  He concluded that “Skeptics are right when they claim that constraining a portfolio can only increase risk; but they frequently ignore the magnitude of the change in risk, which can be so minor as to be virtually irrelevant.”  He back-tests divested vs. diversified portfolios and claims to find only a minuscule negative impact.

And a 2013 paper from the Tellus Institute makes much of the so-called stranded-assets argument to persuade us that future returns in energy stocks will inevitably be much lower than past returns.

Divestment vs. Fiduciary Duty: For Whom do we invest?

What the divestment debate comes down to is how boards define their fiduciary duty.  Traditionally that duty included getting the best possible returns from donated funds consistent with an appropriate level of risk.  This would ensure that each gift to the endowment has maximum impact on the various missions and sub-missions which the givers had in mind when they entrusted their money to the school.

American University’s board defended that traditional view when they decided in November, 2014 to resist the divesters.

They concluded that divestment would only be consistent with their fiduciary duty (according to DC’s Uniform Prudent Management of Institutional Assets (UPMIFA) Act) if their investment advisors could assure them that divestment would have an “insignificant effect” on investment returns.  But their general consultant, Cambridge Associates, declined to offer any such assurance.

We may infer from this that Cambridge, with their very considerable experience and resources, are of the same opinion as the Compass Lexecon researchers: the impact of divestment would not be negligible.

Among name-brand schools, only Stanford has so far succumbed to the divesters.  But it’s a pretty limited carve-out when you look at the fine print.  In May, 2014, the board announced that they would “not make direct investments of endowment funds in publicly traded companies whose principal business is the mining of coal for use in energy generation.”

Both student activists and a posse of professors think the move is grossly inadequate and are relentlessly pressing for comprehensive McKibben-style divestment.
But other top schools are, so far, not on board the McKibben train.

At Harvard, President Faust was admirably straightforward in 2013 about their fiduciary duty:

“The funds in the endowment have been given to us by generous benefactors over many years to advance academic aims, not to serve other purposes, however worthy.  As such, we maintain a strong presumption against divesting investment assets for reasons unrelated to the endowment’s financial strength and its ability to advance our academic goals.”

Cornell is also unconvinced. Chief investment officer A.J. Edwards has said:

“If the University decided to exclude [energy sector] investments from its endowment, this decision would have a material impact on the return of the endowment and its contribution to the operating budget of the University.”

He also pointed out that the expected rate of return from the energy sector was one of the highest of all asset classes.  And, he said, alternative energy strategies so far have rarely produced returns that met the school’s risk and return needs.

Divesting from America: The strange allure of a futile gesture

The Anti-Industrial Revolution

Investment professionals may suspect that divestment would degrade their returns, but they probably have little interest in the larger question of whether it could actually shut down fossil-fuel production.  But it ought to matter to the divesters.  If divestment won’t mortally wound the energy-producers, then what’s the point?

It seems obvious that an endowment selling a share — or several thousand shares — of Exxon to another investor at the current market price has absolutely no effect on the profits of Exxon.  The shares are just in the hands of different, non-endowment investors (who already own about 98 percent of energy stocks).  But this insight, requiring an acquaintance with financial markets, may not be so obvious to the rank-and-file divesters.

Many in the movement actually seem to think that divestment would, somehow, seriously impact the profits and policies of hundreds of global firms, ultimately driving them out of business and leaving only a verdant, pastoral world powered by sunshine and righteousness. Presumably they think it would have no effect on their own lifestyles or job prospects, apart from boosting their sense of duty.

The divestment leaders are probably a bit more sophisticated, but what are they actually trying to accomplish?  We suspect that it is primarily a symbolic, consciousness-raising operation.

That’s certainly the opinion of President Skorten at Cornell.  Pushing back against faculty calls for divestment last year, he said:

“I believe divestment in this case will be predominantly a symbolic gesture.  Symbolism and thought leadership certainly have an important place in all universities.  However, the potential financial risks to our campus do not support divestment at this time.

Professor Matthew Nisbet at American University, who spent six months reading all Bill McKibben’s works, wrote a long and mostly admiring profile of him.  He concludes that Mr. McKibben’s real goal is to “generate a mass consciousness in support of limiting economic growth and consumption.”  In his energy-starved utopia we would rarely travel, we would grow our own food, and divert our excess wealth to developing countries.We doubt that limiting economic growth and consumption meshes with the actual career goals of the student divesters at elite schools.  It certainly doesn’t augur well for the average American worker who is already hamstrung by years of too little economic growth.

Fortunately Mr. McKibben has laid out his preferred future very specifically in a 2010 book: Eaarth [sic]: Making a Life on a Tough New Planet.  He writes: “we need to cut our fossil fuel use by a factor of twenty over the next few decades.”

What does that mean?

In 2012 the world used 218 million barrels of oil equivalent (BOE) per day.  A twenty-fold decrease cuts that to just 11 million BOE.  That would make the average daily ration of oil about 0.002 BOE, or .25 liters of oil equivalent (LOE) per person per day for the world’s 7 billion inhabitants, down from the current 4.9 LOE.

To put that in perspective, the average inhabitant of an energy-starved country like Bangladesh now uses twice the prescribed McKibben energy ration: 0.50 LOE per day.  That is, in large degree, why he is already poor.

How about the U.S., where Ivy graduates aspire to prosperous, upper-middle-class lifestyles?  We each use 20 LOE per day.  To be globally fair and good corporate citizens, we would have to cut back by a factor of 20, just like the Bangladeshis, leaving us with just 1 liter per day.

How would that affect the average Stanford student, driving her Prius up Highway 101 to her favorite coffee shop?  Driving to and from a coffee shop just 6 miles away would burn 95 percent of her daily energy ration, even in a Prius.  The remaining 0.05 liters would be just enough to generate the 0.5 kilowatt-hours needed to make a 100 ml cup of coffee (including shipping, roasting, grinding and brewing).

But that taps out her energy budget, leaving nothing left to charge her iPhone, keep her lights on, or produce a hot shower.  She would be living on half the energy allowance currently enjoyed by the average citizen of Peru.

[This argument follows Robert Bryce in Smaller Faster Lighter Denser Cheaper: How Innovation Keeps Proving the Catastrophists Wrong (2014).  Statistics are from BP Statistical Review of World Energy 2013] Also, see this paper.

We don’t think this back-to-the-land, forty-acres-and-a-mule existence is what the average Ivy student is spending $50K per year to achieve.

Reductio ad absurdum:

The Ultimate Divestment: Divesting also raises the slippery-slope argument.  The world is full of people aggrieved about something or other, and they would be glad to compel others to support them by divesting from their targets.

Most campuses, for instance, have a small but intense minority who would like everyone to divest from firms who do business with Israel.  This is has become known as the Boycott, Divestment and Sanctions (BDS) movement, and it has gained wide support.

Two weeks ago the University of California Student Association (UCSA), the official voice of the whole multi-campus UC system with its quarter-million students, overwhelmingly passed a vote in support of divestment from companies doing business with Israel.  Their next step is to bring their proposal to the governing UC Regents board.  Most individual UC campuses, including Irvine, San Diego, Berkeley, Riverside, and Los Angeles; have already passed Israel divestment measures, as have many other student associations at colleges across the nation.

Divestments from energy companies or from Israel are certainly ambitious goals, but we can report that the UC students are thinking bigger than that – much bigger.

At the same conclave on February 8, the same students passed a separate proposal to divest from Brazil, Egypt, Indonesia, Russia, Turkey, Sri Lanka and Mexico; all, like Israel, said to be engaging in or enabling human rights violations.

That’s pretty bold, but they didn’t stop there.  The proposal also called for the endowment to divest from the United States of America on the same grounds. It also passed by an overwhelming majority.

This kind of comprehensive divestment accomplishes many admirable goals at once.  It strikes a blow at U.S. energy companies, non-energy companies, Israel-enablers, and non-Israel-enablers all at once and should greatly simplify the UC endowment portfolio.

We are reminded of the Fraser College students in Animal House who, protesting a tyrannical administration, decided that the situation “absolutely requires a really futile and stupid gesture be done on somebody’s part.”

Of course, that was just a movie.

Charles A. Skorina & Co is retained by the boards of institutional investors and asset managers to recruit chief investment officers, portfolio managers, and financial professionals.

Charles Skorina earned an MBA at the University of Chicago and began his professional career at Chemical Bank (now JPMorgan Chase), completing the management training program then working as a credit and risk analyst in New York and Chicago.  After a stint with Ernst & Young in Washington, D.C., he founded his own search firm headquartered in San Francisco, focused on the global financial services industry.

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