Some people believe that investing in an ethical or sustainable way means sacrificing returns. Fortunately, responsible and ethical investing can still lead to positive investment outcomes, as well as positive outcomes for society at large.
Can ethical investing lead to good financial returns?
The research on the long-term performance of ethical or sustainable investing is mixed, but most studies show that ethical investing doesn’t result in lower returns. Research has found that performance is very comparable between sustainable and conventional strategies.
However, not all sustainable investments have the same return, so it’s important to research or choose a trustworthy investment advisor. Many sustainable investments often have higher management fees which could eat into your returns. That’s why Stockspot prefers to use exchange traded funds (ETFs) in our portfolios, as these are lower cost than the average ethically managed fund.
Is ethical investing more risky?
There are still misconceptions that responsible investing is too niche and leads to sub-optimal outcomes, particularly because this type of investing strategy may exclude certain profitable sectors in the market.
The good news for ethical investors is that companies with higher Environmental, Social and Governance (ESG) scores can demonstrate lower investment risk. In fact, during the 2020 COVID-19 crisis, sustainable investments displayed more resilience than non-sustainable investments.
Companies with lower ESG scores can open themselves up to legal action, reputational damage, and lack of transparency. Avoiding companies with low ESG scores could mitigate the overall risk of your portfolio, and supporting companies who embrace sustainable practices (e.g. employee safety, society welfare, and community impact) can help those companies perform better, and, as a result, perpetuate their ethical behaviour.
Once the misconceptions are addressed, it’s clear that ethical investing can have both financial and non-financial value.
Additionally, having a diversified portfolio that also includes defensive assets like bonds and gold can also help reduce the overall risk in your investments.
Focus on asset allocation, not cyclical performance
While an ethical approach doesn’t necessarily mean lower financial returns, it won’t always outperform non-ethical strategies either. That’s because returns tend to be dependant on how certain industries are performing at any given point in time.
A key tenet of investing is that performance of any portfolio will be cyclical and primarily driven by which sectors the companies are in. For example, sustainable ETFs have outperformed other ETFs because of their preference for healthcare and technology companies, and a lower (or zero) preference for things like energy companies. Find out more about the performance of ethical ETFs.
Another important factor to consider is asset allocation, which involves balancing risk by apportioning the assets in a portfolio according to your individual goals and risk tolerance. Asset allocation generally determines over 90% of your return.2 By focusing on asset allocation instead of cyclical performance, ethical investing can result in positive returns.
Conclusion
An important takeaway is that sustainable or ethical investing is an approach based on personal ethics and preferences. It’s not a way to beat the broader market index. However, community demand is leading to a rise in ethically focussed products and services, leading to more confidence in this investment strategy and alleviating concerns around lower returns.
Whether you call it responsible, sustainable, or ethical, investing in this way shows that it’s possible to do well, while still doing good.
Sources:
1 International Monetary Fund (IMF) Global Financial Sustainability Report (2019)
2 Ibbotson, Roger G., and Paul D. Kaplan. “Does Asset Allocation Policy Explain 40, 90, or 100 Percent of Performance”, Financial Analysts Journal 56, no. 1 (2000): 26–33.
