Wednesday, 7 May 2008

Equity Linked Compensation and the Efficacy of Ethical Investments

There are many ethical investments on the market today. Here in Australia, Hesta has a socially responsible Eco Pool Fund. This fund looks at different sectors and invests in the best in that sector. The best is defined as the company that best adheres to the ethical standards of the fund manager. The benefits of Hesta's Eco Pool is that fees are fairly low, probably due to economies of scale. The main problem with the Eco Pool is that Hesta won't give us any idea of what companies they are investing in, which means that investors will have to simply guess or have faith that the fund manager is investing in ethical companies.

Two very prominent ethical funds management companies in Australia are Hunter Hall Investment Management and Australian Ethical Investments. Hunter Hall has a value investing fund that has produced spectacular performance. Their newest product is a Global Deep Green Trust that doesn't just avoid unethical companies but also seeks out ethical companies. Australian Ethical is worthy of mention because they provide a list of all the companies in which they invest.

Some people criticize ethical funds, saying they make no difference. One argument is that companies only issue stocks during the IPO (initial public offering). The company will definitely care about the demand for stock at this stage. However, once the IPO is finished, the stocks are then traded on the secondary market. The company has little or no say in what happens in this secondary market. The critics of ethical investment argue that whether or not stock prices are high or low is irrelevant because the company has already received all the capital it needed from the IPO.

I would like to now give a reason why ethical investing may work very well. The reason is because the board of directors nowadays are increasingly using equity linked compensation. That is, the CEO is paid in stocks of the company. The better the CEO performs, the higher the stock price, and the higher his or her pay. This then provides an incentive for CEOs to do a good job. If they don't, stock prices will fall and the CEO's net worth will drop.

Since ethical funds have the potential to affect equity prices by changing demand and supply for stock depending on how ethical the company is, CEOs then have a powerful incentive to clean up the companies they lead.

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