Tag Archives: divestment performance

Fossil Fuel Divestment – An Easy First Step For Individuals

The post on October 18 talked about the hypothetical impact of removing fossil  fuel investments from broadly diversified mutual or exchange traded funds. When taking money out of any single industry, whether the unwelcome stocks are in fossil fuels or mass media or donuts, it is hard to argue that extracting investments from a single industry will have a measurable effect on long-term fund performance. Diversification means that the sensitivity to whatever happens in any one industry is going to be very low.

The practical question then is this – how can an individual divestor who wants to be in diversified funds take this idea and do something with it? You can’t tell a mutual fund company “I’d really like to invest in your XYZ fund – except, can you take out the fossil fuel companies?”

In fact, there are many, many ways for an investor to move into these waters. And, there’s one easy place to start.

The most straightforward first move is to reinvest freed up money into diversified small or mid-cap Exchange Traded Funds (ETFs), or small-cap mutual funds. (“Cap” is short for capitalization – the dollar figure you get when you multiply the number of company shares by the share price. There’s no standard designations, but large usually means a capitalization greater than $10B, mid cap is between $2B-$10B and small cap is below $2B.)  There are also a few funds that are specifically designed to exclude fossil fuel companies.

The major players in the fossil fuel business are big – really big. ExxonMobil’s market cap is currently about $400B. By putting your money into small and mid cap funds, you can avoid investing in these stocks. Stocks that are at ground zero when it comes to global warming since they are issued by the largest companies that find and sell fossil fuels. There are a lot of diversified small and mid-cap funds to pick from – both approaches are bread-and-butter offerings for many fund companies. (Note that a mid-cap mutual fund is fairly likely to hold some large cap companies, so an easy way to have a diversified position in mid-cap stocks would be with a mid-cap ETF.)

Investments are bets. And, so the natural next question is what bet is an investor making when using this approach?

Interestingly, a common conclusion of comparisons between mid or small cap stocks versus large cap stocks is that both tend to outperform large cap stocks (while both tend to be more volatile). Take a look at two example discussions from CNBC/Yahoo Finance: one and two.

Take a few minutes and look around for yourself. There are a lot of articles on these comparisons, particularly the small-large cap version. Most brokerage sites and personal finance sites have areas where you can compare small, medium and large cap funds for yourself. You can also look at the historical performance of market indexes that track different market cap stocks. Keeping with the diversification theme, the most meaningful comparison would be a combination of small and mid cap funds versus large cap funds, since a diversified investment approach would probably mean you’ll hold both types.

So, what’s the takeaway from all this? It’s a virtual certainty that people and the planet are in big trouble if we don’t massively curb the burning of fossil fuels. As we do that the value of the traditional fossil fuel companies will fall.  On the flip side, it would be reasonable to think that diversified small and mid-cap funds will hold up well against their large cap brethren over the long haul.  (Also, keep in mind this is just one of many reinvestment possibilities an investor  can follow – including supporting the growth of the new energy economy by investing in funds that tie to that theme or investing in fully fossil free funds.)

Many investment advisors make the point that your investment decisions should allow you to sleep at night. Will betting against the planet and your kids’ future keep you up at night?  Think about it.

Fossil Fuel Divestment Means Lower Returns – Huh?

One of the key arguments against divestment that shows up again and again in the press and on the web is the idea that fossil fuel divestors will sacrifice investment performance. Or, stated another way, their investments will do worse then those of people who choose not to divest. On the surface, it seems a simple point – if you don’t invest in a major sector of the economy (i.e., the fossil fuel industry), you’ll be missing out. But, as is true with most simple arguments in an increasingly complex world, this soundbite analysis is wrong on multiple levels.

By a big majority, most people who have stock market investments put their money into mutual funds or exchange traded funds (ETFs). And many people also follow the general investment axiom that it’s a smart idea to be diversified. So, the more relevant question is – what happens if a diversified mutual fund or ETF does or doesn’t hold stock in the fossil fuel industry?

By definition, a diversified fund isn’t going to invest a high percentage of its money in any one industry. If you look at the Security and Exchange Commission filing information for diversified funds, you’ll generally find that somewhere between 0-4% of such a fund’s holdings are in the fossil fuel industry. So, for the sake of argument, let’s say that on average a typical diversified fund invests 2% of its investors’ money in these companies.

Let’s look at a hypothetical fund we’ll call the “incredibly neutral mutual fund (INMF).” The INMF manager’s general performance turns out to be supremely neutral. Somehow, with all the ups and downs of all the industries in the fund’s portfolio of stocks, the gains of almost all the stocks that do well are almost exactly counter-acted by the stocks that do poorly, and every year the fund’s annual return is basically 0%. But, there is one exception to this staggeringly bland performance – the fund’s investments in the fossil fuel sector.

Suppose that in an incredibly amazing 10-year streak, the combined fossil fuel investments in INMF go up 50% every single year. But, since the fund only invests 2% of its money in fossil fuels, the investors will gain just 1% each year. A return of 1% per year — that’s what you get if the fund manager has a completely unrealistic ability to pick an astounding set of fossil fuel stocks year after year after year.

Human beings and markets being what they are, a more realistic view of a fund manager who has a strong ability to pick fossil fuel winners (and avoid losers) would be if that part of the fund  had a consistent return of 5-10%. Now, the annual total return to you as a fund investor has fallen to between 0.1-0.2% per year. If you had invested $5,000 in INMF, your first year return would be $5-$10. The total cumulative ten-year return range would be slightly more than $50-$100 (due to compounding).

So, can moving away from fossil fuels negatively affect investment performance. Possibly. But if you invest in broadly diversified funds, the potential effect is tiny. The variation would be swamped out by the manager’s many other fund investment decisions, and also the myriad economic impacts that push all the other sector investments in the fund  up and down.

And, here’s a far more important point. New stocks that replace the fossil fuel investments may do as well as, or better than, the fossil fuel stocks that were removed. In which case, the divestor has lost nothing or may indeed do better after divesting.

The core argument that divestors should expect to lose out is just not accurate or reasonable.  More to come on how to put this idea into action…..