Is swapping a good alternative to divesting?

Many investors do not want to be involved with harmful or morally questionable products, for example controversial weapons, thermal coal or tobacco. A common practice is to divest the current holdings in such firms and exclude them from the eligible investment universe going forward. However, divestment also means losing the rights investors have as shareholders, in particular the right to vote and to initiate proposals at shareholder meetings.

In order to address this concern, investors might consider the use of swaps as an alternative to divestment. In the most simplified case, the investor hires a passive manager to fully replicate the market portfolio, and then adds a swap with a short leg that brings the exposure to the companies on the exclusion list back to exactly zero. The long side of the swap can consist of either all other stocks or a customized basket of stocks, such as a portfolio of highly sustainable stocks, or stocks that are expected to provide the best hedge for the neutralized stocks.

Similar to divestment, the swap approach establishes zero economic exposure to the excluded firms, as the physical long positions are offset by the short side of the swap. From a financial risk management perspective the two approaches are therefore equivalent. However, the swap solution offers two benefits.

First, by retaining ownership of the excluded firms, investors preserve their rights to vote and initiate shareholder proposals, contrary to investors who choose to divest. Secondly, the return of the swap directly reflects the cost or benefit of the exclusion decision, as the short leg consists of the excluded stocks, while the long leg consists of the substitute portfolio. With divestment it is harder to pinpoint the impact on performance, because it is not obvious which specific stocks were bought to replace the excluded ones.

Swapping does have certain drawbacks. For one, it may be difficult to explain to stakeholders. Clients, media and NGOs may not understand the rationale behind simultaneously buying a firm and shorting it with a swap. People may also fail to see these two choices in conjunction with one another and look at the physical holdings in isolation instead.

Moreover, derivatives add complexity, such as legal contracts, counterparty risk management, and collateral management, for which not all investors are equipped. The counterparty of the swap may also charge a fee to facilitate the swap, reducing the total return for the sustainable investor.

The main concern with swapping, however, is that it may have less real-world impact than divesting. In particular, if a company wants to scale up its business activities and decides to raise fresh capital by issuing new stocks or bonds, then clearly none of the investors who exclude this company will subscribe. Thus, divestment limits the access these firms have to capital markets.

Passive managers, on the other hand, are committed to following the weights in the index. This means that if they expect that issuance will cause the weight of a stock or bond to go up in the index, they will need to subscribe to the issuance in order to adhere to their full replication policy. The asset owner can of course decide to neutralize the increased portfolio weight with additional swaps, but by then the company in question has already raised its fresh capital.

Swap transactions take place in the secondary market and hence do not limit access to capital in the primary market, at least not directly. Therefore, the real-world impact of swapping is likely weaker than with outright exclusion.
Finally, one could also wonder whether voting or initiating shareholder proposals for a firm in which the investor has zero economic exposure is ethically responsible. This so-called ‘empty voting’ is against best practice and in conflict with stewardship codes in countries such as the Netherlands.

To illustrate this point, consider a situation where an investor owns certain stocks but uses swaps to not only reduce the economic ownership to zero, but to obtain a net negative (i.e. short) position. In this case, the investor would benefit financially from voting in favor of proposals that intentionally hurt shareholders. Such conflicts of interest may hamper the proper functioning of financial markets.