We were recently contacted by a magazine about our July article on ‘terror-free” investing. 

The first question was how can you distinguish between companies providing “real” aid to the enemy as defined by the U.S. State Department list of terror sponsoring nations, versus companies that just get caught in a “key word search” of SEC filings that name a country on the terror list? 

The second question was how can you quantify the degree of involvement with a terror sponsoring state, including what constitutes indirect aid by knowingly working with nations or companies that in fact do provide aid to nations on the terror list?

Two great questions — and we have no idea how to answer either of them.  Apparently nobody else does either. 

The problem is that Congress continues to mull ways to draft legislation that will define who is on the right side and the wrong side of the issue, and how to define penalties for being on the wrong side of whatever rules they develop.

Our idea is to try something entirely different and, by the way, more democratic than relying on our federal legislators. 

Legislators are unfortunately too often burdened by conflicts of interest and more concerned with re-election than on what really makes sense for the country – not because they don’t care, but because they are so busy managing their careers that they do a less than optimal job of managing the country.

Here’s something the government might try if they are going to legislate on terror-free investing.  Pass a law that requires every significant investment pool (large corporate, government and union pension plans, university endowments, mutual funds, hedge funds and the like) to develop and PUBLISH their definition of terror-free investing, so that any investor or member of the public can access and read it.  Require those pools to manage their investments consistent with their published policy, and provide annual certification to the SEC that they have done so.

The result would be a wide variety of approaches in the beginning, but in this world of the internet and blogs, the dialogue around the published policies would be vigorous.  There would be active choices made by all sorts of constituents and stakeholders to the published polices.  As a result, the policies would begin to change and over time they would probably converge to some kind of general consensus based on what the American people believe is correct, and not what our hurried, harried and conflicted elected officials think is best. 

Unintended Consequences:

Unintended consequences of laws is always a concern.  Unfortunately the legislative system is very slow to change and adapt to discovered unintended consequences.  Regulation of investing would result in many untoward and unanticipated outcomes.  We think a public dialogue resulting in free-market choices relating to terror-free investing is a more sensible and workable approach.

The net public wisdom would deal with unintended consequences as they became apparent in the dialogue or in practice and would adjust accordingly.

Let’s look at a simple hypothetical example of an unintended consequence. 

Assume the law says no U.S. company or company doing business in the U.S. can have business relations with any country on the State Department list of terror sponsoring nations, and if they do they will lose their right to do business in the U.S.

With that law, consider two companies.  The first company is an Indian IT outsourcing company with substantial operations in or relating to the U.S.  The other is a U.S. pharmaceutical distributor with domestic and international sales. 

Now assume that the Indian company has no operations in Syria (one of the countries on the terror list), but it operates a Bangalor based computer operations center for Russian construction company building highways in Syria that would be helpful moving military personnel and equipment more efficiently.  They might be OK under the law.  And now assume the U.S. pharmaceutical distributor has offices in Damascus where they sell insulin for diabetics, AIDS medications, and childhood vaccines.  They would not be OK with the law.

We ask you which company in this hypothetical example is doing more to aid terror, the U.S company that is violating the law or the Indian company that is not?  Is it possible that the pharmaceutical company is actually working against terrorism by the nature of its operations?  The hypothetical law we presented would probably not be seen as helpful in combating terrorism in this instance, but that kind of law and that kind of outcome is possibly what could result from a legislative prescription. 

There will be unintended consequences under our suggested approach too, but the public forces at work will evolve a way to solve the problems, whereas a law would likely continue on the books whether or not it continues to make sense or to be fair and reasonable or to be good for our country overall.  Laws will exist, be perpetuated and enforced for their own sake. The reason for their creation will be lost in the zeal to enforce them.  Our approach, on the other hand, would be organic and develop and adapt appropriately as the world around us changes.

We think relying on the forces of the market and the larger community is a better way to evolve a best solution for terror-free investing than one-time legislation of specific and detailed investment rules by our elected officials. 

We think voluntary “terror-free” investing is a good thing to do.   After-all we are in a war and investments are one kind of resource and weapon for that war.  However, we think using a process like the one we have described is best.  The American people in the aggregate have more than enough common sense, patriotism and practical thinking ability to make the right decisions through the process we have outlined. 

Index Fund Implications:

Terror-free investing, regardless how it may come about, if it comes about in any policy or legislative form, will have tremendous impact on debt and equity indices, particularly non-U.S. indices and the funds that track them.  Consider Vanguard’s FTSE World ex U.S. ETF (VEU), or Barclay’s MSCI Emerging Markets ETF (EEM), or State Street’s SPDR S&P Emerging Middle East & Africa ETF (GAF), just to name one fund from each of three leading ETF sponsors.  Those sponsors and the three corresponding leading index providers (MSCI, FTSE and S&P) would have to re-examine the indices and/or the degree to which the funds track the indices to be “terror-free”.  The dislocations and disruptions under any set of scenarios would likely be quite something to observe.

Richard Shaw
QVM Group LLC

Disclosure:  Author owns VEU

Terror-Free Investing, a National Security Approach

“Terror-free” investing is a relatively new form of investing that excludes from portfolios those companies that have identifiable business activities in countries that support terrorism.

Just as the South Africa disinvestment movement decades ago caused companies to terminate operations there, the theory is that terror-free investing will cause companies to stop doing business in or with countries considered to be state sponsors of terror.

The Missouri State Treasurer gave birth to the movement in June 2006 when she set up a terror-free investment fund within the Missouri Investment Trust. Provisions are being made in Missouri for college 529 savings plans to have a terror-free investment option.

Since that time several other states have begun exploring terrorism-free investment mandates for their state agencies. Yet some  say it is not for states to decide such issues, preferring to defer to federal decisions on the matter.  Portfolio managers and plan administrators say that as fiduciaries they cannot take on social causes unless the are imposed on them by mandate.  The movement is gaining ground, but is still young with a not entirely certain future.

For investors, the basic questions are: “Do I want to own stock in companies that do business with countries that sponsor terrorism?” “Do I want my money to help pay for the bullets, bombs or poisons that may one day kill me, my family or others?”

Conceptually, the idea is simple, but practically implementation is difficult. How would one establish a method and rules for such an investment approach? How would one do the research to develop a list of companies to exclude from investment?

It is likely that a terror-free portfolio could perform just as well as an unscreened portfolio. We have not tested that assumption in this instance, but have previously tested other socially screened portfolios against their unscreened index benchmarks and found ample return opportunity.

As is the case with most socially screened investments, certain arbitrary definitions and limits need to be established to make the portfolio management job feasible within reasonable costs and timeframes, and to reach clear conclusions as to what is permitted and what is prohibited for investment.

In the U.S., so far, the working definitions for terror-free investing have been evolving through legislation and government agency decisions. The U.S. State Department has designated five countries as providing state support for terrorism: North Korea, Iran, Sudan, Syria and Cuba. The SEC formed the Office of Global Security Risk in 2001 to review filings of companies trading on U.S. exchanges to identify business connections with countries on the State Department terror list.

The List:

The list of 90+ companies recently published by the SEC that have business in countries designated as sponsoring terrorism is provided in the chart below:

  click to enlarge image

Putting Teeth into the Laws:

Senator Chris Dodd of Connecticut, Chairman of the Senate Banking, Housing and Urban Affairs Committee, has made a point of saying that we must get much tougher on terrorism through financial controls as well as other means.

Congress has been working on legislation that would levy tough sanctions against companies doing business directly, or to some degree indirectly, with designated terror supporting states, and may involve seizure of the U.S. assets of those companies, including their affiliated companies; and nullification of U.S. contracts with those violating companies.

Another piece of legislation under consideration would eliminate current exemptions for major oil companies doing business in restricted countries.

Kiplinger’s pointed out that “The law could also be applied to foreign banks, insurers or shippers that are part of a supply chain for Iran. Companies in Germany, the United Arab Emirates, China, Italy, France, South Korea and Russia are most likely to have business links to Iran.”

Law of Unintended Consequences:

If the sanctions legislation passes, as we think it will in some form, there will be confusion in the securities markets until the regulations are promulgated and the administration of them is clear in practice. The confusion will manifest itself as extra volatility in prices of stocks that may or may not come under the hammer of the law.

The legislation will contain loopholes and unexpected problems. Unintended consequences of implementation will create additional administrative exceptions. Until it is all settled in terms of administrative interpretation of the legislation, extra volatility will persist in potentially impacted stocks. Those thought to be OK may experience multiple expansion as a result.

Implementation problems will arise because the world is a totally interconnected system and it will be difficult to impossible to create clear lines of demarcation on what is trading with the enemy and what is not.

Consider questions such as these:

• Will major oil companies be required to abandon billions of dollars of long established properties and operations in designated states to avoid seizure of U.S. assets — putting them in a lose-lose situation?
• Will a major consumer staples company have its U.S. headquarters building seized by U.S. agents because it cannot prevent the flow of its soap and toothpaste into designated terrorist countries?
• Will a major pharmaceutical company selling proprietary drugs that save children’s lives in Iran be forced to stop to protect its U.S. franchise? Will the U.S. effectively encourage terrorist states to manufacture their own generic versions of needed drugs that they might otherwise have avoided out of respect for patent rights?
• If a company is a parts or material supplier to a company that in turn does business with a terrorist state, will that supplier be sanctioned too? How many levels in the supply chain would be implicated?
• Would a utility company supplying energy to a violating company be legally exposed to penalties if they knew the company was on a government terror list? Would they have the authority to refuse to provide electricity or gas without breaking other laws and contracts?
• Would a country like France, that has long standing business connections with Iran, stand idly by as the French economy was damaged by the impact of the U.S. laws on key French companies such as TOTAL (TOT)?
• China has long term energy supply relationships with Iran. If delisting were a penalty, would Petro China (PTR) be delisted in the U.S? How would U.S. investors in delisted companies exit their positions?
• Petrobras (PBR) has Iran connections and they are the principal exporters of Brazilian ethanol. Will Bush’s recent plans to collaborate with Brazil on ethanol development be torpedoed because Petrobras is in Iran?
• Will the S&P500 energy sector (XLE) be modified to eliminate Connoco Philips which is on the list of those doing business with states sponsoring terrorism?
• Will we now have the “S&P 500 ex Terror index”? Which index will be the benchmark for state pension plans – the original S&P 500 or the Terror-Free index?
• Will mutual funds be taxed or regulated differently if they include companies on the terror list than those that exclude those companies?

The Funds Problem:

It is very difficult to avoid owning companies on the terror list if an investor uses funds, as most retail investors do. The only effective way to avoid owning terror list stocks is to manage an individual stock portfolio, or to buy a specialist fund that represents itself as terror-free.  Only one such retail fund exists today, the The Roosevelt Anti-Terror Multi-Cap Fund (formerly the Bull Moose Growth Fund), symbol BULLX.  

Will the government take steps to require mutual funds, pension plans, endowments and other pooled investments to divest of companies on the terror list?  If they did, would they step on the secret and hallowed ground of the hedge fund industry? 

There are some groups pressing for voluntary and state mandated divestment by public pension funds, as well as federal requirements for mutual funds and endowments to divest.  Others are pushing back with arguments that voluntary divestment will not work and that state regulations have been found by some courts to be assumption of foreign policy decisions that are outside of the scope of authority for states. Still others say that plan administrators do not have the authority to subordinate fiduciary obligations to maximize return to social causes.  Where they all seem to agree is that if anything comprehensive is to be accomplished with respect to pensions, endowments, mutual funds and other regulated investment funds, it will have to come from federal legislation and regulation.

The Oil Problem:

The concept of not consorting with the enemy via commerce is a good one in principle, but how effective will it actually be at increasing security? Take the case of oil.

The money we all pay for gasoline and heating oil may do more to finance governments supporting terrorism, even North Korea indirectly, than the business connections terror-free investing is meant to interupt?

At the same time, how much oil money in the hands of black-listed countries comes back to public companies in the form of share purchases and bond purchases? Will that become a future area of additional scrutiny?

Foreign Policy Problem:

To the extent that security is the issue, we face the potential problem that some countries may deserve to be on the black-list but are not for strategic reasons, while others may be on the list that no longer need to be there?

Bureaucracy and Politics Driven Process:

If terror-free investing is important to you for your account, then you must keep in mind that governments and their agencies behave bureaucratically and politically, and that may not be the same as behaving in ways that will meet your information objectives.

Case in point: When we began looking at terror-free investing in March of 2007, we contacted the SEC Office of Global Security Risk to request a copy of the list of companies they had identified as working in counties that the State Department designated as supporting terrorism. We were told flatly that the data was private between the companies and the SEC and was not available to the public. When asked how that was supposed to help protect investors, which is part of the SEC mission, they had no answer.

Foruntately, Senator Dodd of Connecticut took initiative and wrote to the SEC in May asking them to step up their efforts to help investors understand Global Security Risk. The list of companies subsequently became available online.

Government works in its own ways on its own timescale.  It cannot be relied upon to present all the relevant facts to investors when and as they need them. You need to do your own research in addition to that supplied by the government.

This article is not about politics. We don’t want to digress from the basic issues of investing, except to say that if you want a terror-free portfolio that meets your concerns, you need to decide what that means and then carefully consider whether government lists are driven by the same set of issues as your desire to keep your hard earned money from aiding the enemy. Terror-free investing to be effective for your purposes may require a more complete and careful review of countries and companies to satisfy your sense of security. Government lists are helpful, but may not be sufficient. However, they are a good place to begin any terror-free research and screening efforts.

You can access the SEC list of companies, the SEC comments about each company and links to the relevant company SEC filings at:

http://www.sec.gov/edgar/edgartlistfilings.htm

Richard Shaw
QVM Group LLC

Disclosure: Author owns Conoco Phillips (COP) and may own other stocks on the list indirectly through funds, such as PetroBras (PBR) owned indirectly through the Brazil ETF (EWZ), or various other companies owned indirectly through the MSCI EAFE index ETF (EFA) or other funds owned by the author.