Far from compromising investment performance, 'green' companies should outperform less ethical peers.
Ethical investing, by its very nature, means you have a smaller number of possible companies to invest in than someone unconstrained by an ethical mandate.
How much of the market you screen out is dependent on how strong the ethical principles are of the fund in which you are investing. For an ethically-minded fund manager who focuses on the UK, some funds have very strict ethical criteria, which eliminate over 60% of UK stocks from their available list, while others have less severe criteria, choosing to avoid only a couple of sectors – with some eliminating as little as 3% of available stocks.
This reduction in available companies is one of the key reasons why many investors avoid ethical funds and trusts: they assume that ruling out so many potentially profitable companies will hit their returns. However, recent evidence suggests that this is far from the truth.
Simon Holman, head of client investments at Castlefield Investments, which specialises in ethical investment, believes that far from being an impediment, a smaller number of companies for ethical funds to choose from could be one reason they are shown to perform better.
"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 says.
He cites a 'study of studies' conducted by Deutsche Asset and Wealth Management in conjunction with the University of Hamburg in 2015, which looked at 2,000 studies since 1970 into the impact on returns of 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% that displayed a negative impact, it found.
"It's an overwhelming bias for positive performance from ethical investing," says Mr Holman.
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 in the future.
"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."
"A company will always have financial and non-financial risk factors. But if non-financial risk factors aren’t addressed then they can become material financial factors. Take BP’s safety fines, for example."
The Deepwater Horizon explosion and spill in 2010 knocked more than 50% off the BP (LSE:BP.) share price, not surprising given that it resulted in eventual costs of around $65 billion.
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.
In 2015, Arabesque Asset Management analysed 200 academic studies to look at the correlation between sustainability and economic performance. It found 88% of studies showed that companies with solid ESG practices had a better operational performance, while 80% of studies showed that stock price performance is positively influenced by good sustainability practices.
Looking specifically at environmental sustainability, the Arabesque report found "a direct relationship between the environmental performance of firms and stock price performance."
It said positive environmental news triggers share price rises, while the opposite is true when firms behave environmentally irresponsibly, and share price falls can be significant.
Arabesque's research also found that firms that are generally more polluting have lower stock market valuations. "Corporate eco-efficiency and environmentally responsible behaviour are viewed as the most important factors leading to superior stock market performance," the report stated.
Companies with more sustainable policies also benefited from a lower cost of capital – both debt and equity. Arabesque found 90% of studies showed a relationship between better sustainability practices and a lower cost of capital, which should support higher company valuations.
Meanwhile, a 2019 study from MSCI found data to support the idea that high ESG-rated companies "were more profitable and paid higher dividends."
Borne out in practice?
There will always be funds that outperform their rivals, but there are an increasing number of ethical options that are delivering significant returns above their peer group year after year.
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 is a Money Observer rated fund and 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 to 26 July 2019 it is up 94.8%, compared to a sector average of 38.6%.
Amongst the funds that Mr Holman rates are Stewart Investors Worldwide Sustainability and Asia Pacific Sustainability – two funds with a positive screening approach. The worldwide fund is up 87.3% over five years to 26 July 2019, compared to an average 72.3% for the global sector. The Asia Pacific fund meanwhile has returned 81.5% compared to an average of 37.1% in the IA specialist sector over the same dates. He is also a fan of Wheb Sustainability. Over five years to 26 July 2019 it is up 83.9% compared to global sector average of 72.3%.
While there may not be any reason for ethical funds to underperform over the long term, they may perform differently from other funds in their respective sectors over shorter timescales.
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 affected in the same way."
In the case of tobacco companies, for example, avoiding this sector would indeed have compromised investment performance in the period up to 2017, but since those highs the sector has sold off significantly, benefiting those funds which are not exposed to tobacco.
"The shape of the performance profile will be different and will vary through the economic cycle," Mr Holman adds.
"You should still get a diversified portfolio – the risk will be different, not necessarily higher."
Others argue that you may have to take more risk with your portfolio.
Gareth Chalk, financial adviser at Blackstone Partners, notes volatility can be higher when certain sectors of the market are excluded. "As there is a more limited range of investment options, this can lead to a higher concentration of risk and resulting higher level of volatility. This means returns can be exaggerated compared to traditional investment portfolios – both going up and going down. People need to understand this - and be prepared to hold on through any bumpy rides."
Last year's Schroders Global Investor Study found that 67% of investors had increased the amounts they put into sustainable investments in the past five years.
This may be the Al Gore effect, with the ex-vice-president of the US suggesting that sustainable investing "represents the biggest investor opportunity ever writ in history" and that the world is in the "early stages of a sustainability revolution" that had "the magnitude of the industrial revolution and the speed of the digital revolution."
The move towards greater sustainability and an avoidance of companies that are perceived to do harm could well be self-fulfilling for ethical funds and trusts. Increased popularity of ethical companies should increase their performance – and as more investors start to avoid certain sectors, like tobacco, those investments are likely to disappoint.
For many years, ethical investing was deemed something of an oxymoron – how could you combine capitalism with ethical responsibility? The idea that some fund managers could do better when they were forced to avoid sin stocks and sectors such as pollution, addiction or other questionable business practices didn't seem to make sense if other fund managers had an unconstrained mandate and could invest where they liked.
But the list of reasons to invest ethically is growing, especially when you consider the possible reasons for better performance of ethical investments - which include:
- companies that take their responsibilities to society and the environment seriously having more sustainable business models than those who do not
- governments regulating/punishing unethical business practices – for example, anti-bribery laws and investigations; markets for carbon emissions; requirements to recycle; restrictions on Fixed Odds Betting Terminals
- unethical businesses suffering as consumers shift away from their products – including big tobacco and diesel car manufacturers
- ethical products gaining from shifts in consumer sentiment – the recent IPO and performance of Beyond Meat (NASDAQ:BYND) demonstrates the interest in vegan products
- activism, causing many investors to look at environmental and sustainable issues
Overall, the numerous studies that all point to an increased correlation between sustainability and performance and the increased interest in what we are doing to our planet means that ethical investing is becoming far more mainstream and has moved away from its alternative reputation.
Rebecca O'Keeffe, Head of Investment at interactive investor concludes: "Ethical investing is, by its very nature, hugely subjective. However, far from compromising investment performance, there is a growing body of evidence that suggests that companies with good environmental, social and governance practices should be expected to outperform their less ethical counterparts, especially as interest in sustainability and environmental grows. Investors need to stop thinking that ethical options limit their investment potential and think about ways in which they could help improve both the planet and their financial future."
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