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June 29, 2018

Grantham Foundation Ignores Economic Research, Claiming Divestment Won’t Hurt Fund Performance

A recent op-ed published by the Grantham Foundation for the Protection of the Environment tries to claim that “fossil fuel divestment will not undercut fund performance.” As we all know, this claim is highly flawed.

To support their statement, the foundation took the top 10 sectors in the S&P 500 and analyzed how the index performed if they took out each sector.  They conclude that over a 90-year period there was a 54-basis point difference between the best and the worst scenarios and therefore the performance of the index is essentially not impacted if one of the sectors is removed.

Their analysis not only oversimplifies the impact of divestment, but fails to account for numerous other factors that impose additional costs and impact returns. Studies from leading economists and university professors, as well as the real-world feedback from fund managers, show that divestment creates significant financial costs and risks.

Here are the key reasons why the Grantham analysis misses the mark on the true impact of divestment:

1) Fossil Fuel Divestment Can Significantly Reduce Returns. Daniel Fischel, Professor of Law and Business Emeritus at the University of Chicago Law School, found that divestment will hurt the overall performance of a portfolio. According to his study, portfolios divested of energy equities produced returns 0.7 percentage points lower each year than ones that invested in energy on an absolute basis. Over a 50-year period that represents a 23 percent loss.

A second study by Prof. Fischel found that 11 of the nation’s top pension funds would lose up to a collective $4.9 trillion over 50 years if they were to fully divest from the energy sector.

Grantham’s piece conveniently doesn’t give specifics on the performance of the S&P when the energy sector is removed. However, even a 54-basis point difference can add up to significant losses over an extended period of time.

2) Divested Funds Experience Increased Risks Due to Lost Diversification. Grantham also does not consider the impacts of lost diversification and how that effects the performance of a portfolio. According to Prof. Fischel, 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. By divesting from fossil fuel, one loses this particularly potent diversification benefit and is therefore exposed to increased risk above and beyond what may happen if a fund divested from other sectors of the economy.

3) Divestment Poses Significant Transaction Costs, Regardless of Performance. Grantham only looks at returns and does not even consider the additional fees and costs that are caused by divestment. A report from Hendrik Bessembinder, Professor of Finance at the W.P. Carey School of Business at the University of Arizona, found the transaction and management costs related to divestment – what he refers to as “frictional costs” – have the potential to rob endowment funds of as much as 12 percent of their total value over a 20-year timeframe. This includes the onetime immediate transactions costs an endowment must endure, as well as ongoing annual management fees to stay in line with the changing definition of “fossil free.”  Since many public pensions and endowments hold assets in mutual funds, commingled funds, and private equity funds, divestment generally requires the sale of an entire fund – not just its fossil fuel holdings. This imposes substantially larger transaction costs for endowments.

The Fischel study also finds that an increase in compliance costs of just one percent on the estimated $22 billion of those endowments invested in energy stocks would further decrease growth by an additional $220 million per year.

A subsequent report by Prof. Bessembinder calculated the cumulative costs associated with divestment and found that the financial hit will be significant, and that students and pension beneficiaries will suffer.  When factoring in all the losses incurred thanks to trading costs (1.65 percent), compliance costs (0.56 percent), and diversifications costs (0.23 percent), the average “hole” created by divestment results in a 15.2 percent drop in transfers from endowment accounts to school programs. For public pensions, this would cause a 5 to 7 percent reduction in monthly pension benefits for a typical pensioner.

4) Cities, States and Universities are Rejecting Divestment Because it Violates their Fiduciary Duty. Out in the real world, the divestment movement is failing because investment managers understand the financial implications. Across the country, cities and states such as Seattle, San Francisco, and Vermont and universities such as Swarthmore and NYU have opposed divestment because of the steep financial costs.

The economic consultants for the San Francisco Employees Retirement System (SFERS) stated that “Symbolically, using the assets that are trusted to you to make a political statement is not a good fiduciary duty.” He noted that divest would impose a one-time transaction cost of $1.2 million and a performance shortfall “within a range of $5.765 million to $23.058 million per annum.”

Likewise, the Seattle City Employees’ Retirement Systems (SCERS) rejected divestment after finding that “divestment would materially increase expected risk and decrease expected net-of-fee return for SCERS’s investment portfolio.”

At Swarthmore College, the chair of the board of managers noted that divestment would place the performance of the fund “at risk.”  Furthermore, NYU determined that divestment is inconsistent with the university’s legal duty to “invest funds in a manner that is prudent and in the University’s best interest.”

5) Divestment is an empty gesture that carries no tangible environmental benefits. The Fischel study found no evidence that divestment has any discernable impact on the companies being targeted by the policy. This is because divestment merely transfers shares from one investor to another. The only entities punished under a fossil-fuel divestment regime are the institutions actually doing the divesting. This is why the Chief Investment Officer for the California State Retirement System (CalSTRS), the second-largest pension fund in the United States, said he opposes divestment because “it doesn’t change cooperate behavior” and that it “hasn’t made the world a better place.”

6) Grantham’s own leadership has highlighted the need for fossil fuels. Jeremy Grantham stated in The Gaurdian in 2013, “We need oil. If we took oil away tomorrow, civilisation ends. We can burn all the cheap, high-quality oil and gas, but if we mean to burn all the coal and any appreciable percentage of the tar sands, or even third-derivative, energy-intensive oil and gas, with ‘fracking’ for shale gas on the boundary, then we’re cooked, we’re done for.”

Grantham’s claims that fossil fuel divestment won’t impact fund performance flies in the face of years of research on the topic, as well as basic investment principles.  And while the foundation’s op-ed is quick to joke about how conservative, and possibly change-adverse, investment committees are, not much thought is given to the people who rely on these funds’ performance: retirees and taxpayers. Time to focus on costs, not politics.