Investing ethically does not have to mean sacrificing returns

Contributor: Rachel Lacey | Interactive Investor

 

Far from compromising investment performance, 'green' companies should outperform less ethical peers. 

 

Ethical investing, by its very nature, means you have a smaller number of possible companies to invest in than an investor who does not invest ethically.

How much of the market you rule out is dependent on how strong the ethical principles are of the fund in which you are investing. For an ethically-minded fund manager who focuses on the UK, some funds have very strict ethical criteria, which eliminate over 60% of UK stocks from their available list, while others have less severe criteria, choosing to avoid only a couple of sectors – with some eliminating as little as 3% of available stocks. 

This reduction in available companies is one of the key reasons why many investors avoid ethical funds and trusts: they assume that ruling out so many potentially profitable companies will hit their returns. However, recent evidence suggests that this is far from the truth, and a smaller number of companies for ethical funds to choose from could be one reason they are shown to perform better.

A 'study of studies' conducted by Deutsche Asset and Wealth Management in conjunction with the University of Hamburg in 2015, looked at 2,000 studies since 1970 into the impact on returns of investing along ESG (environmental, social and governance) lines.

In 62.6% of studies, the use of ESG criteria had a positive impact on corporate financial performance, compared to just 10% that displayed a negative impact, it found. 

A range of ESG indices created by Morningstar to analyse the performance of ethical investment tell a similar story. The 56 indices cover a range of ESG themes including sustainable leaders and sustainable environment, women's empowerment, minority empowerment and societal development. Of these, 41 have outperformed their non-ESG equivalents.

In 2015, Arabesque Asset Management analysed 200 academic studies to look at the correlation between sustainability and economic performance. It found 88% of studies showed that companies with solid ESG practices had a better operational performance, while 80% showed that stock price performance is positively influenced by good sustainability practices.

Looking specifically at environmental sustainability, the Arabesque report found "a direct relationship between the environmental performance of firms and stock price performance".

It said positive environmental news triggers share price rises, while the opposite is true when firms behave environmentally irresponsibly and share price falls can be significant.

Companies with more sustainable policies also benefited from a lower cost of capital – both debt and equity.  Arabesque found 90% of studies showed a relationship between better sustainability practices and a lower cost of capital, which should support higher company valuations.

Meanwhile, a 2019 study from MSCI found data to support the idea that high ESG-rated companies "were more profitable and paid higher dividends".

 

Additional risk?

While there may not be any reason for ethical funds to underperform over the long term, they may perform differently from other funds in their respective sectors over shorter timescales.

In the case of tobacco companies, for example, avoiding this sector would have compromised investment performance in the period up to 2017, but since those highs the sector has sold off significantly, benefiting those funds which are not exposed to tobacco.

Others argue that you may have to take more risk with your portfolio.

Volatility can be higher when certain sectors of the market are excluded because a more limited range of investment options can lead to higher concentration of risk. Returns compared to traditional investment portfolios can be exaggerated – both going up and going down.

 

Investor interest?

In 2019, the Schroders Global Investor Study found that 48% of UK investors either do invest ethically or have a desire to do so, while figures from the Investment Association show that the amount of money invested ethically has risen from £5.9 billion in 2009 to £20.9 billion by July 2019

This may be the Al Gore effect, with the ex-vice-president of the US suggesting that sustainable investing "represents the biggest investor opportunity ever writ in history" and that the world is in the "early stages of a sustainability revolution" that had "the magnitude of the industrial revolution and the speed of the digital revolution."

The move towards greater sustainability and an avoidance of companies that are perceived to do harm, could well be self-fulfilling for ethical funds and trusts. Increased popularity of ethical companies should increase their performance – and as more investors start to avoid certain sectors, like tobacco, those investments are likely to disappoint.

 

Conclusion

For many years, ethical investing was deemed something of an oxymoron – how could you combine capitalism with ethical responsibility? The idea that some fund managers could do better when they were forced to avoid sin stocks and sectors such as pollution, addiction or other questionable business practices did not seem to make sense if other fund managers had an unconstrained mandate and could invest where they liked. But the list of reasons to invest ethically is growing, especially when you consider the possible reasons for better performance of ethical investments - which include:

  • Companies that take their responsibilities to society and the environment seriously having more sustainable business models than those who do not
  • Governments regulating/punishing unethical business practices – for example, anti-bribery laws and investigations; markets for carbon emissions; requirements to recycle; restrictions on fixed odds betting terminals
  • Unethical businesses suffering as consumers shift away from their products – including big tobacco and diesel car manufacturers
  • Ethical products gaining from shifts in consumer sentiment – for example rapidly growing demand for vegan products
  • Activism, causing many investors to look at environmental and sustainable issues

Overall, the numerous studies that all point to an increased correlation between sustainability and performance, and the increased interest in what we are doing to our planet, means that ethical investing is becoming far more mainstream, and has moved away from its alternative reputation.

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