Ethical investing: Myth buster!

Posted on May 1, 2018 in Ethical Investing

Ethical, or socially responsible investing (SRI), is gradually emerging as a highly credible form of investing one’s money, with the objective to deliver financial returns whilst doing good for society and the environment we live in. Fund managers are becoming increasingly aware that incorporating Environmental, Social and Governance (ESG) factors into their investment process leads to an enhanced due diligence process and a more accurate assessment of risk which can lead to the inclusion of some of the highest quality companies within their portfolios. What’s more, ESG issues are now becoming firmly embedded within the investment process of many funds, as an added layer of qualitative analysis, regardless of whether they are marketed as being ‘ethical’ or not.

Despite the progress that’s been made in this area, the views of many proponents of ethical investing have been suppressed for fear of being heralded as preachers or “do-gooders”, who are not concerned about financial returns. As a result, the common myths surrounding the subject have remained and continue to impede further progress being made. Fear not! We’re here to challenge some of these myths that surround the topic of ethical investing and present our reasons why they should, in fact, be discounted.

“Ethical investing is niche”

Interest in ethical investing has grown substantially in recent years, becoming an area that managers simply cannot ignore if they are to remain competitive and meet the growing demands of their clients. This growing demand is highlighted by the recent launch of several SRI-focused index funds by some of the largest and most reputable investment managers, including iShares, SPDR and UBS. These are efficient, cheap and liquid ways to invest ethically into broader areas of the market. These passive ESG strategies saw assets increase by 18.1% in 20161, highlighting the growing popularity.

We are now seeing some form of ethical or socially responsible investment product being offered by the majority of well-known and highly regarded asset managers who are seeing no choice but to keep up with this growing trend which is by no means a passing fad.

You simply have to open any widely distributed investment magazine and you will almost certainly see at least one article relating to ethical or sustainable investing- in our view, ethical investing has well and truly entered the mainstream!

“Ethical investments deliver lower returns”

Probably the most common myth of all, but in our opinion, the easiest to refute as it simply doesn’t hold water. How can a company which pays more attention to matters such as improvement in health and safety standards, reducing bribery and corruption and maintaining a good reputation with customers, not be benefitting from lower costs through increased efficiency and more business opportunities? At the very least, these extra considerations should not hinder the company’s growth.

Perhaps there was an element of truth to this argument when ethical investing was in its infancy and traditional SRI funds focused solely on exclusion. Typically, the excluded sectors (for example, tobacco, oil and mining) have been some of the best performing sectors over the long term, which could have contributed to relative underperformance versus mainstream investments. Things have drastically changed since then. While several of these ‘dark green’ funds do remain, there has been a huge rise in the number of positive impact funds launched, which use positive screens to target companies doing good for society and the environment. The idea is that these companies are better able to meet the rapidly changing needs of society, through originality, efficiency and productivity and by paying close attention to the latest trends such as the growing interest in health and fitness, cyber security and increasing efficiency.

If you need a little more convincing, the numbers tell a similar story…

A simple comparison of the returns of the FTSE All Share Index of UK companies versus the returns of the FTSE4Good UK Benchmark of UK companies demonstrating strong ESG practices, shows that over a 5-year time horizon, the FTSE4Good UK Benchmark returned approximately 46.3% versus the FTSE All Share which returned 45%2.

The simple fact that socially responsible investing is moving further away from being considered as a niche market, is evidence that SRI strategies must be producing investment returns that are rivalling mainstream investments. We do not believe that the overarching fear of underperformance should be allowed to cloud your judgment any longer!

“Ethical investing is too expensive”

Ethical investments tend to command only a slight premium over mainstream investments, due to the added layer of due diligence involved in the process. The difference in the average OCF of mainstream vs. ethical portfolios is often minimal, and we believe that this small premium over mainstream investments should be accepted, given the higher returns generated.

The recent launch of new passive ethical funds and ETFs is also helping to keep overall costs down and the increased competition we are seeing with new fund launches, can only help keep prices competitive.

“Investing ethically means being excluded from many areas of the market”

It is becoming less common for them to apply a broad-based exclusion of any particular sector or region from the outset of their investment process. Any exclusion of sectors or regions tends to be a by-product of a screening process which selects high quality, well-managed companies which are generating sustainable cash flows.

From our experience, it is not hard to construct well diversified ethical portfolios: most asset classes such as fixed interest, UK equity and overseas equity, are well covered, and that this coverage is only improving over time.

“Ethical investing involves higher risks”

The strong association of ethical investing with negative screening has led to the belief that by restricting the size of your universe through implementing a negative screen, you are reducing the diversification and in turn increasing the risk of your portfolio.

Of course, the nature of ESG investing can result in a smaller investment universe and therefore a reduction in investment opportunities, however we believe the risks associated with poor management of ESG issues could be far greater. The risks of poor corporate governance are well-known, however there are also risks relating to environmental or social factors such as costs incurred from fines and litigation and reputational risks for poor environmental practices. Companies are becoming more aware of these risks and beginning to incorporate ESG considerations into their discussions, which means that the universe is likely to expand further over time.

SRI’s greater focus on positive inclusion also means that negative screens are not as strict as they once were and the universe of ethical investments available to fund managers is broader than ever before. This is compounded at the fund level, with significantly more offerings available for us as investors, which means that we are not having to severely reduce our choice of acceptable funds.

Ethical funds also tend to be more cyclical in nature, with some of the more defensive sectors such as tobacco, underweighted. They also tend to be biased towards small and medium sized companies, which are generally considered as more volatile than larger companies. Though this may be the case, we believe investors are ultimately rewarded with higher returns in the long-term.

“My money isn’t really making a positive impact”

This simply isn’t true. Impact investing is centred on investing in companies which have been identified as being able to meet the needs of our society and environment and which can generate a positive, long-term impact. These are companies involved in the provision of sustainable goods and services, such as energy efficient home appliances, required infrastructure, such as social housing and clean water, and responsible finance companies, which are prudent when gathering deposits and lending to customers. This merely scratches the surface of the ways your money can help to support companies doing positive things for our society and the environment.

On top of this, many asset managers are involved in positive engagement with companies, lobbying for increased transparency and disclosure policies surrounding sustainability. Examples of this include dialogue with retail companies regarding their supply chain management and engaging with corporates with regards to improving the gender diversity of boardrooms.

Rest assured, your money is being put to good use!

Don’t get us wrong, many ethical and socially responsible funds underperform their peers, but so do many traditional funds…does this mean that traditional investment strategies don’t make financial sense? We believe that the arguments above justify the case for SRI as a legitimate alternative for investors who seek financial returns whilst believing companies should be held accountable for their environmental, social and governance practices.

We are confident that combining negative screening with a more flexible approach delivers results, and it is this thinking that has driven our own research and has led to the construction of what we believe are high quality ethical portfolios, built from a diverse range of funds at different points on the “green” scale, but all meeting our goal which is to provide outstanding financial returns for our clients.

2. Data from Morningstar and figures quoted in GBP, accurate as at 30 April 2018