Can you earn good returns without investing in dirty industries? Matt Nippert and Caleb Tutty report

Key Points:

The storm over the Herald's Dirty Secrets of KiwiSaver series widened this week, as the pervasiveness and scale of international indexes -- many containing traces of controversial, potentially illegal investments -- became apparent. The broadening of debate has raised questions about how far potential legal problems spread, whether current disclosure by providers is sufficient and how much it will cost funds -- and, indirectly, individual KiwiSavers - to come clean. The widespread use of index funds - first highlighted by Radio NZ's Anusha Bradley - has widened the number of providers found to be exposed to controversial holdings. Initial Herald analysis of disclosures of direct KiwiSaver holdings found three providers - Westpac, AMP and Aon -- with holdings in cluster bomb manufacturers. In-depth analysis of just one index fund, one of the many used by KiwiSaver providers, has seen this number double. As a case study in how index investments affect fund exposure to controversial stocks, the Herald analysed the Vanguard International Shares Index Fund (VISIF). That fund is used by at least three KiwiSaver providers: Grosvenor, Westpac and ASB. A total of 2.64 per cent of VISIF's holdings were found to be in stocks of companies that have been blacklisted by the NZ Super Fund over ethical and legal concerns. • See our Herald Interactive: Dirty secrets of your KiwiSaverKiwiSaver clusterbomb: Banks run for cover The 18 companies identified were mostly in the tobacco industry, but also included a handful involved in the production of nuclear weapons, anti-personnel mines and cluster bombs. This means the $734 million in combined investments that the New Zealand providers have in the VISIF results in their KiwiSaver clients having an indirect exposure to these blacklisted companies, amounting to $20m. While it's a headline-grabbing figure, the sum becomes considerably smaller once it is broken down by industry and then by individual funds. Indirect exposure to the most troubling category - companies producing cluster munitions - drops to a combined $1.1m, spread across 15 schemes. Over the past week, Westpac and ASB have announced a review of their KiwiSaver investment policies. Radio NZ reported that Grosvenor went further and announced that it would divest from Vanguard entirely.

Having a responsible investment policy is necessary but nowhere near sufficient.
Matt Whineray, NZ Super Fund
AMP has said it will divest its cluster bomb holdings - held indirectly through unit trusts - by the end of October. Aon has not responded to media queries. The widespread use of index funds - the VISIF outlined above is just one of many which have received billions of investments by KiwiSaver providers -- calls into question whether fund providers' current disclosures of their holdings are sufficient, and also whether the information provided is accessible or understandable to the average retail investor.
The eventually-found disclosure statement was a spreadsheet with just three columns - featuring each investment's name, its percentage of fund holdings and identification numbers - stretching down to nearly 2500 rows.
These questions are being asked by fund managers themselves. Carmel Fisher -- whose Fisher Funds had declared a small exposure to tobacco and nuclear weapons firms -- said the saga had progressively widened over the past week to include competitors whose own controversial holdings had been folded into index investments. "Since your first report, various KiwiSaver providers have come out and acknowledged that they do have exposures to armaments and tobacco, even though a casual glance at their disclosures suggested otherwise. We know that KiwiSaver members want to know actual exposures to certain industries and companies and they don't want their KiwiSaver providers to hide behind index funds or other funds managed for them by someone else," she said. More mundane issues of administration have also come to the fore. One provider, seeking to talk up their transparency, noted that their fund holdings were available on their website. Having become aware the link was broken, the provider then sent through instructions on how interested parties could access the statements through the Companies Office disclosure register. The accompanying instructions outlined a process requiring no fewer than seven clicks. The eventually-found disclosure statement was a spreadsheet with just three columns -- featuring each investment's name, its percentage of fund holdings and identification numbers -- stretching down to nearly 2500 rows. The Financial Markets Authority, which publishes providers' periodic disclosures, said current regulations meant providers were only required to break down underlying holdings if they were internally held. A spokesperson for the regulator said the levels of detail required depended on a fund's structure, particularly when investments were made -- as they often are -- in other funds. Only if the underlying fund was also run by the same provider -- in other words, if it is a related party -- is a breakdown required to be published.
If investors want to find further information about an underlying fund then they can ask their provider to give them more detail.
"If investors want to find further information about an underlying fund then they can ask their provider to give them more detail," the spokesperson said. Even as the scale of the problem has widened, the issue has cystallised debate over what it would cost to resolve it. New Zealand Superannaution Fund chief investment officer Matt Whineray says he is "encouraged" by the way debate has evolved, and moved from denying a problem existed to putting a cost on a solution. Broad index investments are relatively cheap, but management costs creep up with the more tailoring -- and exclusions -- that is required. "The response has not been the older, traditional one, we used to get of 'We're only concerned with financial returns,' but it's 'We take this seriously and we'll take a proper look at it'," he says. The $30 billion NZ Super Fund isn't tackling the concerns or complaints of individual KiwiSaver investors, but it has grappled with responsible investment issues since its formation in 2001 as part of the state-owned fund's mandate to not prejudice New Zealand's international reputation. The Super Fund went through its own ethical firestorm in 2008, facing criticism from the Green Party and others over what were claimed to be unethical holdings. By the end of 2009, the fund had decided to divest from tobacco and armaments companies making weapons banned by New Zealand and international law. As to the financial cost of taking such a moral stance, Whineray says it has been negligible or nonexistent for the Super Fund, with analysis suggesting that maintaining its current exclusion list had reduced its returns by just four basis points -- a difference in annual returns of 0.04 per cent. "It's bugger all," he says. "It's not a big number of stocks we exclude - 169 out of more than 6000 we hold in total. When we took out tobacco we expected it would have no material affect one way or the other. "All the rest of our activity, we think it's positive in the long term because these concerns affect financial returns." However, Whineray cautions that running a wider exclusions policy may not prove so costless. Current debate in this area, driven partly by public health and environmental groups, calls for divesting from the fast-food or fossil fuel industries. Companies in these sectors add up to a much larger slice of the global economy, and would consequently have a bigger effect on risk profiles.
Having a responsible investment policy is necessary but nowhere near sufficient. You have to actively care about it and go and investigate and talk to these [underlying] fund managers.
"If you take out that sort of size chunk from the equity market you'll lose diversification. Our job is not to make everybody happy, but our job is to approach this in a structured and reasonable way," says Whineray. This isn't to say Whineray is saying he expects the Super Fund to remain in the fossil fuel game (a decision on whether the fund will divest from this sector is expect in the coming months), just that it is a big decision to make. "How you make your balance sheet resistant to the challenges of climate change is the $64,000 question -- or perhaps the $64 billion question." Making responsible investment decisions work in the face of indiscriminate index investments, says Whineray, requires work by fund managers. "The answer is, you have to want to do it. Having a responsible investment policy is necessary but nowhere near sufficient. You have to actively care about it and go and investigate and talk to these [underlying] fund managers." While not willing to disclose exactly how much the Super Fund's underlying fund managers charge to tailor their international index so it avoids companies on its blacklist, Whineray says it is "low to mid single figures." That is, the Super Fund gets charged fees of only 0.01 to 0.08 per cent of funds invested. This appears to be considerably lower than the costs faced by smaller, and fractured, KiwiSaver providers. Stephen Bennie, a partner at Castlepoint Funds, says the smaller players in KiwiSaver (the Super Fund is equivalent in size to all KiwiSaver providers combined) might not find switching to be so easy. He says Grosvenor's sudden move from low-cost Vanguard to an ethically-screened UBS index had probably doubled its costs. "It's charging 38 bps [basis points] -- which suggests there's not huge competition in that space -- and it's more than double the cost of Vanguard Fund 18 bps," he says. Bennie says the best prospect for resolving the issue would be a new index fund tailored to New Zealand KiwiSaver, but this would require co-operation from New Zealand providers -- who together might achieve enough scale -- and an agreement on what constitutes an ethical bottom line. "Someone could do it, if it got the backing of all these funds," he says. Sam Stubbs, the managing director of KiwiSaver startup Simplicity, which bases its business on low-cost Vanguard indexes, this week issued such a rallying cry, calling for New Zealand providers to use the Super Fund's exclusion list as a bottom line, to better lobby international fund providers. Adopting Super Fund policy, given its focus on local laws, mores and government policy, made sense, he says: "It also reflects what matters to ordinary Kiwis, and is in line with every agreement and treaty we have signed as a nation." However a senior financial source, familiar with both Super Fund and KiwiSaver operations, expressed doubts over whether peace would break out. "It's much easier for them [the Super Fund] to go and get an individual tailored fund. It's much more difficult for a collective group to do this. There's no KiwiSaver association, and everyone's a competitor," the source says. The sector would absolutely meet legal requirements, but it needed individual investors to vote with their feet and show they were willing to balance competing concerns. "The vast majority of people want to get the highest returns people, but also not invest in companies they consider are not acting socially responsible. It's not easy to have it all."