How to build an ethical portfolio

Buy quality, says First State fund manager David Gait,and think long-term.

When I went to interview David Gait the highly rated First State Investments fund manager a few weeks ago, I had ethical investing on my mind.

I was due to speak at a social enterprise event, and I had to decide exactly what I thought made an investment an ethical investment, an impact investment, a social investment, or a sustainable investment.

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As David runs two funds with the word sustainability' in their titles, and as First State prides itself on a forward-thinking approach to corporate governance, he seemed the right person to ask.

So, what makes a firm sustainable? First State has always been interested in the corporate guidelines a company works within, and in the social and environmental aspects of those guidelines. Its views were crystallised by the fact that it invests heavily in Asia, and so is "at the sharp end" of China and India's sustainability issues.

About ten years ago it became clear that "large emerging-market economies" would be "unable to follow the same development path" as the West. Population growth means that by "2050 there's another whole India and a whole China to come".

I suspect the population will peak long before that, but nonetheless we're seeing serious "population pressure". So it makes sense to consider scarce resources, water supplies and how to create a "genuinely sustainable balance" defined as "high human development within the environment of constraints".

Investing sustainably also appears totake account of society's likely reactionsto our most obvious big problems.This brings us to obesity. It doesn'tmatter what your political view is onthis, given the scale of the problem "it seems reasonable to accept something needs to change".

Society will address it, be it via changing consumer preferences or via regulation. I note that this doesn't seem to be going very well so far. But David points out that in the US, Coke consumption is starting to fall, which is borne out by this week's disappointing results from the company).

First State wouldn't invest in Coke (unlike Warren Buffett) not because it has moral issues with sugar consumption, but because David is convinced that changes in consumer preference will hurt the market for its core product.

So, what does he hold instead? A soya drinks producer (Dabur Group) that, among other things, makes the "oldest brand in drinks in the world" from a natural herbal paste called chyawanprash.

Is any particular sector a no-go? No. Investing starts with "a blank sheet of paper". There is no formal negative screening. So, while David would never invest in tobacco, say, it isn't written down anywhere.

If there was a negative screen what else might he exclude? Listed stock exchanges. Why? "They have become so focused on prioritising short-term profits over anything else" (think high-frequency trading).

That is "so damaging" to an investment industry that is already ludicrously short term. When all investors do at company meetings is ask "can you give me some colour on intra-quarter results?" you have a problem.

How can we make the industry lessshort term? Make bonuses for fund managers a three-yearly rather than an annual event, says David. Then look at offering loyalty dividends or new shares to long-term holders, or perhaps delaying voting rights until shares have been held for a certain period. If nothing changes, we will end up with a market full of businesses focused on only the next quarter.

We also need to look inside companies at how pay motivates people: research shows that financial incentives only work well for "extremely simple tasks". Offer them for complicated tasks, and you create an incentive for "poor behaviour" and "corner cutting".

So, the bonus system across the corporate world needs looking at. This is something the wider fund-management industry does have influence over, which therefore suggests it has responsibilities to the rest of us.

It is also why David disapproves of passive investing. Track an index and you are effectively "shutting your eyes [and] handing money straight over to a bunch of companies, many of which don't deserve" it.

The more passive investors there are, the better the remaining active investors should do (it leaves them with more opportunity), but the worse the corporate world will become. Fund managers have to "stand up and be accountable".

We talk a little more about the fund-management industry. He thinks it isn't in good shape. But what if it were more aware of the importance of the social role David thinks it should have (as it gathers our savings and reinvests them for abetter future)?

Would it count as asocial enterprise? Neither of us is sure. What's his definition of one? Perhaps one that runs with a fair level of profits, and so has a "licence to operate within a fair society". But what's a fair level of profits? That's "indefinable".

This is something we also discuss later in the interview. When David asks me how I think fund management can improve, I suggest they cut their prices (First State funds don't come cheap). If they want to make life better for pensioners and help young people build wealth, surely reducing the gains that accrue to the fund-management firm is a simple way to do it.

This never goes down well with fund managers and David isn't convinced either. What's the right price, he asks. It isn't easy, this process. Still, it's right for firms to grapple with how much return they should be making, says David. Look at tax.

These days corporation tax "is in my view almost entirely voluntary, so you can choose what you want to pay as a company". Yet "most companies don't pay zero". So while the corporate world has its faults, most firms understand their role in society they appreciate that "ultimately you don't exist in a vacuum".

We talk about the introduction of the B-Corp' in the US. The official idea is that they "use the power of business to solve social and environmental problems". Think private capital, public good.

Set yourself up as one (they have been legal entities since 2013), says Gait, and you have to "commit that your business will have a positive impact on society" and you also have to "try and measure" that impact.

How? This seems an inexact science but it does, says Gait, suggest companies don't always have to "put the interests of their shareholders above everything else".

Is there a firm example of a firm that fits all of David's criteria and is in his portfolio? He suggests India's Marico. It is a consumer products firm (products range from coconut oil to a healthy curry porridge), which should benefit as incomes rise and people choose better-quality food. It is also heavily family-owned.

There are risks in this, but "lots of benefits too" the main one being that families tend to have long-term outlooks and conviction. What about the price? Can we buy now? "That's the challenge."

Like everything else, Marico is expensive valuations have reached "extreme levels" all over the place. What does a fund manager do in a situation such as this? "Think long term" and "invest in better quality". David isn't selling Marico. He's "holding for the next ten years, hopefully".