The Evolution of Ethical Investing

17th October 2011

Ethical investing was long seen as the preserve of churches, trades unions, local authorities and individual investors who were prepared to give up some of the returns that the stock market could offer in order to comply with certain beliefs or simply so they could have a clear conscience.

This approach was seen as problematic because of its negative screening, which excludes stocks in sectors such as armaments, alcohol, tobacco, gambling and pornography from the portfolio. This limiting of the investment universe was bound to reduce returns, particularly at times of crisis when these sectors are seen as more resilient than other parts of the economy.

Investors were also uncomfortable with the focus on environmental, social and governance (ESG) factors. These were also known somewhat disparagingly as "non-financial" issues and many fund managers insisted that they were not material to a company's financial performance.

Such considerations had no place in the concerns of serious money managers, the argument went, because their job was to make money for their clients not to make moral judgments about the companies they invested in.

These arguments have become increasingly untenable or irrelevant in recent years, however, and you could say that investment managers are failing in their duty if they don't consider these factors. Did BP's safety lapses in the run-up to the Macondo oil leak turn out to be immaterial to the company's performance? Is the culture that allowed News of the World journalists to hack into the phone messages of murder victims' families having no effect on the performance of News International? On a broader scale, does it not matter to investors in Russia that the country's adherence to the rule of law seems arbitrary at best?

ESG issues affect all businesses one way or another. Customers and regulators are increasingly concerned about issues such as climate change, water shortages, worker conditions and executive pay so companies cannot afford to ignore them. Safety issues are central to the business performance of mining companies, oil and gas companies cannot ignore CO2 emissions and the impact of water shortages affects everyone from drinks companies to chipmakers.

It is easier to ignore such issues when your attention is entirely on meeting quarterly targets. For any individual quarter, the impact of ESG is likely to be small. But if, as many investors believe you should, you take a longer term approach to investing, you cannot help but take into account these factors. "Concentrating on quarterly results is not rigour," argues Ketan Patel, SRI analyst at Ecclesiastical, a charity-owned insurance and investment firm that has produced impressive returns in recent years. "It is just chasing short-term returns."

Sustainable and responsible investing is less focused today on blanket exclusionary screens and more focused on understanding how companies operate – and how they manage ESG risks and opportunities in particular, says Seb Beloe, Mindful Money blogger and head of SRI (socially responsible investment) at Henderson Global Investors. "These are the wider issues that any sensible investors should be looking at when they analyse a business."

Another problem, it has been claimed, is that there is a limited choice of funds available, and these are all focused on equities. Those objections are no longer tenable – there are hundreds of funds available with a responsible investment slant and they cover the full range of asset classes. "Green and ethical investing has evolved and it deals with mainstream concerns," says Penny Shepherd, chief executive of UKSIF, the social investment and finance association.  "It is about providing modern solutions to modern problems such as the loss of biodiversity, scarce resources and the ageing population."

Some say that sustainable investing has no place in a world that remains mired in financial crisis – but it is a very useful way of understanding the problems that we face today and will face in future. "One of the reasons the economy is in such dire straits is because of our attitude to debt, which has not been managed effectively at a corporate or a governmental level," Beloe adds. "The same thing applies with the environment – we are in ecological debt because we are using resources more quickly than they can be replenished."

This is not an entirely negative message – that if you ignore these issues your business will suffer. The ESG agenda creates opportunities, too, that investors are exploiting by investing in particular themes, such as clean energy, water, healthcare and education. "Investing ethically is not about feeling good about yourself," asserts Patel. "We are here to make money."

Ecclesiastical focuses on nine core themes – community relations, labour relations, environment, human rights, urban regeneration, healthcare, education and corporate governance – and has performed well in the last few years despite the financial crisis. "An ethical approach should be no excuse for underperformance," Patel says. "If you invest well for the long term, you should be at the front of the pack. I hope people will start to realise that being sustainable has moved from being a cost centre to being a profit centre."

More from Mindful Money:

Give a little, profit a lot

Who invests in SRI and why?

A Brief History of Socially Responsible Investing (SRI)

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