Three myths about ethical investing

There are three myths about ethical investing that I frequently encounter. Investments marketed as 'ethical' or 'sustainable' mean they focus on companies that incorporate environmental and social corporate-governance practices into long-term corporate strategies such as avoiding environmental damage, pornography production, alcohol/tobacco retailing, armament; also including positive criteria such as animal welfare and corporate governance.

 Myth 1: Ethical funds under perform

There is a prevailing myth that investors have to sacrifice returns to do good. Like all funds, within the choice for ethical funds, there are better performing funds and worse performing funds. When I look at the hard data, comparing a portfolio of ethical versus non ethical funds, there is little or no reason to worry.

The myth stems from the way ethical funds were constructed in earlier years by focusing more on exclusion criteria like tobacco or pornography rather than inclusive criteria such as animal welfare or social and community. I must admit, there is more that can be done to ensure higher attention is paid to positive, inclusion criteria such as social and environmental outcomes; however things have moved in the right direction in more recent years.

I suppose there can be poorer performance too in theory as one is excluding certain sectors (that could be profitable) with ethical funds. Depending on the client's criteria, ethical portfolios would usually exclude commodities, mining and oil stocks. If these sectors do badly, ethical funds would do well in comparison and vice-a-versa. Also, by default, ethical funds in the UK are actively managed funds - over time, the costs have an effect on returns as composed to say, a passive fund portfolio that is non-ethical – this can also have a negative effect. Also, the universe of funds you have to pick is much smaller for an ethical portfolio.

In my experience, this is never a deterrent to clients who are determined to invest with financial integrity. I don’t see the potential performance differential between an ethical and non-ethical portfolio as a negative and in some cases, clients opt for a 'flexible' ethical portfolio which includes some 'non-ethical' funds.

Myth 2:Ethical funds offer less choice

It is definitely possible to construct a very well diversified portfolio with ethical funds including most asset classes like fixed interest, UK equity and overseas equity. There are a significantly smaller number of ethical funds as compared to standard funds although most asset classes are well covered. There isn't an ethical ‘commercial property’ fund to invest in and there certainly is noticeably less choice with investing in Asia for example, than standard funds.

One then has to decide between a 'flexible' ethical strategy (including a standard property fund) and a strictly ethical portfolio that excludes property. Here is it up to the client to make an informed choice and my role as an adviser is to clearly explain the options, so the client can decide in line with their own values. It does not have to be an 'all or nothing' approach and it maybe that some clients are happier with a blended, flexible approach depending on what is important to them.

Unfortunately there isn’t much investing choice with ethical passive funds. The ftse4good index, for example, does not meet many of the ethical exclusion criteria most clients tend to have. Ethical investing is not passive by nature and does not lend itself easily to passive selection criteria. However, this is hardly a deterrent to most clients determined to invest in line with their values.

Myth 3:Ethical funds are more volatile

As ethical funds tend to exclude certain sectors like mining or energy, they can be seen to be less diversified. Again, though, by avoiding certain sectors, many ethical funds have performed also performed better than standard funds. In 2015, for example, some of the largest constituents of the FTSE All Share (that most ethical managers wouldn’t buy due to their screens) like mining, oil and banks struggled.

To earn a decent return on your capital, you have to learn to accept volatility in some form. Risk and volatility are also not the same thing. Clients that are committed to excluding certain sectors are happy to accept the slightly higher volatility that may come with ethical investing. An investment’s volatility should be a concern to investors if the money is needed in the immediate future. But just because an investment is more volatile does not necessarily mean it is more risky in the long term. As an investment’s time horizon gets longer, the effect of volatility is reduced greatly.

For ethical portfolios that I have constructed for clients in the last few years, I have not seen any disadvantage in performance nor volatility affecting portfolios negatively. Numbers from Moneyfacts and Lipper show over the past three years to 15 October, 2015 the typical ethical/SRI fund delivered a total return of 30 per cent versus 24 per cent from the average non-ethical portfolio. Five-year numbers paint a similar picture, with the two styles giving respective returns of 40 per cent versus 34 per cent. Over the past 10 years, ethical funds fall back but only just, with an overall average of 78 per cent against an 83 per cent mean return from non-ethical vehicles.

Ethical investments also tend to steer away companies with high carbon intensity; low carbon investment is needed for global stability. In the long run, it is likely that ethical investments will be a better bet with regulatory measures that allow investments in a way that boosts the growth of low-carbon industries.

If you are looking for an IFA in London that specialises in ethical investing, please get in touch.

Other related resources:

A guide to investing in ethical funds