Does Ethical Investing Really Work?

It’s a loaded question, but it’s worth asking: how effective is ethical investing in tackling environmental and social concerns?

Ethical investing can be thought of as industry-speak for the concept of “putting your money where your mouth is”. As we might use public transport, reduce water consumption or choose to take fewer flights, investors want to be sure that ethical investing has a significant real-world impact before embarking on the task of reevaluating their entire portfolio.

This article will take an empirical standpoint, asking the question: does ethical investing really work? 

What is ethical investing?

Ethical investing is a strategy in which an investor chooses to invest in companies that meet a certain moral standard. Every time you direct capital towards certain companies or industries, even certain everyday products, you are indirectly casting a vote with your capital.

 This is why ethical investing is typically centralised in areas like clean energy, sustainable products, and socially positive services. It’s a growing movement, with proponents claiming that ethical investing can also produce positive economic performance. In other words, it seems that you can do good, and make money.

Ethical, sustainable & socially responsible investing

There are multiple terms generally used for this type of ethics-based investing: sustainable investing, impact investing, socially responsible investing, and ESG investing. These terms generally refer to the same principle of investing your money in companies and industries for positive change. 

Where they differ is in the approach that investors take to reach that goal. Some portfolios may only include positive-impact investments, while others may exclude overtly negative-impact funds like firearms and tobacco. 

Most ethical investing uses Environmental, Social, and Governance (ESG) investing factors to judge specific investments: environmental, social, and corporate governance; a high ESG score represents a company’s long-term exposure to environmental, social, and governance risks. 

For example, if you want to focus on social justice, you may look for investments with a high ESG score in the social category. For a strong environmental focus, you may include companies with a high score in the environmental category. 

Sustainable Investing

Sustainable investing is another branch of ethics-based investing. It is the practice of investing in companies that seek to combat environmental harm and climate change while promoting corporate responsibility.

Socially responsible investing (SRI), for example, is a strategy that aims to promote social change and provide financial returns. 

This approach to business, however, has received criticism in the past through the argument that businesses should not have a social conscience. Developing on Friedman’s stance, some analysts believe that social responsibility undermines the point of business: profit over all else. 

So, it is important to ask the question: 

Is it possible to make money investing ethically?

The ESG market is fairly new, but growing rapidly. In just the first three months of 2020, more than 70 new ethical funds were launched. In that time, around £27bn was invested into ethical funds while £133bn was withdrawn from other European funds. Now, there are over 2,500 ethical funds on the market. 

This growth is spurred not only by public interest but also by the positive performance of ethical funds. The traditional thought that ethical investing is good for the soul but not beneficial for the wallet, has been overturned by the recent performance of ethical funds.

66% of sustainable funds finished 2019 with returns in the top half of Morningstar categories, outperforming many traditional funds and boosting confidence in this type of investing. In the first quarter of 2020, when the COVID-19 pandemic first struck and caused a downturn in the market, 24 out of 26 ESG index funds outperformed comparable conventional funds. 

This evidence suggests that ethical funds may offer lower levels of risk, even in such volatile markets, making them even more attractive. In addition to this, there is an increasing belief in the longevity of companies with high ESG scores. What’s more, companies thinking about their social and environmental impact may be less prone to scandal or corruption, which can result in a longer lifespan and material reward.

After the tumultuous events of 2020, more public attention is certainly on the topic of social responsibility. As younger generations become more prominent and involved in their own investment decisions, companies with a strong social base may reap the benefits. 

Issues in ethical investing

With its popularity comes some confusion and obstacles in ethical investing. Some issues within the ethical investment space are: 

Industry label confusion

A survey by Which? News revealed that the ESG investing industry uses labels that most investors don’t truly understand.

You already know the definitions of ethical, sustainable, and socially responsible investing and how much they overlap. Here are even more labels frequenting the industry:

Currently, there is no regulation on using these labels, so they can vary by a fund manager and allow for a wealth of approaches. By its very nature, ethical investing is subjective, so labels and funds vary by each investor. 

For example, take the automobile industry. You could argue that this is a negative-impact industry since most cars run on fossil fuels and contribute to pollution. However, some companies, like Tesla, are famous for their electric vehicles and thus could be considered ethical investments. 

Take Audi, which manufactures both electric and gas-powered cars. You could argue that Audi should be included in a light green investing portfolio for its electric vehicles or excluded from a traditional ethical portfolio for its gas-powered cars.

Unreliable data

The vagueness of data also makes for difficulty in truly understanding the market’s performance, since these interchanging labels and standards can lead to varying research. Furthermore, companies’ activities cannot always be proven, and often, it may take months or even years for ethical or sustainable behaviour to be proven.

While it is well-known that industries like clean energy are growing and carry great importance, they are still relatively young. Their fullest potential is yet to be realised and it is therefore difficult to estimate their future performance accurately. 

Greenwashing

A common issue in ESG investing is companies ‘greenwashing’: misrepresenting an investment to appear more sustainable than it is. Think of eggs labelled “farm fresh”, gas companies called “environmentally-conscious”, and so on, when those claims are exaggerated or cannot be strictly proven. 

As the market realised that the public was becoming increasingly socially conscious, the “green” label suddenly appeared on everything. Critics have called sustainable investing a marketing ploy or scam for this exact reason, noting that companies are merely trying to capitalise on the trend. Greenwashing can cause companies to be incorrectly included in ESG funds and contribute to the problem of unreliable industry data.

However, some believe that any commitment toward sustainability is better than nothing. Ultimately, it’s up to the investor to decide whether this is the case. Some might agree and choose to reward the oil company that at least proposes a 20-year goal to become environmentally conscious over the companies that make no such promises. Others might claim that that isn’t enough and only invest in companies with viable actions and products.

In-depth research is the key to reducing the harmful effects of greenwashing; often, with a bit of digging, investors can make more informed decisions about whether their investments truly fit their ethical standards. Many parties have also called for more explicit guidelines and standardisation around ESG scoring and investing, such as the Biden Administration and The Climate Group. 

Positives of ethical investing

The growing trend of ethical investing has already begun to show its potential as more companies make sustainability commitments or enact new protocols to uphold social values. 

By engaging in ethical investing, you can access the benefits listed below:  

Returns on investment

As we’ve explored, there is data to back the claims that ethical funds can yield returns. Particularly since the beginning of 2020, some funds demonstrate their ability to withstand market volatility and perform well against their traditional peers. The number of ethical funds available to invest in has grown, as has the value of the industry, and some ethical indices have grown faster than the FTSE 100 over the last decade.

Growing popularity

Powered mainly by the ethical lapses revealed in the COVID-19 pandemic and the growing economic power of the next generation, the popularity of ESG investing is growing. 

As a more significant portion of the public becomes interested in supporting companies with social and sustainable benefits, pressure on investment managers and corporations builds. 

This also paves the way for more formal guidance on ethical investing, such as calls for standardised ESG scoring, government involvement in regulating claims, and more independent research around ethical claims being conducted.

Building the future

In some circumstances, impact investing can be quite powerful with enough people and capital behind it. However, there is still scepticism that unless this is the case, ethical investing may be more of a symbolic act rather than a world-changing one. 

In-depth reports have highlighted that access to capital is a much bigger deal in smaller markets with fewer investors and perhaps smaller companies. In these environments, investors may have more power to influence change. 

Still, we cannot assume that ethical investing is automatically worthwhile or promise that every fund will bring record-breaking returns. Even in traditional investing, the direction of the future is not guaranteed. While not every impact investment is likely to yield dramatic results, many analysts are optimistic that, if done right, it can be powerful.

This publication is for informational purposes only and is not intended to be a solicitation, offering or recommendation of any security, commodity, derivative, investment management service or advisory service and is not commodity trading advice. This publication does not intend to provide investment, tax or legal advice on either a general or specific basis.