As an investor, you have the power to drive change in the world. You can use your money to support those companies that are making good things happen through the products and services they provide, the way they do business, or how they give back to society. If you’d like your investments to have a positive impact as well as making you a return, you should think about ethical investing.
What is ethical investing?
There is no single definition of ethical investing because it means different things to different people, but in essence, it is a type of investing driven by morals, principles or religious values. Usually it is associated with negative screening, which means removing objectionable industries and sectors from your investment universe (the things you’d consider adding to your portfolio).
What is an ethical fund?
It’s a fund that invests according to certain rules or parameters it sets for itself that reflect its ethical or moral stance. For example, it might avoid investing in the most environmentally and socially damaging industries, or those with poor human rights records. But what makes a fund ethical for you might miss the mark for another investor. Perhaps you just want to exclude the ‘worst’ industries such as fossil fuels and tobacco, while another investor wants to only back those companies finding new and innovative solutions to environmental and social problems.
Is it riskier to invest ethically?
Not necessarily, but you should bear in mind the possibility of concentration risk if you are disproportionately invested in certain industries, and higher volatility if you are excluding whole sectors of the market. For example, if you excluded alcohol, cosmetics and tobacco, you would be avoiding a lot of consumer-focused stocks that tend to do well in market downturns, which could unbalance your portfolio.
Is the stock market ethical?
Specific ethical or Economical, Social and Governance (ESG ) indices do exist. But if you just bought a passive fund tracking a major market like, say, the FTSE 100, you would be investing in every stock in there and no, they would not be screened according to ethical criteria. You’d have exposure to tobacco stocks, alcohol producers, weapons manufacturers, pharmaceutical companies that test on animals and fossil fuels through miners and oil and gas companies. A survey by Morningstar found that around half of the FTSE 100 is ‘unethical’ by most people’s standards. The only way to avoid those companies is to choose a fund which has explicit ethical criteria that it uses to select its underlying investments.
How does ethical investing work?
There are many different types of ethical investment and the space is peppered with buzzwords with no standard definition, so they can be tricky to compare. But here is a very brief outline to give you an idea of the differences:
- Ethical investing - the application of morals, values or religious principles to investment selection, often using negative screening
- Socially Responsible Investing (SRI) - sustainable or responsible investing are umbrella terms for investment strategies which consider companies’ ESG records in things like human rights, a sustainable supply chain, environmental stewardship, and gender diversity.
- Impact investing - a subset of SRI that is less about negative screening and more about a proactive approach to investing in projects or businesses aiming to generate a positive social or environmental benefit as well as a financial return.
- Environmental, Social and Corporate Governance (ESG) - takes environmental, social and corporate governance factors into account when analysing companies
- Green investing - usually has an environmental focus.
You’re probably wondering ‘how can I be sure the funds I’m investing in are ethical?’ Sustainable investing is very popular right now, and to grab some of the money flowing in, some providers have been guilty of ‘greenwashing’. This is when fund providers slap an ‘ethical’, ‘sustainable’ or ‘green’ label on a fund when actually it isn’t really invested ethically at all, and still contains investments most investors would not want or expect to see in such a portfolio.
The only way to be sure is to do your own research – you can find fund factsheets on provider’s own websites or on investment platforms, read them and look at the asset allocation in the fund – this is the split of how the money in the fund is invested. You should be able to see sector breakdowns and also the top 10 holdings which will show you individual stocks in the portfolio. This should give you a flavour of what’s in the fund. You can also contact the fund group directly for a more detailed breakdown, or ask your financial adviser.
Which providers offer ethical investing?
If you’re interested in ethical investing, you’ll want to know where you can invest money ethically and how to begin researching ethical investment funds. The good news is that product choice is ever increasing. Many of the large, mainstream fund houses now have dedicated ethical or responsible investing divisions or you could go to a smaller, specialist provider which is focused solely on this type of investing.
For an impact investing approach, Triodos Bank’s investing arm has three portfolios focused on global equities, microfinance, and small and mid caps. WHEB is a positive impact investment boutique focusing on the transition to a low carbon economy. Its FP WHEB Sustainability fund invests in mid-cap companies “providing solutions to sustainability challenges” with fund themes including resource efficiency, sustainable transport and health.
EdenTree has a 30-year track record in ethical investing. Its Amity fund range follows a three-pronged investment approach focusing on ethics and values, ESG and sustainability, including eight negative ethical screens. At the level of the large providers, behemoth fund house Aberdeen Standard Investments has a wide range of ethical funds, while Liontrust has a dedicated Sustainable Future range boasting some strong performance. Rathbones has a long-established Ethical Bond fund which has been a good long-term performer, while Kames Capital also boasts excellent credentials in the ethical fund space with its standout Ethical Equity and Ethical Cautious Managed funds.
If you’re not sure where to start, you could have a look at some recommended fund lists. Interactive Investor, for example, has an ethical best-buy list, the ii ACE 30, which shows fund options from across 11 different sectors. You can run searches for ethical funds on most fund platforms and fund supermarkets.
Increasingly, digital wealth managers (also known as robo-advisers) are offering ethical or sustainable options. It is worth reading our article "Which are the best ethical Stocks and Shares ISAs?"
Nutmeg, for example, has a Socially Responsible portfolio of passive funds in which it uses ESG scoring to rank investments on things like carbon emissions, health and safety, business ethics and tax transparency. Wealthify offers five Ethical Plans where investors can invest from as little as £1. The plans range from Cautious to Adventurous, comprising a mix of active funds and ETFs from providers including Liontrust, Kames, Vanguard and Royal London. They seek to exclude companies involved in areas like weapons, gambling, adult entertainment, deforestation, intensive farming, tobacco and nuclear power. Wealthsimple has a Socially Responsible investing portfolio of ETFs which it selects using ESG screening. The platform says around a quarter of its customers have chosen to invest in this ethical option, which requires a minimum £5,000 investment.
How much does it cost to invest ethically?
Most investors will have an eye on cost when constructing their portfolios, so you may well ask ‘is it more expensive to invest ethically?’ When you buy organic veg, high welfare meat or free range eggs, you expect to pay more, and rightly so. You should think about ethical investing in the same way. Actively managed ethical funds can be more expensive than others and this reflects the greater amount of research and tyre-kicking the fund managers have to do to make sure the portfolio is in ethically-run companies that can still make investors money. For example, the WHEB fund mentioned above has an ongoing charge figure of 1.05%, while you’d pay 0.88% for Liontrust Sustainable Future Global Growth.
You could buy a passive product like an exchange-traded fund which has an ESG label on it and it would be cheaper, but the chances are you would still have exposure to some companies doing things you might not like. For example, buy the UBS MSCI UK IMI Socially Responsible UCITS ETF through Hargreaves Lansdown and you’d pay an ongoing charge of 0.28% but your top holdings would include GlaxoSmithKline, AstraZeneca and Unilever, all of which test on animals (although Unilever says it supports a worldwide ban on testing for cosmetics by 2023); oil giant BP and miner Rio Tinto, both of which are environmental polluters.
The robo-advisers mentioned above also charge a bit more for their ethical and sustainable portfolios. Nutmeg’s Socially Responsible offering costs 0.32% on average, which is more expensive than its Fixed Allocation and Fully Managed portfolios which average 0.19%. Wealthify’s ethical portfolios are more expensive than its other products with average investment costs of 0.71% versus 0.16%, on top of its annual management fee of 0.60%. On Wealthsimple, you’ll pay a 0.70% management fee, the same as on the rest of its range, but fund fees on its SRI portfolios are higher at 0.22%-0.32% compared to 0.18% for the standard funds.
How well do ethical portfolios perform?
There’s a common perception that ethical portfolios underperform mainstream funds but, in fact, research suggests that you could benefit from stronger share price growth if you hold sustainable companies over the long term.
An often-cited study from Arabesque Asset Management reviewed 200 academic studies into the sustainability of companies’ business practices and their financial performance. It found that 80% of studies showed firms with higher ESG scores have better share price performance.
Research from Charles Stanley Direct compared the average one-, three-, five- and 10-year performance of funds within the UK All Companies and Global sectors which are marketed as ethical, sustainable or socially responsible. It found that these funds were “significantly more likely to generate outperformance” versus standard funds. In UK All Companies, for example, SRI funds returned 82.6% over a decade versus 63.4% from non-SRI funds and 54.6% from the FTSE All-Share. In the shorter term, excluding miners and energy helped SRI fund performance because a slump in demand for natural resources meant these sectors were worst hit in the recent market sell-off.
Nutmeg says its own analysis of socially responsible investments found there are “no meaningful differences” in the performance of SRI strategies compared to others. In fact, looking at UK equity markets between 2007 and 2018, the SRI index actually outperformed the market index with an annualised return of 6.73% versus 5.95%, although volatility was fractionally higher. But, interestingly, in emerging markets, the SRI index outperformed with lower volatility, most likely because of a stronger focus on good corporate governance in economies where corruption and bribery are more widespread. We take a look at recent stock market performance from a number of platforms and specialist ethical providers in our article "Which are the best ethical stocks and shares ISAs".
However, we have seen that charges can be higher in ethical and sustainable investments so, in a real portfolio, you might experience a drag on performance over the long term from paying higher fund charges on actively managed ethical funds. You could also see performance suffer from excluding companies in the consumer staples and other sectors that can have defensive characteristics during down markets. But that doesn’t mean you won’t make a positive return and, as recent events have shown us, whatever the makeup of your portfolio, nothing is guaranteed when it comes to investing.
The FTSE4Good UK is an index based on the FTSE All Share, but with an ESG screen applied. Its stated aim is to invest in companies that demonstrate good sustainability practices. If you compare it to the All Share, it has outperformed over one, three and five years in terms of percentage returns and with lower volatility, according to data from FTSE Russell.
For many investors wanting to invest with a conscience, high returns at any cost are not what they are looking for. For them, a positive social or environmental return is just as important as a reasonable financial return. Only you will know what ethical investing means for you, what your priorities are and where you are happy for your money to go.
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