The delicate issue of divestiture

More and more financial advisers are likely to be confronted with client demands for the divestiture from their portfolios of the stocks of companies that fail some moral screen. Currently, the issue that resonates with many investors is the genocide in the Darfur region of Sudan. Activist groups have urged companies doing business in or with that country to cease such operations. They also have begun to pressure pension funds, endowments, foundations and individual investors to divest the stocks of companies that have refused to disengage from Sudan. But other divestment campaigns have occurred, and others will no doubt follow. Already, some groups are calling for divestment of the stocks of companies doing business in or with Israel. That would involve far more companies than the Darfur campaign. The issue of divestment has been tricky for corporate pension plans because of the fiduciary obligations under the Employee Retirement Income Security Act of 1974 requiring trustees to invest "solely in the interests of the beneficiaries and for the purpose of providing pensions." They can take social issues into consideration only when financially equivalent investments exist that have similar risk and return profiles, and similar costs. Even so, most corporate pension funds remain reluctant to consider social issues, because capital market theory suggests that any artificial restraint on the investment universe inflicts at least opportunity cost on the investor. Limiting the investible universe also may hamper diversification, thus increasing specific risk. Most public pension funds, though not bound by ERISA, follow similar fiduciary standards. However, they have been more willing to use divestiture to pressure companies to change their behavior or operations. Many such funds were heavily engaged in the successful campaign to end apartheid in South Africa during the 1980s. Portfolio managers have been slow to divest companies publicly in response to activist campaigns, because of fears that non-sympathetic shareholders might sue if performance suffered after divestiture. Rather, they have often quietly replaced targeted companies with other, similar companies, without fanfare or acknowledgement. Individual investors have every right to drop from their portfolios companies whose behavior offends their moral standards. However, advisers have a responsibility to advise their clients of the possible consequences of divestiture. They should point out that divestiture might mean lower investment returns in the long run. The $169 billion California State Teachers' Retirement System in Sacramento is reconsidering its long-standing ban on investing in tobacco stocks, because it has calculated that the ban has cost the fund $1 billion in returns since 2000. Other public-employee pension funds have complained about the transaction costs incurred in selling shares of the pariah companies and replacing them with other stocks. Yet divestiture doesn't always reduce performance. InvestmentNews reported last week on a report by the Sudan Divestment Task Force — a project of the Washington-based Genocide Intervention Network — suggesting that ridding portfolios of the most recalcitrant companies doing business in the country would have improved portfolio performance, at least in the short run. And some socially conscious mutual funds have outperformed other funds during various periods. But clients should be advised that negative consequences are possible from a policy of divesting such stocks. If the clients wish to divest for moral reasons and accept the possibility of lower returns, so be it. Likewise, if they wish to vote their mutual fund proxies in favor of mutual fund divestment of such companies, or to move their assets to funds that divest funds that decline to invest, so be it. Once the clients have been told of the possible consequences and costs, the investment advisers have done their duty. They then must help the client implement the decision in the most cost-effective manner.