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Ethical Investment Funds: Choose Wisely if You Hope to Match Your Values with Returns

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Ethical and sustainable investing is one of the fastest growing investment ‘categories’ in terms of the growth in the amount of capital being attracted. Data published by Investment Association, the UK’s fund management trade body, highlighted a £100 million April capital inflow to funds characterised as ‘ethical’. The past twelve months has seen overall capital under management in ethical funds grow by £2.4 billion to a total of £15.8 billion. That equates to annual growth of just under 18% and indicates a sector very much on the up.

The annual Schroders’ Global Investor Study, a yearly canvassing of investor perspectives and sentiment conducted by the fund manager, also highlights this shift in attitudes. 78% of retail investors responded that the sustainability of their investments has grown in importance to them over the past half-decade. Interestingly, while millennials are, as might be expected, a driving force behind the shift in the priority investors are giving to their capital being invested ethically, the older baby boomer generation are not far behind. 67% said that sustainable investment had grown in importance to them over the same period. The shift appears to be one of growing awareness across the demographic spectrum.

Government and regulators are also getting behind the shift of capital allocation towards companies whose businesses are considered to be ‘ethical’ and ‘sustainable’. While guidelines look broad, last week the UK Government’s Department for Work and Pensions published a consultation on trustees’ investment duties with regards to ethics of investment strategy. The consultation proposes that trustees should be obliged to make a statement on

“how they will take account of the views which they consider scheme members hold in the development of the policies”,

within the statement of investment principles.

The approximate translation of that sentence amounts to the likelihood that pension trustees will soon be obliged to address their investment strategy’s ethical framework as part of informational literature and prospectuses.

Ethical and Sustainable Investment Funds – How Are They Defined?

The biggest question both investors and fund managers have to grapple with is how to define an ‘ethical investment’ or ‘sustainable investment’ strategy. Ethics are a personal, and often fluid, concept and there is not a ‘one size fits all’ approach. For one investor, buying shares in a tobacco company might not be an ethical dilemma as long as the company has good governance, pays their workers and farmers fairly and prioritises ecologically sustainable tobacco farming. For many others, tobacco is likely to be off-limits entirely as an industry.

Passive and actively managed funds that label themselves as ‘ethical’ and ‘sustainable’ based on low-carbon or other ecological benchmarks were the first major group to appear. Some entirely cut out investments into companies involved in the fossil fuels sector. Others do invest in the fossil fuels sector but on a principle of selecting ‘best practise’ companies. This could mean, for example, an energy company that has a significant, growing renewables unit and is investing heavily in renewables R&D, but still also drills for oil.

One investor will surmise ‘well, my own car and the economy still relies on oil so it would be hypocritical to cut any company with interests in fossil fuels out of my investment portfolio. But I can reward those taking a pro-active approach towards a practical transition towards sustainable energy’. Another will consider any kind of investment in a company with fossil fuel interests as tantamount to a contribution to maintaining the status quo and slowing down the economic and industrial transition towards renewables. A third investor will dig deeper still and expect their investment fund to only invest in renewables companies whose supply lines do not involve rare earth metals mined in an ecologically harmful way.

Last year saw the launch of Europe’s first ETF investing in a weighted benchmark of 150 international companies that score highly on an appraisal of their approach to gender equality – Lyxor’s Global Gender Equality (DR) UCITS ETF. Funds that invest according to the values and rules of a particular religion or religious denomination, such as Islamic Finance funds and Christian or ‘Catholic Values’, also exist.

Are Ethical Investment Funds Really Ethical?
This all goes to demonstrate the complexity and ambiguity of active fund managers and passive index tracker compilers labelling an investment strategy as ‘ethical’ or ‘sustainable’. It also highlights why investor outcry when particular investments that constitute part of their ‘ethical’ investment fund turn out to not fit their own personal values is becoming a common occurrence.

A recent Telegraph article featured a couple who had invested in Legal & General’s ‘Future Worlds’ fund. With £4.5 billion under management, the fund was marketed by both the manager and the pension company they bought it through as “aiding the transition to a greener economy” by investing in “low-carbon” firms. The couple were subsequently disappointed to discover that fossil-fuel intensive energy company Royal Dutch Shell featured among the fund’s top 10 holdings. The investors believed that an investment in Shell went against the principles they had wished to adhere to. The fund manager argues that Shell is investing heavily in electric car charging networks and reducing the carbon footprint of its operations and products. Romi Savova, chief executive of PensionBee, the fintech pensions provider that marketed it to the couple as a ‘low carbon’ investment choice, also explained why her company feels comfortable doing so:

“We think there’s more to be gained by taking a seat at the table and attempting to influence a company’s policies directly.”

And there is at least some merit in this argument. At least for those who believe that the most practical way to action real, lasting transition towards a sustainable economy will come from ‘evolution’ not ‘revolution’. However, that is, again, to a significant extent a personal position and there is no black or white right answer.

Investing ‘ethically’ according to one’s own personal set of values and beliefs will for the foreseeable future boil down to putting in some additional research. Unless you have a personal financial advisor who has a detailed appreciation of your requirements around companies you wish to invest in, and you invest enough for there to be a business case for that financial advisor to screen individual companies and funds according to that framework, you’ll have to do it yourself. You can’t, realistically, outsource your personal morals to a money manager.

Realistically, a ‘sustainable’ or ‘ethical’ investor has two choices. The first is to define what their priorities and red lines are when it comes to investing. Then some time must be taken find funds whose investment strategy approximately corresponds to those and double checking by assessing the major holdings held by those funds.

The second is to go one step further and choose individual companies to invest in, blackballing those that do not meet personal criteria for sustainability or ethics. This could become quite the endeavour as the most devoted ethical investor would have to dig into details such as suppliers, waste management and employee working conditions.

The first approach, however, is probably that which is a realistic option for most retail investors. It may not be perfect but it will certainly be a significant improvement on how closely investments match personal values than if no such personal screening were conducted. With no concrete framework on what criteria a fund labelled ‘low carbon’, ‘ethical’ or ‘equal rights’ actually has to apply when choosing its holdings, this will always boil down to the approach of the individual fund or manager. If that doesn’t turn out to match your own preferences but you just presumed it would, can the fund manager or pension platform really be held accountable?

Does Investing Ethically Necessarily Mean Compromising Returns?
PensionBee selects sustainable funds which do not engage in “negative screening”, such as blackballing any company in or connected to the oil industry. While explaining how ethical/sustainable fund choices the provider offers are chosen, chief executive Savova, perhaps tellingly, remarked that the blackballing approach can “hurt returns”.

Which brings us neatly to the question as to whether it is practically possible to invest ethically and sustainably without significantly compromising returns? The answer, again, has to be a nuanced one. If we talk about companies that adhere to a broad brush ‘ESG’ (Environmental, Social and Governance) approach to their development, it is logical that these companies stand a better chance of delivering long term success.

The world’s economy is, even if more slowly than many would have, moving towards a lower-carbon footing. Companies who fail to recognise this have suffered. German electric utility company RWE was slow to recognise that renewables would become a key pillar of the energy mix and lost half a million from its market capitalisation as a result.

Nestle saw its brand, and revenues, impacted as a result of high profile scandals around its business practises. Facebook’s share price was recently hit in the wake of the Cambridge Analytica personal data abuse scandal.

George Serafeim, a professor of business administration at Harvard Business School recently wrote an article for Forbes which tackled the question. He believes that companies that truly reflect ESG best practise become more efficient and forward thinking and that ultimately improves their long term prospects:

“we analyzed more than 2,000 stocks over 22 years and showed that firms improving their performance on material ESG issues, such as on environmental impact in the power sector, workplace safety in the mining sector, and employee inclusiveness in the information-technology sector, have significantly higher future risk-adjusted returns”.

Research conducted by New Model Adviser earlier this year also demonstrated that UK equity funds that screen for sustainability and ethical investment criteria are outperforming their peers. Of 12 ethical funds analysed, the average one year performance was 16.39% better than that of the overall equities-fund average. Over three years the ‘all company average’ was beaten by 2.11% and over five years by 8.6 points. All 12 ethical funds also outperformed the FTSE All-Share index over 5 years.

So sustainable and ethical investing, according to the broader definitions of the approach, can indeed result in returns that not only match but can be superior to peers that do not take ESG ratings into consideration when selecting holdings.

For investors who apply strict personal sustainability and ethical criteria to the companies they invest in, there is certainly no rule that says returns will not be strong. However, practically speaking, if these criteria significantly narrow the field of companies that are viable investments, putting together a well-balanced portfolio of companies with strong prospects will necessarily become challenging. Which is why many ethical and sustainable investment funds take the approach of selecting ‘best practise’ companies in industries such as oil and gas rather than completely blackballing the sector.

Conclusion
Investors favouring funds and companies that show strong sustainability practises and ethical corporate culture is important. If capital markets favour such companies, there will be an ongoing process of natural selection which give them a competitive advantage. Of course, there are other factors in play such as the potential short-term profitability of non-sustainable or unethical practises. However, modern history demonstrates that such short term gains are, in themselves, unsustainable.

There will never be universal agreement on what counts as ‘sustainable’ or ‘ethical’ in business. However, at the same time, the qualities these labels are seen as relating too also tend not to vary hugely across social demographics, religions and political affiliations. Or, at least, the gap is narrowing. The key is clearly to invest in a way that you are personally comfortable with. And in most cases, there is no reason why that has to significantly compromise investment returns.

Risk Warning:

Please remember that financial investments may rise or fall and past performance does not guarantee future performance in respect of income or capital growth; you may not get back the amount you invested.

There is no obligation to purchase anything but, if you decide to do so, you are strongly advised to consult a professional adviser before making any investment decisions.

Paul

The author Paul