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Ethical Investing

Ethical investing is frankly confusing. There are plenty of good products, but also a number of products whose promoters may not be as ethical as the stocks they invest in…

For me, there are three key issues:

  1. What is the effect on investment performance
  2. How are the stocks chosen
  3. What are the fees

Read on for a summary of how I look at ethical investing, or you can watch the video. 

Some Definitions

Ethical investing is often termed ESG: Environmental, Social and Governance. 

Investopedia defines this as: 

Environmental criteria looks at how a company performs as a steward of the natural environment. Social criteria examines how a company manages relationships with its employees, suppliers, customers and the communities where it operates. Governance deals with a company’s leadership, executive pay, audits and internal controls, and shareholder rights. 

This is a pretty common framework, and I’ll use it to look at the key issues. 

1. Effect on investment performance

This part is the confusing part. How much investment performance do you give up by being ethical?

Unfortunately, there are plenty of media outlets prepared to muddy the waters in (probably) well-intended ignorance. For example, Canstar publish the following:

Do responsible investment funds perform as well?

Yes, and in fact, they often perform better. According to the 2016 update from Responsible Investment Association Australasia (RIAA), responsible investment funds outperformed other funds in the following categories over the following investment timeframes:

This is wrong.

It is absolutely possible for ethical funds to perform better, but if you thinking of investing in ethical funds so that you can outperform the rest of the market I suggest you look elsewhere.

Reducing the opportunity set

There are 1,600 stocks in the MSCI World Index – a common investing benchmark containing only very large companies. If you give fund manager A the ability to invest in any stock and fund manager B the ability only to invest in 800 of the better ethical stocks, then you are asking fund manager B to beat fund manager A with one hand tied behind his back.

The good news? Reducing the opportunity set that a fund manager has doesn’t affect performance too much – especially if you are only cutting out a few sectors. There are plenty periods where fund manager B will outperform.

The bad news? If fund manager A and B have the same skill, you have to expect the ethical one, in the long run, to have a worse performance.

Real World Examples

However, it plays out differently in the real world. 

For example, over the last few years, the oil price fell from $100+ to $50 and stock prices of oil companies plummeted. Energy is generally negative in ethical screens and so managers who couldn’t invest in oil stocks (the ethical managers) outperformed those who could (everyone else).  

In the other direction, there are funds that exclude only tobacco, and these funds over the last 10 years have generally underperformed the world index as tobacco stocks rocketed up: 

US Tobacco vs World
Source: Factset

This says nothing about the ability of the ethical managers or does it suggest that tobacco stocks will outperform forever – it simply means that one sector of the market performed well over a period and so anyone who was prevented from buying stocks in that sector was at a disadvantage.

Corporate Governance is the exception

From a quantitative perspective, corporate governance (the “G” in ESG) is a factor that outperforms – i.e. companies with good corporate governance tend to perform better than those with poor corporate governance.

But, as with all quantitative measures, it comes with some large caveats.

  • Buying companies with good corporate governance tends to work more than it doesn’t, but there are plenty of counter-examples – there is no guarantee.
  • Price matters. If I can buy two similar companies at a similar price then the one with good corporate governance is more likely to outperform. If, however, I can buy the one with poor corporate governance for considerably cheaper then the advantage disappears.
  • Finally, corporate governance is a subjective measure – there are many elements that are shades of grey and how much should you weight various factors. For example, share structures that give the founders more votes than other shareholders is usually bad corporate governance.  Having a large, diverse board with a majority of non-executive directors is good corporate governance. Google (Alphabet) has both – which is more important?  

So, how much negative performance are we talking?

It is hard to say with any precision.

The key question is how much of the market you are removing.  At Nucleus, we let investors customise to their own needs and exclude stocks that don’t fit their own ethics. A common ethical screen at Nucleus is to remove any stocks involved in cluster munitions from the portfolio.  The effect of this is only to remove a few stocks from the universe of 1,600 and so is unlikely to have any meaningful effect on performance. 

Investors can then choose to remove companies involved in any weapons manufacturing. This will also remove not only a number of large US defence contractors but also stocks like Boeing and so the effect will be greater.

If I run simulations and assume about 25% of all stocks are excluded, sector outperformance is relatively random and that investment managers have some skill then you can pencil in a typical performance hit of less than 0.5% over the long term.  In individual years the difference can be much greater, a 2-3% difference in performance would be quite common.   

If you cut out more or less the effect changes – but not linearly, the expected performance gets exponentially worse as you remove more stocks.  Also, the more skill that you think managers have, the greater the effect is likely to be as well. 

 

2. How are the stocks chosen

There are three different approaches that different ethical funds use to select stocks:

  1. Positive ethical investing: This involves finding companies that are actively contributing to causes that you feel strongly about. It might mean investing in a solar manufacturer, a biotech with a potential cure for cancer or an electric car manufacturer.
  2. Negative screening: This involves excluding companies that do not meet ethical standards. It may mean not investing in any companies that are involved in tobacco, that produce carbon or that make weapons.
  3. Best of breed: This involves ranking companies on a range of metrics and excluding those that don’t meet particular standards. For example, a carbon/global warming strategy may exclude companies involved in brown coal or tar sands (generally considered the most polluting) but include companies that produce natural gas as it pollutes less.

Positive investing is difficult – finding stocks that are good quality and cheap is hard enough. If you find a stock with very positive ethical characteristics that is only average quality and the stock is very expensive should you buy it anyway, expecting a poor return?

Negative screening needs to be customised, which makes investing in an ethical fund difficult. One investor may think that tobacco is a terrible additive product but gambling is an individual’s choice. Another investor may have exactly the opposite view.

Best of breed can be similarly problematic. If you don’t want exposure to fossil fuels, then holding a gas producer with the view that it is “the least damaging, and it is cheap and so I think I can profit from it” can seem hypocritical.

Nucleus: At my fund, we decided that the best result for our investors would be to incorporate corporate governance screens into our stock selection process, and then to allow investors to add negative screens that customise the ethics to investors own views.

This is possible as we run managed accounts, but is something that you wouldn’t be able to do if you invested in a traditional managed fund.

3. What are the fees

If you are going to invest ethically, you should pick a manager charging fees that also would be considered ethical!

Have a look at the fees before you invest. There are a number of large, well-known brands that charge up to 2.5% for ethical investment. If you need to add a financial planner for another (say) 1% then you are down 3.5% every year before you even start. Ouch. 

In comparison, a Nucleus portfolio tailored to your ethics would be 70% cheaper (around 1%). We have a number of competitors that charge a similar amount or a little more. You can get ethical Exchange Traded Funds (which invest in a basket of stocks based on fixed, pre-determined rules) costing somewhere between 0.5% and 1.3% per annum.

Look at the fees before you invest.

The problem with positive ethical investing

As I already mentioned, finding a company that is good quality, cheap and will positively benefit society is incredibly difficult – it is rare to find two of those qualities and so getting all three together is next to impossible. 

My weakness with positive ethical investing is that I’m a sucker for a good biotech or green technology story. Hearing these companies talk about how they are curing this disease or that, seeing the pictures of the kids who will be saved if their drug/device works, hearing about how this new technology will produce cheap, clean energy can be an uplifting experience.

“Not only will my investment make me money, I’ll be saving sick kids/the world from global warming!”

If you ever get the chance to hear some of these presentations, its hard not to be moved.

But the focus is rarely on the value of the proposition, its all about the technology/good that it is doing. And that’s a recipe for losing money on an investment.  

If there is a cause you are passionate about and you want to support companies in that area, there are four ways you can support that cause, in order of most helpful to least helpful:

  1. Make a donation. Are you trying to help or are you trying to make money? If it is the first then by donating you can feel good straight away, you get a tax deduction up front (rather than waiting to book a capital loss when you sell shares!).  Donating directly to companies is not generally tax deductible – but I’m guessing if your cause is ethical then there will be industry bodies that are tax deductible.
  2. Buy the product yourself. Most companies want more customers rather than more shareholders – and the ones that don’t you shouldn’t be investing in.
  3. Buy shares from the company in a capital raising. That way your money will actually go to funding the company expand or its research and development.
  4. Buy shares on the market. This is the least helpful way of helping the company. All you have done is transferred money to another investor. 

Final word

  • If you want to make the world a better place using your money, consider other ways first – would a donation be more helpful?
  • If you want to ensure your investments don’t make the world worse, then find a product that avoids stocks that align with your values or use one like the Nucleus fund that allows you to customise your ethical choices.
  • If you are buying free-range eggs, fair trade coffee or ticking the box for green energy, you don’t expect a discount vs the alternative.  Think of ethical investing in the same way – expect to give up a little performance, and occasionally you will be pleasantly surprised when it outperforms.
  • I’m sure there are plenty of jobs that you wouldn’t do, regardless of how much more money you get paid.  Why should your investments be any different?
  • Check the fees. Please. If not for yourself then do it for me. Few things in the investment world irk me more than seeing ethical funds sold for unethical fees.

Damien Klassen is Head of Investments at Nucleus Wealth.

The information on this blog contains general information and does not take into account your personal objectives, financial situation or needs. Past performance is not an indication of future performance. Damien Klassen is an authorised representative of Nucleus Wealth Management, a Corporate Authorised Representative of Integrity Private Wealth Pty Ltd, AFSL 436298.

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