How Ethical Investing Can Be Profitable

Money

How Ethical Investing Can Be Profitable

Ethical investing is becoming increasingly popular among today’s investors. But can ethical investments deliver the same level of returns as conventional investments?

Published on 4 April 2018

While every investor’s aim is to earn a profit, an increasing number want to achieve this goal in a manner that is socially responsible as well. Investors who adopt this dual objective may, for example, refuse to buy the shares of companies that produce coal or oil. Other may wish – on ethical grounds – to avoid putting their money into the shares of weapons manufacturers, firms that are in the gambling or alcohol business, and even employers who don’t promote gender equality.

Environmental, social, and governance (ESG) investing has gained popularity in recent years. According to the World Economic Forum, an international not-for-profit organisation headquartered in Geneva, investments totalling US$15 trillion were screened in 2016 to ensure that they met the ethical standards laid down by investors.

ESG investments are not restricted to individuals. Several large pension funds have adopted this strategy as well. Japan’s Government Pension Investment Fund (GPIF), which has US$1.3 trillion in assets, is a recent convert.

ESG, SRI, Ethical Investing, Environmental, social, governance investing, socially responsible investing

Japan’s Government Pension Investment Fund (GPIF)

GPIF is the world’s largest pension fund. Hiromichi Mizuno, the fund’s executive managing director and chief investment officer, said that 3% of the fund’s Japanese equity holdings have been invested in ESG indexes, adding that GPIF’s objective is to raise this percentage to 10%.

Mark Makepeace, the chief executive officer of FTSE Russell, a leading provider of stock market indexes, says, “ESG investing has gone from being a sort of theme for retail investors to actually being adopted within the core portfolio of institutional investors.”

But is ESG investing – or socially responsible investing (SRI), as it is also known – profitable? Can you expect to earn a reasonable rate of return or do you have to reconcile yourself to making lower gains?

ESG indexes have outperformed their benchmarks

ESG, SRI, Ethical Investing, Environmental, social, governance investing, socially responsible investing

Surprisingly, ESG stocks have performed exceedingly well. Consider the performance of the MSCI Emerging Markets ESG Leaders index with its benchmark, the MSCI Emerging Markets index:

The MSCI Emerging Markets ESG Leaders index consists of large and mid cap companies in 24 emerging market countries. Chinese firms make up about 25% of the index by market capitalisation and companies from Taiwan account for another 14%. The other important countries that are represented are South Africa and India.

The index consists of 417 companies that score highly on environmental, social, and governance issues. In addition to this, firms involved in alcohol, gambling, tobacco, nuclear power, and weapons are excluded from the index.

The MSCI Emerging Markets ESG Leaders index has outperformed the MSCI Emerging Markets index in nine out of ten years:

Some ESG funds that have delivered high returns

ESG, SRI, Ethical Investing, Environmental, social, governance investing, socially responsible investing

Here are several funds that focus on investing in companies that give high importance to social and environmental issues:

Vanguard FTSE Social Index Fund – this fund has delivered a return of 24% in the year to 31 December 2017, an annualised return of 11% over a three-year period, and 17% in the last five years. It was launched in May 2000 and is one of the oldest ESG-focused funds.

About half the assets under management of the Vanguard Social Index Fund are in tech stocks and the financial sector. There are also large allocations to consumer goods and services.

The top ten holdings of the fund include Apple, Microsoft, Alphabet (Google’s parent), Facebook, and Johnson & Johnson.

Parnassus Fund – the fund’s investments are made in companies that focus on ESG criteria. The Parnassus Fund was established on 31 December 1984. A sum of US$10,000 invested on this date would have grown to US$253,936 by 31 December 2017. That works out to an average annualised return of 10.3%.

ESG, SRI, Ethical Investing, Environmental, social, governance investing, socially responsible investing

In the same period, the S&P 500 index provided an average return of 11.33%. The fund has also not done as well as the S&P 500 index over the one-year period ending on 31 December 2017. It earned a return of 16% to the S&P 500’s 22%. But over a longer timeframe of ten years, the Parnassus Fund has done better. It provided a return of 10.7% to the S&P 500’s 8.5%.

The assets under management total just over US$1 billion. The fund’s top holdings include IBM, Intel, Alliance Data Systems, and Mondelez.

Invesco Summit Fund – this is another good option for investors who want to steer clear of investing in a fund that would buy “sin” stocks. The Invesco Summit Fund does not invest in firms who derive 50% or more of their sales from alcohol, tobacco, or gambling.

The fund has total assets under management of US$2.16 billion. Its top holdings include Alphabet, Amazon, Apple, and Facebook. The fund has provided an annualised return of about 9% over the last 10 years. In the last one year, it has gained 28.2%.

The drawbacks

ESG, SRI, Ethical Investing, Environmental, social, governance investing, socially responsible investing

Selecting ESG stocks can be a complicated endeavour. It’s simple enough to exclude companies that are involved in gambling and alcohol. But what about the firms associated with them? If a tech firm derives a large part of its revenue from a tobacco company, should an ESG fund invest in its shares?

Similarly, should funds that focus on ESG stocks invest in firms that supply equipment to coal and oil companies? These questions can often be tricky and difficult to answer.

There is another issue that could arise in the minds of investors who choose to buy funds that prioritise ESG stocks. The holdings of many of these funds are very similar to those of other large cap funds. Tech stocks often account for a large part of the assets under management. In fact, there often does not seem to be much difference between an ESG fund and one that invests merely to maximise investors’ gains.

The bottom line

Investors would do well to think about the social and environmental implications of their investment decisions. Last year, when Norway’s US$1 trillion sovereign wealth fund announced that it would sell its shares in oil and gas companies, it immediately led to a fall in Europe’s index of oil and gas shares.

Your portfolio could be impacted by ESG issues, even if you are not a socially responsible investor.

SIGN UP