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Ethical investing seems like a great idea. Who wouldn’t want to help the planet, or the people on it as well as make great long-term financial returns?
I have been skeptical about the ability of these funds to match general market financial performance. After some time developing a financial plan, and choosing investments, ethical investing was put in the “too hard basket”.
In this article, I finally take a deep dive into ethical investing.
Types of Ethical Investing Strategies
What is Impact Investing?
Impact investors invest in companies with the intention of making the planet a better place. Investments are selected for their positive social and environmental impact, alongside a financial return.
Impact investing sits as a hybrid, somewhere between charitable giving and investing for profit.
What Sort of Investments are Included in Impact Investing?
The decision on which companies make a positive impact on the world is prone to subjectivity. These decisions come down to the opinion of a panel of fund managers.
Funds invest in companies they feel are making a positive impact on social and environmental issues. They can also provide low-interest loans to non-profit organizations.
Renewable energy, affordable housing, equitable healthcare and education, sustainable agriculture, conservation, and microfinance are some of the areas impact investing may invest.
What is ESG Investing?
ESG investing aims to invest in companies with positive environmental, social, and governance practices by using positive and negative screens.
ESG investors feel businesses with positive behaviours in these areas are more likely to profit over the long term. The primary aim is financial profit, with social benefit a side benefit.
It seems logical that companies that have abandoned fossil fuels in favour of greener alternatives are likely to have a brighter future.
What is Socially Responsible Investing?
Socially responsible investing selects investments based on a set of ethical standards. Those investments that don’t pass the filter are eliminated from the fund. Some examples of unethical behaviours that can be excluded are companies that are affiliated with terrorism, alcohol & tobacco and gambling.
How does Impact Investing, SR or ESG Investing Differ from Philanthropy?
Companies raise money to expand by listing on the stock market with an “Initial public offering”.
After that, their shares are traded between investors (and institutions) on a secondary market. The company does not directly benefit from those secondary market trades, just as Toyota doesn’t when one of its cars is sold secondhand.
So by investing in some sort of ethical, socially responsible or positively impactful company, you are not actually supporting that business. But you are (at least trying) avoiding profiting from unethical, socially irresponsible or negatively impactful businesses.
ESG, SRI or impact investing may fit better with your moral compass. But it is not usually the same as charitable giving. Impact investing is the closest to philanthropy, as this can include micro-loans to socially disadvantaged persons who can use those loans to better their lives.
Some funds cross boundaries and use a mixture of approaches. The Responsible Investing Association of Australia only certifies investment products as “responsible investments” if they:
“Have implemented an investment style and process that systematically takes into account environmental, social, governance or ethical considerations, and this investment process reliability has been verified by an external party. The product or service meets the strict operational and disclosure practices of Certification Program requirements.”Responsible Investments Association of Australasia
As you might expect, investing ethically usually involves a small fee premium. The selection of investments is, by definition, more active than a simple index ETF. But the fee premium is far smaller than I had expected.
Vanguard Australian Shares Index ETF charges just 0.10% management fee. Vanguards ethically conscious Australian shares ETF charges 0.16%.
Vanguard ethically conscious International shares ETF charges 0.18% but Vanguard Australian Shares Index ETF also charges 0.18%.
Is Impact Investing, Socially Responsible & ESG Investing Profitable?
Research into the results of ethical investing is often limited in its applicability by:
- Timeframe researched (we really want 30-year results, but not many researchers are that patient is getting a paper published!)
- Variable definitions of “ethical investing”. What counts? What doesn’t? The definition has likely changed over the years
- Conflict of interest – obviously studies by funds pushing ethical investors (or vice versa) have potential to be biased
- Selective publishing (would a research group release their data if they found a poor result?) and access to data (research showing a fund’s positive result is generally available free on their website).
Many studies over the years have largely found ethical investing to produce comparable, sometimes better returns than traditional investing. The longest duration of study I could find was over 20 years. Ippolito compared socially responsible and traditional mutual funds between 1965 and 1984 and found net risk-adjusted returns to be comparable.
A further study of 103 mutual funds between 1990 and 2001 also found no difference in risk-adjusted returns for ethical and traditional mutual funds.
Tippet, in contrast, found Australian ethical funds on average underperformed the market by 1.5% between 1991 and 1998. A further 89 ethical Australian funds were compared with the market return between 1986 and 2005, demonstrating a 0.88% underperformance for ethical funds over this period.
2000-2010 slight (statistically insignificant) advantage in British ethical funds over the market return. Socially responsible mutual funds were also found to outperform the S&P 500 between 2001 and 2012.
More recently, the Responsible Investment Association of Australasia reported responsible investments outperforming consistently over the past 10 years (ending 2021),
It certainly seems promising that responsible investments can outperform the market some of the time, and match it a lot of the time.
Returns, similar to other active investments, seem to vary significantly over different time frames, swinging above and below the market returns over time.
Studies that broke down the “mean return” tended to state significant variation between the best and worst-performing fund at the time, likely due to a huge variation in investment selection strategies.
Ethical Investing is Trending
” Responsible Investment AUM increased by $298 billion to $1,281 billion in 2020, while the AUM managed by the remainder of the market decreased by $234 billion to $1,918 billion.”Responsible-Investment-Benchmark-Report-Australia-2021.pdf (responsibleinvestment.org)
Younger investors are demanding ethical investing options, and superannuation funds are providing these options increasingly.
There is over $3 trillion in Australia’s superannuation accounts. Given mandatory superannuation contributions, young people are far more represented in superannuation than investing outside super.
Super funds want members, and their members are increasingly wanting ethical options. The significant inflow of funds through superannuation into ethical investments may well be pushing up these prices, contributing to the good recent returns of ethical funds.
Super funds are also in a powerful position of being able to encourage positive ethical and environmental outcomes in companies that want institutional investors.
The Case for Ethical Investing
If you are frustrated by your inability to make the world a better place (on a large scale), ethical investing may appeal to you.
The idea of investing for profit whilst making a positive impact is attractive. With the increasing flow of super funds into responsible investment choices, you may believe the underlying responsible investments are likely to continue increasing in value over the next few years.
When considering the viability of the companies you invest in long-term, those already with sustainable and ethical practices may perform better financially as a result.
Challenges of Impact investing
Involves Active Management and Reduced Diversification
Ethical funds can be heavily skewed towards tech stocks due to their low environmental burden. Entire sectors (eg resources) can be excluded by some ethical funds, whilst others include every sector and select the best ethical option available. A lack of diversification can lead to more volatility and active management is known to underperform index investing over the long term.
Like people, very few businesses are all good or all bad. Hitler and Mother Teresa were extreme outliers. But most of us have a complex (and fluctuating) amount of good and bad personality traits.
Companies are the same. Tesla is one of the most front-of-mind ethical stocks for most people. Electric vehicles can make a huge difference to our carbon footprint. But lithium mining (required for Tesla battery manufacture) has been associated with child labour, severe air, and water pollution.
This means each company requires a careful weighing up of positive and negative factors, the weighting of which is highly subjective. Would you want to be on a panel deciding which investments to include in an ethical fund?
What makes it even harder, is that some factors are easier to measure than others. Social and governance factors seem a lot harder to define, prove and measure.
How do you weigh the impact of avoiding child labour vs avoiding environmental devastation?
Green Washing & Spin
Greenwashing is when a business spends more effort portraying itself as “green” than trying to make a positive environmental impact. It is commonly used as a marketing gimmick to encourage you to buy something you don’t need because it’s “environmentally friendly.”
Businesses may be motivated to push up their own share price if key people own still own significant equity. Encouraging ethical super funds to invest may also be where greenwashing comes in. If the company is able to find specific criteria on which they will be judged, they may manipulate this.
Ethical Investing is less Powerful than Ethical Consumerism
Businesses are highly motivated by our purchasing power. Minimizing purchases, researching companies, and only purchasing from those you consider fit your personal values is likely more impactful than investing with an ESG filter.
Going car and meat-free are some of the most impactful environmental choices an individual can make.
There is also likely plenty of whitewashing going on. You may have noticed that your employers’ behaviour doesn’t always reflect its documented values and mission statement. Choosing to invest in a company because they make a written commitment to increasing the number of women in leadership positions is optimistic.
Quite often trying to “kill 2 birds with 1 stone” results in missing both. And you shouldn’t be trying to stone birds to death anyway, that’s hardly ethical ;).
Perhaps investing and doing good together may result in a suboptimal result in both. Is there a better way you can make a positive impact on the world? Perhaps through the donation of time and/or money or using your position of power to correct some wrongs you witnessed during your ascent to the top.
Investor pressure in “bad companies” can Create Positive Outcomes
Particularly when large and powerful, as are super funds, investor pressure can have a lot of influence.
Choosing Values and Aligning a Fund with Them
If you have strong opinions, and firmly held values you now need to find a fund that matches them.
Many others will be unsure of certain issues. Many ethical funds, for example, exclude Alcohol-related businesses. Alcoholism is a terrible disease that causes enormous social harm.
But I would still visit a vineyard and enjoy an afternoon of wine tasting. It feels pretty hypocritical to ban alcohol from my investments whilst directly supporting the businesses with my consumer dollar.
I am not a gambler. Casinos, pokey machines, and horse races all have their addicts too. But I don’t feel so strongly that all casinos, sports betting or pokey machines should be outlawed.
Just like alcohol, there are plenty of people who enjoy an occasional gamble relatively harmlessly. I just think there should be more protections for those that have the potential to become addicted.
How to Invest Ethically
If you have read all the above, and want to invest ethically, the first step is to choose whether you want to invest primarily for social good (impact investing) or profit (ethical, socially responsible, or ESG investing).
Wannabe Impact investors, check out the GIIN.
Start at the RIAA if you are interested in ethical, socially responsible, or ESG investing. They have a really useful tool, that first prompts you to choose your priority values and then provides a selection of funds that match the best. From there you can check how each fund checks its investments, its long-term performance (as long as possible), fees, and liquidity. Read this article for more information on choosing ETFs.
If you wish to switch your superannuation to an ethical option, RIAA is the best place to start
Many will choose to keep investing and doing good separate to keep things simple.
Ethical investing has many shades of grey, nuances, and traps naive investors. But it also has a reasonable body of evidence that it can at least match market returns, and sometimes exceed them. The Responsible Investors Association of Australia has a great tool to narrow down ethical investments that more closely match your values.
Are you an ethical investor? Please share any tips you have learned or helpful tools for budding impact or socially responsible investors below.
Aussie Doc Freedom is not a financial adviser and does not offer any advice. Information on this website is purely a description of my experiences and learning. Please check with your independent financial adviser or accountant before making any changes.