Dispelling the myths about ethical investment
Ethical investing, or socially responsible investing (SRI), is gradually emerging as a highly credible form of investing, with the objective to deliver financial returns whilst doing good for society and the environment we live in. Although trustees have a duty to their beneficiaries to maximise financial returns, "doing good" is an increasingly important consideration, especially as ethical investing becomes more mainstream, accessible and profitable.
Charities must consider the impact that their investments are having on our society, as well as maintain their reputation amongst existing supporters and the wider public.
Despite the progress that’s been made in this area, many proponents of ethical investing have held back on their views for fear of these being regarded as coming from preachers or “do-gooders”, who are not concerned about financial returns. As a result, the common myths surrounding the subject have endured and continue to impede further progress being made.
Ethical investing can however be a valuable strategy for trustees who want to ensure strong financial returns whilst ensuring that their investments are socially responsible, and in line with their core values. Here are some of the most popular myths, and why they should be discounted.
"ETHICAL INVESTING IS NICHE." Interest in ethical investing has grown substantially in recent years, becoming an area that investment 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.
These are efficient, cheap and liquid ways to invest ethically into broader areas of the market. The popularity of passive environmental, social and governance (ESG) strategies is notable, with significant inflows, and assets increasing by 18.1% in 2016.
We are now seeing some form of ethical or socially responsible investment product being offered by most 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.
Fund managers are also becoming increasingly aware that incorporating ESG factors into their investment process leads to an enhanced due diligence process and a more accurate assessment of risk. This 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.
"ETHICAL INVESTMENTS DELIVER LOWER RETURNS." This is probably the most common myth of all, but also 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 benefiting 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 on exclusion. Typically, the excluded sectors (for example, tobacco, oil and mining) have been some of the best performing sectors over the long term.
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.
Let’s compare the returns of the FTSE All Share Index of UK companies against the returns of the FTSE4Good UK Benchmark of UK companies demonstrating strong ESG practices. We can see that over a 5-year time horizon, the FTSE4Good UK Benchmark returned 29.3%, while the FTSE All Share returned 26.4%. This shows outperformance of ESG focused investments of just under 3%.
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 those from traditional investments.
The challenge for trustees is ensuring they invest in an ethical fund that is aligned with their own criteria. Due to increasing demand, there are many more options now available then there used to be, and trustees must do their own due diligence to ensure there’s nothing in the fund that they don’t want to be associated with.
"ETHICAL INVESTING IS TOO EXPENSIVE." Ethical investments tend to command only a slight cost premium over traditional investments, due to the added layer of due diligence involved in the process. The difference in the average ongoing charges figure (OCF) of premier versus ethical portfolios is minimal, and this small premium over traditional investments should be accepted, given the potential for advantageous returns.
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.
"Loss of opportunity"
"INVESTING ETHICALLY MEANS BEING EXCLUDED FROM MANY AREAS OF THE MARKET." It is becoming less common for ethical fund managers 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 capable of generating sustainable cash flows.
It’s not hard to find well diversified ethical portfolios: most asset classes, such as fixed interest, UK equity and overseas equity, are well covered, and 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 environmental, social and goverenance investing can result in a smaller investment universe and therefore a reduction in investment opportunities, but 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, litigation and reputational risks for poor environmental practices.
Companies are becoming more aware of these risks and are 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, which means that trustees do not have to severely reduce their acceptable fund choices.
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 to be more volatile than larger companies. However, track records have shown, there is potential for higher returns in the long term.
"No social impact"
"OUR 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 charity's investment 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 regard to improving the gender diversity of boardrooms.
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? SRI is a legitimate alternative for trustees who seek financial returns for their charity, whilst believing companies should be held accountable for their environmental, social and governance practices.