Ethical investing: can investors do well by doing good?

It’s surely a sign of the times that ethical investing, which was once laughed off by some as the practice of naive do-gooders, now makes up more than 25 per cent of all professionally managed investment assets. “Ethical investing is an investment approach that allocates capital with a dual purpose,” explains John Crowe, chief executive of Kestrel Capital. “Typically, investors allocate their capital with a single purpose of achieving a financial return. With ethical investing, you have a dual purpose. That is to invest in companies that A) contribute to an environmentally sustainable economy and B) support and develop human capital by implementing best production and safety principles.”

Put simply, ethical investment comes down to 'doing well by doing good,' and allocating capital to areas that will return a healthy profit and make some kind of positive social impact. Deirdre Timmons, senior investment manager at Bank of Ireland Investment Markets, explains: "The principle is to exclude investment in certain stocks or sectors that are deemed to be unethical. In the case of SRI [socially responsible investing] funds, fund managers may 'positively' screen for stocks that are deemed to make a positive contribution to society. An example of this would be if a fund allows the inclusion of energy stocks, then a company such as Vestas, a wind turbine developer and manufacturer, may be in scope for many SRI funds."

Examples of socially conscious investments include renewable energy, water conservation, environmental solutions and diversity programmes. On the flip side, so-called “sin stocks” ethically aware investors may wish to avoid include tobacco, armaments, pornography, gambling and in some cases, fossil fuels. While the concept of investing with a conscience feels like a very millennial idea, it’s starting to catch on. “There has been a massive upswing in this style of investing over the past decade. The numbers show that to be true, says John Crowe.

Sin stocks

That said, what counts as “sin” stocks is up to interpretation. In Ireland, charities and religious orders would typically be considered the largest ethical investors, but the latter would have a more extensive list of investments requiring exclusion. “For example, the Catholic ethos would exclude investment in pharmaceutical companies that produce and distribute contraceptives, whereas a charity may not be as prescriptive in this instance,” explains Timmons.

A wide number of factors have contributed to the rise in SRI in the last decade, says Crowe. “The financial crisis certainly resulted in a change of investors’ attitudes regarding how they invest their capital. Investors started to remember that they as shareholders can have a collective voice to influence change. Millennials, charities and religious orders have been the pioneers of the growth. These three investor groups put a greater emphasis on investing being a way to achieve a financial return along with having a societal impact. Finally, the debate around climate change has certainly grown louder in the past decade. Investors have taken note and have chosen to reward companies that have demonstrated strong environmental practices.”

Ethical investment has moved on in the past number of years and the momentum towards such investment has been overtaken, and replaced, by ESG investment, another category of SRI. “There is often a misunderstanding that leads to the two terms being used interchangeably, which naturally leads to some confusion,” says Timmons. “In general, the main difference is ethical investment is exclusionary in nature and restricts investment in certain categories or companies. ESG investment, however, focuses on companies that are performing well under the various headings of environment, social and governance and therefore the focus is on those who are ‘best-in-class’ companies, and regarded as ‘sustainable’ whilst not damaging the environment or having a damaging influence on society.”

Financial return

Of course, the point of any investment ultimately is to make a financial return, and there’s an argument to be made that by limiting their options, investors could be losing out in the long run profits-wise. “If you purely invest on an exclusionary basis, yes you may have a drag on your portfolio’s rate of return as certain businesses have provided strong returns despite their practices. The tobacco sector is a classic example of that,” says Crowe.

The jury is still out on how SRI affects returns in the short term, however studies suggest that integrating ESG factors into the investment process pays off – literally – in the long run.

Ethical investment has evolved over the years from a niche strategy to one that is becoming more and more widely accepted. “As ESG investment, in particular, moves into the mainstream, companies will be rated by a variety of rating agencies and analysts with regard to their ESG credentials,” says Timmons.

“I believe that eventually the ESG rating which a company has achieved will be equally, if not more important, than their credit rating. The better the score, the bigger the investor universe open to them, and the more widely available investor capital is, then the cost of equity and debt becomes cheaper for that company too. That’s an incentive for change in itself and will, I believe, become a driving force for change across corporate activity.”

In March 2018, the EU launched an action plan on financing sustainable growth. This will have the effect of bringing ESG investment into the mainstream as it requires investment managers to incorporate ESG risk factors into their process. “This is the single biggest factor driving the movement towards ESG funds and investment strategies currently and many investment houses began their process of integration over the past number of years in anticipation,” says Timmons.