Forget lost returns: Transaction fees could cost divested institutions billions

New study quantifies for first time significant transactional and compliance costs divested schools will be forced to bear

WASHINGTON, D.C. – A new study commissioned by an American producers organizations shows that the divestment of oil and gas assets carries hidden costs may exceed losses that divested institutions would expect to suffer from weaker portfolio performance.

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Jeff Eshelman, senior vice president of the Independent Petroleum Association of America (IPAA)

Previous studies have shown that divesting portfolios of oil and gas assets weakens investment returns over time, forcing investors to take on more risk as their portfolios become less diversified, the Independent Petroleum Association of America said in a press release.

But not as much analysis has been done to-date on the other costs that accompany divestment, specifically the costs related to conducting the actual transaction and then actively managing the account to keep it compliant with ever-changing definitions of what it means to be “fossil-free.”

The study released this week by Prof. Hendrik Bessembinder, professor of finance at the Arizona State University’s Carey School of Business, says those costs are significant.

According to Bessembinder’s research, transaction and management costs related to divestment – what he refers to in his paper as “frictional costs” – have the potential to rob endowments of as much as 12 per cent of their total value over a 20-year timeframe.

This includes the immediate transactions costs, as well as ongoing management fees to stay in line with the changing definition of “fossil free.” Prof. Bessembinder estimates these frictional costs could cost a typical large endowment fund growing at a historically reasonable rate as much as $7.4 billion in value over a 20-year period.

“How a divested portfolio performs over time from a returns standpoint is a question we can model, but without a crystal ball, it’s difficult to predict how securities will fare in the future,” said Prof. Bessembinder, who also serves as managing editor of the Journal of Financial and Quantitative Analysis.

“But we don’t need a crystal ball to quantify the costs that divested institutions will be forced to

bear by merely executing the necessary transactions. These costs have nothing at all to do with the speculative matter of how stocks or industries will do in the future. These are largely unavoidable costs, every institution that divests will incur them, and as my research shows, they significantly add up as time goes on.”

Prof. Bessembinder analyzes 30 separate US universities of varying endowment sizes and quantifies what the frictional impact would be on each segment under a divested scenario.

Focusing on that sample – including large, medium-sized, and small endowments – conservative estimates of the initial transaction costs range between a loss of 60 basis points and 269 basis points for large endowments; between 25 and 180 basis points for medium endowments; and between nine and 124 basis points for small endowments.

Meanwhile, conservative estimates of ongoing annual compliance costs range between 8 basis points and 58 basis points.

Combining these estimates of transaction costs with ongoing compliance costs, Bessembinder estimates that endowments would lose between two and 12 percent of their value due to divestment over a 20-year period – over and above any losses incurred due to weakened portfolio performance.

“Activists like to say that ‘past performance isn’t an indicator of future performance’ when they attack independent studies that show divesting fro

m oil-and-gas companies harms returns,” said Jeff Eshelman, senior vice president of the IPAA, which commissioned the report but says it had no control or influence over its design or conclusions.

“But this study isn’t about modeling the future – it’s about quantifying what the actual, real-world costs are today for simply conducting the transaction, which often requires the wholesale sell-off of mutual funds and the transitioning of accounts over to activist management firms that charge sky-high fees for being ‘fossil-free,’ to the extent we even know what that means anymore.”

As activists continue to pressure institutions to divest their portfolios of oil and gas assets, a cottage industry of “green” money management firms has sprung up to open campaigning alongside activists in support of divestment – notwithstanding the fact that many of these firms themselves continue to own, and have no plans to sell, fossil-related assets, the IPAA said in its release.

One of the reasons that transaction and compliance costs related to divestment are so high is that many of these firms charge management fees that are significantly higher than their peers, according to the Bessembinder report, which says these funds have expense ratios that are on average 10 basis points higher than other active management firms – and as much as 73 basis points higher than passive investment firms.

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