Ethical Investment Approach

Introduction

We recognise that a growing number of clients wish to apply ethical screening to their investment choices. Ethical screening means different things to different people and clients vary in the extent to which they wish to overlay criteria which are unrelated to investment performance when constructing their portfolios. Bridgewater will therefore offer a core set of ethical portfolios which are based on strict ethical criteria, which should meet the requirements of the clients with the most purist views.

In common with the main investment approach, Bridgewater aims to achieve a consistent, evidence based approach (as far as reasonably possible) and to use a common process for all of its clients. This enables a cost effective and efficient service to be delivered to clients. Bridgewater’s service pricing will therefore be the same for both sets of portfolios. As will be seen below, in respect of the ethical portfolios, a degree of hybridisation between the ethical and non-ethical portfolios is needed in order to ensure better risk: return consistency between the two types of portfolio. As this may breach the ethical requirements of certain clients three sets of model portfolios will be offered:

  • Full (non-ethically screened)
  • Pure Ethical
  • Hybrid Ethical

Where clients require a more bespoke approach, Bridgewater will be able to offer this but, due to the substantial increase in work load at the level of the individual client, will need to agree a higher level of charges to cover the increased time spent on advice, implementation of transactions and ongoing reviews.

Investors need to understand that by applying non-investment performance related criteria on their portfolios they are likely to achieve sub-optimal risk: return performance. In layman’s terms this means that the portfolios may not generate the returns that would reasonably be expected given the risk taken and at the lower end of the risk spectrum, risk control may be less efficient. This must be understood and accepted before recommendations are provided and implantation is carried out.

Overall Approach

The approach taken by Bridgewater is to stick to the core principles behind its main investment philosophy. This means that the high level split between equities and bonds and cash will be retained. The portfolios also maintain a UK bias to reflect the fact that most clients are resident in the UK. This should ensure that the variance of the ethical and non-ethical portfolios should be broadly similar. However, when selecting funds ethical screens are applied.

The consequences of this are that a more limited range of funds is available on which the initial ethical filtering is carried out and the funds which are available are, at least officially, actively managed from a stock selection and market timing point of view. This inevitably means that fund manager error will be present within the funds, which is absent from the main (non-ethically screened) portfolios.

Further implications of a purely ethically driven approach stemming from the limited fund range that is available are that Value and Smaller Company Equity funds are not available and the bond funds are longer dated. This means that it is not possible to apply the Value and SMB tilts that are present in the main portfolios and the level of risk control provided by the Short Dated Bond and Index Linked Gilt Index fund is not possible in pure ethical portfolios.

Bridgewater’s aim with the ethically screened portfolios is for them to have risk: return characteristics which are as close as is reasonably possible to the main portfolios. The primary measure of risk which has been used is standard deviation, which is a measure of fund volatility. The composite standard deviations of the main and ethical portfolios have been compared and for the more equity oriented portfolios, the characteristics are fairly similar. However, for the lower risk portfolios, the greater volatility of the longer dated bond funds in the ethically screened portfolios results in a material difference in risk.

Ethical Screening Criteria

Funds have been filtered first by reference to the ethical standards and then by their investment charactistics.

The ethical screening criteria are summarised below. Most funds apply the same positive criteria but vary in the extent to which they apply negative criteria (i.e. activities in which they will not invest). Bridgewater has therefore used the negative criteria. Some funds apply partially negative criteria, i.e. they allow them but to a limited extent. Where this is the case and there are other funds in the same sector which fully apply the negative standard, they will be selected in preference. The decision on which filters to use and their severity has, inevitably taken into account that fact that excessively strict criteria could result in the removal of all candidate funds from the shortlist. In order to avoid this, where necessary, a pragmatic approach, which sticks as far as possible to the ethical intent of the process, has been adopted.

The ethical criteria have been summarised below:

Ethical Criteria Filter Applied
Alcohol – Production Exclude if possible but not essential
Alcohol – Sale Exclude if possible but not essential
Animal Intensive Farming – Retail Exclude
Animal Intensive Farming – Wholesale Exclude
Animal Testing – Cosmetics and Toiletries Exclude
Animal Testing – Pharmaceuticals Exclude
Environmental Abuse Exclude
Financial Services Don’t Exclude
Gambling Exclude if possible but not essential
Human Rights Abuse: Yes Exclude
Military: Yes Exclude
Nuclear Energy: No Exclude
Pornography: Yes Exclude
Tobacco: Yes Exclude if possible but not essential

Investment Screening Criteria

The funds which have been shortlisted using ethical criteria were then reviewed for their risk return characteristics and charges. In the latter case, account has been taken of the discounts which would be applied by the two main dealing platforms which are used by Bridgewater have also been taken into account.

In order to comply as close as is reasonably possible with Bridgewater’s fundamental philosophy that market timing and stock selection strategies are in general ineffective and therefore to be avoided, the main performance factor which has been reviewed is the funds Beta. This is its performance relative to the market. A Beta of 1 indicates that the fund moves in line with the market. Where it is more than 1 it moves by more than the market and vice versa. Funds with a Beta of 1 or less suffer less from fund manager error than funds with higher Betas. Therefore, wherever possible funds with Betas as close to 1 will be selected. Betas over 1, 3 and 5 years have been used wherever possible and a consistent rating, as far as possible, is sought.

It is worth mentioning that past investment performance has deliberately not been included as an investment selection criterion because it provides no meaningful indication of future investment returns. Even where individual fund managers have performed well, this tends not to be continued in future.

Cost is important but due to the limited range of funds which is available, this cannot be applied in an over-riding manner in order to avoid excluding all possible candidates. Investors who wish to apply ethical criteria will need to accept that their investments will cost more and that this will inevitably have a drag on potential performance.

Summary

The Bridgewater Ethical portfolios provide investors with the best of both worlds. They combine strong ethical screening with an overall evidence based approach to the construction of portfolios. This means that, when used in conjunction with our investment portfolio advisory process, clients should get portfolios which both satisfy their consciences and at the same time behalf in the manner expected given the level of risk that they are prepared to take.