Interactive Investor

Ethical investing: Does it have to mean sacrificing returns?

Investing for good reduces the list of potential investments. Does this compromises performance?

17th July 2019 17:07

Rachel Lacey from interactive investor

Investing for good reduces the list of potential investments. We look at whether this compromises performance.

Ethical investing, by its very nature, means you have a smaller universe of companies to invest in. Whether you opt for a so-called dark green fund that rules out companies that do not meet its ethical criteria or a lighter green option that seeks out firms that are making a positive contribution to society or the environment, fund managers' options will be more limited than those funds that don't have an ethical mandate.

Take the Kames Ethical Equity fund as an example – a traditional dark green ethical fund that applies negative screening. The fund manager says it is designed to meet the needs 'of clients that wish to make investment decisions based on strong ethical principles'. After screening has been applied, only 37% of companies in FTSE All Share will meet the fund's criteria. Within the FTSE 100 only 31% of companies will be up for grabs, 51% of the FTSE 250 and 32% of small caps.

It's not surprising then that many investors think that by ruling out so many potentially profitable companies they will have to take a hit on returns.

Patrick Connolly, chartered financial adviser at IFA Chase De Vere says:

"The UK's first mainstream ethical fund was launched by Friends Provident in 1984 and at the time it was rather unfairly labelled the 'Brazil fund' because you would have to be nuts to invest in it."

"There has been a perception that investors have to sacrifice performance to invest ethically as they miss out on potentially strong performing sectors such as tobacco or oil and gas. However, this isn't necessarily the case and indeed ethical funds can out-perform when the sectors they hold don't perform badly."

Simon Holman, head of client investments at Castlefield Investments, which specialises in ethical investment, is more emphatic.

"The view we have always taken is that there is no reason to compromise investment returns by introducing ethical criteria."

His argument is that by applying ethical criteria to stock selection, fund managers have a much better understanding of a company, and its ability to deliver long-term returns.

"By having funds that are adding in a wider range of factors to consider you are getting a better analysis of a company and its financial risk."

He continues:

"A company will always have financial and non-financial risk factors. But if non-financial risks factors aren't addressed then they can become material financial factors. Take BP (LSE:BP.) safety fines for example."

Back in 2009 the oil company was fined a whopping £53 million after failing to address safety issues that were highlighted in the wake of an oil explosion at its refinery in Texas City that killed 15 people.

Mr Holman also argues that changing attitudes towards environmental, social and governance concerns mean it is those companies that tackle these challenges head on that are likely to prosper going forward.

"If you can find the companies that are implementing these factors you are hopefully going to be getting companies that are the long-term winners."

He adds: "Investors may also increasingly want to support these companies that are doing good and want to support them."

This claim is also being borne out by research. Mr Holman cites a 'study of studies' conducted by Deutsche Asset and Wealth Management in conjunction with the University of Hamburg in 2015. "Looking at over 2,000 studies since 1970 it shows that there is a positive impact in returns from investing along ESG [environmental, social, governance] lines."

In 62.6% of studies the use of ESG criteria had a positive impact on corporate financial performance, compared to just 10% which displayed a negative impact. "It's an overwhelming bias for positive performance from ethical investing," says Mr Holman.

A range of ESG indices created by Morningstar to analyse the performance of ethical investment tell a similar story. The 56 indices cover a range of ESG themes including sustainable leaders and sustainable environment, women's empowerment, minority empowerment and societal development. Of these 41 have outperformed their non-ESG equivalents, a 73% success rate.

However, while there may not be any reason for ethical funds to underperform over the long term, it's important for investors to understand that they may perform differently to other funds in their respective sectors.

Mr Holman explains:

"If you don't own oil, gas and mining and they have a strong period, you're not going to be able to catch that but equally when they aren't doing so well you won't be effected in the same way."

"The shape of the performance profile will be different and will vary through the economic cycle," he adds. "You should still get a diversified portfolio – the risk will be different, not necessarily higher."

Returning to the aforementioned Kames Ethical Equity Fund – which employs negative screening – it has largely kept pace with other funds in its sector, despite its investment limitations.

Over five years Kames Ethical Equity has returned 24.9% compared to a sector average of 28.3% while its performance is marginally below the sector over this time frame a look at its charts show that there are periods where it has out-performed the sector. Looking at its six-month performance, for example, it is up 7.7%, more than twice the sector average of 3.6%.

But what about lighter green funds that have a more pragmatic approach to stock selection? Royal London Sustainable World Trust is a well-diversified global and equity bond portfolio that takes environmental, social and governance issues (ESG) into account alongside financial analysis.

It has won the mixed investment 40-85% category of the Moneywise Fund Awards for the last three years – an award that is given based on cumulative performance over three, five and seven years. Over five years it is up 82.5%, compared to a sector average of 32.4%.

Amongst the funds that Mr Holman rates are Stewart Investors' Worldwide Sustainability and Stewart Investors' Asia Pacific Sustainability – two funds with a positive screening approach.

The worldwide fund is up 78.9% over five years, compared to an average 59.2% for the global sector. The Asia Pacific fund meanwhile has returned 89.1% compared to an average of 31.9% in the IA specialist sector.

He is also a fan of Wheb Sustainability. Over five years it is up 61.4% compared to global sector average of 59.2%.

However, while there are certainly ethical funds that can not only keep up, but outpace funds without an ethical mandate, it's vital that you look at where the fund invests closely to ensure its ethical credentials are in line with yours. As Mr Connolly says:

"The ESG criteria used by different investment companies is very subjective. This means that an investor in one of these funds may not be invested as 'ethically' as they would like." 

Full performance can be found on the company or index summary page on the interactive investor website. Simply click on the company's or index name highlighted in the article.

These articles are provided for information purposes only.  Occasionally, an opinion about whether to buy or sell a specific investment may be provided by third parties.  The content is not intended to be a personal recommendation to buy or sell any financial instrument or product, or to adopt any investment strategy as it is not provided based on an assessment of your investing knowledge and experience, your financial situation or your investment objectives. The value of your investments, and the income derived from them, may go down as well as up. You may not get back all the money that you invest. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.

Full performance can be found on the company or index summary page on the interactive investor website. Simply click on the company's or index name highlighted in the article.