Do institutional investors have to choose between divestment and engagement?

For institutional investors, the debate still rages over whether to divest from a company they find to have problematic practices where environmental, social and governance issues are concerned or to remain invested and engage with the company to try to push it in the desired direction.

A new paper by smart beta platform provider Scientific Beta is suggesting there’s evidence that both strategies actually achieve the sought-after effect and can go hand in hand, rather than investors being required to choose just one option.

There are several ways that divestment and engagement can mingle to strengthen the clout of an investor, the paper found. Collaborative engagement campaigns, where both current and potential shareholders come together to push a message to a company, demonstrate that an investor doesn’t need to be invested to express its views in a powerful and relevant way. As well, shareholders of a company have to maintain the possibility of divestment in order for their engagement to carry its full potential weight.

Read: Head to head: Is carbon divestment becoming obligatory for pension plans?

“A shareholder who engages with a company without signalling a willingness to draw a red line — by exit in case engagement fails — will enter the negotiation in a weak position; the possibility of divestment is, in that sense, a prerequisite for effective engagement,” said the paper. “Conversely, engagement can make divestment campaigns more effective: noisy exits can be more impactful than silent ones. Therefore, far from being mutually exclusive, both engagement and divestment are mutually reinforcing.”

The paper also pointed out certain weaknesses in ESG mixing strategies or ESG integration strategies, “whereby ESG data and analysis are mixed with traditional financial inputs in the portfolio construction process.”

Read: Where should institutional investors target engagement in 2020?

Often, one of the results of using an ESG data overlay is the over or underweighting of certain companies based on how they score on certain ESG factors. Strategies that result in this underweighting, which can also be understood as a partial divestment, are less effective than a more straightforward filtering out of a portfolio’s worst ESG offenders, argued the paper. While these strategies create scenarios where an investor is, in a practical sense, divesting, the partial nature of that divestment fails to send a clear signal to the company it’s divesting from.

Meanwhile, ESG filtering removes the worst ESG performers from an investor’s investible universe, sending an unambiguous, actionable signal to companies. When used in tandem with engagement, especially through collaborative shareholder campaigns, filtering was the more effective option for investors using any type of investment, noted the paper.

Read: When companies push back on pension engagement, proxy voting