Charity investors focusing on democracy to improve performance
The trustees of charities overseeing endowments often find themselves somewhere in a state of thinking between two extremes. Those who believe that their number one mission is to provide the highest possible investment returns at any cost, principles be damned. And those who believe that the charity’s investments should be the perfectly virtuous embodiment of the organisation’s mission and values, profitability be damned.
Both sides have a point. For many charities competing in a crowded fundraising field, the endowment is one of the few reliable and predictable sources of income. It’s the bloodstream of a charity, empowering it to do good in the world. Smaller returns equal less impact. With this approach, constraining the investment strategy in the name of ill-defined ethical principles is bound to generate inferior returns, resulting in a self-defeating strategy.
The other side will see it very differently. Money talks, they will say. If an environmental charity is heavily invested in fossil fuels, what good does it really do? If a human rights charity is heavily invested in Chinese and Russian companies propping up autocrats, is it really having any impact? With this approach, aligning the charity’s investments with its values is not only prudent from a reputational standpoint, it’s also an ethical obligation and a mission-driven imperative well-worth the cost of inferior returns.
In the real world, most charities will settle somewhere in between, screening out investments that would be too obviously at odds with their mission, without going out of their way to design the most ethical portfolios, whatever that means to them.
But the premise of this debate is that charities face a necessary tradeoff. That “doing good” is coming at the cost of “doing well”. Is it? Not necessarily.
Asset managers are rarely experts in ethics. They face a complicated world where information is spotty, transparency is in short supply, science is debated, supply chains are interconnected and terms like ESG are politically supercharged (“woke capitalism” anyone?). Their role is not to decide for their charity clients what is good for the world and what is not, what is principled and what isn’t. In other words, asset managers should not indulge in philanthropy with their clients’ money.
What they should be able to discern, though, is what creates long-term value for investors. What works, versus what doesn’t work.
Superior economic returns
There is a lot of academic research suggesting that democracy, as a form of government, delivers superior economic returns. A giant in this field is Daron Acemoglu, a researcher at MIT who has famously shown that when countries go down the path of democratisation, it raises their GDP per capita, while countries which revert to autocracy see their GDP per capita deteriorate.
The reasons explaining this phenomenon are intuitive. Democratic countries are far from perfect, but they guarantee checks on executive power. Journalists, opposition parties, civil society activists and ultimately electors can expose, sanction and remove a leader who makes irrational, corrupt or incompetent decisions. The system is built to self-correct and offer avenues for recourse.
An autocrat, on the other hand, will often make decisions that serve them or their clan and ensure their survival in power, whether or not it benefits the country’s population or the economy. Checks on the autocrat’s power are weak and flimsy. In this form of government, independent journalists are jailed, civil society advocates silenced, demonstrators hunted down and political opponents persecuted or poisoned.
It’s quite clear that autocracy is bad for business. But how are charities and their investments exposed to the vagaries of distant authoritarian countries? In two major ways.
First, directly, through the bonds and stocks they own which are listed in autocratic countries. If they own Chinese tech stocks, they may take a hit when Xi Jinping decides that he needs to crackdown on the entire tech sector or when Jack Ma of Alibaba disappears for a few months, sending the stock into a tailspin.
Heavily reliant
Second, charities may be exposed through the stocks they own which are listed in democratic countries but which are heavily reliant on autocratic countries. Think Volkswagen and its factory in China’s Xinjiang region. This indirect exposure became painfully clear when Russia invaded Ukraine and for example BP wrote off $25.5 billion on its holding in Rosneft or Société Générale took a $3.3 billion hit through its stake in Rosbank.
Through quantitative research, it is in fact possible to demonstrate that, buried deep in market data, there is an “authoritarian risk factor” that can be identified. This risk factor, largely ignored by the market, is negatively rewarded over time and is independent from other risk factors.
Crucially, most of the exposure to this risk factor is indirect (Russia scenario), meaning that even if a charity’s endowment decides to sell all of its Chinese stock, it will still be exposed to the irrational decisions of the Chinese government through stocks listed in democratic countries but which are heavily reliant on China.
Once you can identify and measure an “authoritarian risk factor”, it’s possible to build public equity portfolios that are minimally exposed to this risk. Using publicly available data, you can blacklist stocks listed in autocratic countries and minimise your exposure to stocks which are listed in democracies but dependent on autocracies.
HOW DO THE RESULTING PORTFOLIOS PERFORM? Here lies the good news. Using data over the last fifteen years, you can demonstrate that these portfolios outperform their benchmarks significantly and can help mitigate geopolitical shocks caused by authoritarian countries. In other words, your portfolio can perform very well.
BUT DO YOU DO GOOD? Few people realiSe it, but democracy is under attack globally. The most reputable observers of democracy, whether it’s the Economist Intelligence Unit, Freedom House or the V-Dem institute, all agree that for close to two decades, democracy has been receding in the world. It’s a declining form of government. China and Russia are much less free today that they were twenty years ago, so is India, but democracy has also been receding in the US and several European countries.
This presents an existential threat that few charities can afford to ignore, as it will often profoundly impact their mission.
Stanford Professor Larry Diamond calls the phenomenon a “democratic recession”. According to historian Anne Applebaum, the trend has been precipitated by a club of rogue state actors she calls “Autocracy Inc”, made up of Russia, China, Iran, Venezuela, and the likes. Their corrupt state-owned enterprises do business with one-another and they work together to undermine democracy globally while evading western sanctions.
Unwittingly bankrolling autocrats
In his recently published book (“Beyond the ESG portfolio, how Wall Street can help democracies survive”), economist Marcos Buscaglia argues that western investors have been unwittingly bankrolling autocrats who are hell bent on destroying democracy. They gleefully invested in Russia even after the invasion of Crimea, long before Ukraine, and poured money with abandon into China while Xi was making clear that he would settle for no less than absolute power.
In many of the “Autocracy Inc.” countries, even theoretically private companies are tightly controlled by the state. It is notorious, for example, that the Chinese Communist Party is deeply embedded in multinational Chinese companies or that Vladimir Putin keeps an iron grip on the most dominant Russian companies.
When these companies do well, so do the rulers and their oligarchs. Money being fungible (interchangeable with other assets), any profit they generate for the state can help fund military adventures, finance the control of their own population or pay for propaganda campaigns meant to destabilise democracies. There is a growing body of evidence showing that Moscow and Beijing have been trying to influence elections in the West.
Charities invested in autocratic countries face a lose/lose scenario by which they decrease their risk-adjusted returns, therefore limiting the ability to support their mission. Only the autocrats win at this game.
Buscaglia is urging the ESG ecosystem to add a “D” for democracy. And he is right. If investors in democratic countries shy away from investing in autocratic countries, it will be much harder for dictators to attract the capital they need to consolidate their power at home and undermine democracy abroad.
Comply with laws
Also there is an added benefit to investing in democracy. When a charity’s endowment invests in the shares of a company listed in a democratic country and doing most of their business with other democratic countries, it knows that these companies have to comply with laws that better protect workers, shareholders, consumers and the public.
It’s not a guarantee that these companies will be virtuous, but they will be regulated by governments and legislators answering to voters. They can be taken to court or exposed by the media for polluting the environment or mistreating their workers. Not so much in Russia. It’s much harder getting away with the use of forced labour in Sweden than it is in China.
While not a panacea, at a portfolio level, and in the aggregate, investing in democracy in this fashion can be a way to cut through some of the ESG noise and feel confident that the money of a charity donor in London does not end up subsidising a campaign of mass atrocities in Xinjiang or war crimes in Ukraine. All the while generating superior returns.
In the end, by investing in democracy, doing good is what helps your charity do well.
