Ethical Investment Funds: Where Should Your Money Go?

Ethical investment funds, also known as socially responsible investing (SRI) or environmental, social, and governance (ESG) funds, are a way for investors to put their money into companies that align with their values and have a positive impact on the world. These funds allow investors to balance their desire for profit with their concerns about the future of the planet and other social issues. SRI and ESG funds focus on companies that meet certain criteria in areas such as conservation and protection of the natural environment, relationships with employees and communities, and standards for company leadership and risk controls. By investing in these funds, individuals can ensure that their investments reflect their ethical and moral principles while also seeking competitive returns.

Environmental, social and governance (ESG) funds

ESG funds assess companies based on a range of factors, including their impact on the environment, such as energy use, pollution output, and climate change risks; social factors, such as diversity, human rights, employee relations, and community impact; and governance factors, such as transparency, ethics, shareholder rights, and board diversity.

There are different approaches to ESG investing. Values-based investing, or negative screening, focuses on excluding companies that do not align with investors' values. Integration involves selecting companies that score well on material ESG issues within their sector. Impact investing explicitly deploys investment dollars to achieve a desired outcome, such as improving the environment or society.

ESG funds have become increasingly popular, and investors can choose from a variety of funds, including mutual funds and ETFs. When considering an ESG fund, it is important to understand the fund's specific approach, criteria, and objectives to ensure alignment with personal investment goals and values.

Some benefits of ESG investing include the potential for high returns and lower downside risk compared to traditional funds. Additionally, ESG funds allow investors to promote positive change and encourage companies to improve their ESG practices. However, it is important to note that, as with any investment, there is a risk of losing money when investing in ESG funds.

Values-based investing

Ethical investment funds, also known as socially responsible investing (SRI) or environmental, social and governance (ESG) investing, are a way for investors to balance their desire for profitability with their values and concerns about the future of the planet.

For example, SRI and ESG investors may want to exclude companies involved in gambling, tobacco, weapons, and alcohol production. These "sinful investment" categories are often eliminated from holdings through SRI screening.

For instance, an ESG investor might look at a company's air emissions and quality, energy use and conservation efforts, labour standards and employee relations, local community impact, and executive pay versus employee pay.

By using values-based investing, investors can ensure their portfolios align with their principles and support companies that are making a positive impact in the world.

Integration

The integration approach aims to identify companies that score well on material ESG issues relevant to their sector. By incorporating ESG criteria into investment decisions, funds can construct portfolios that align with the values and principles of their investors while also seeking competitive returns.

For example, an ESG fund with a focus on environmental concerns might select stocks in companies that go beyond fulfilling minimal environmental requirements. They might invest in companies with a small carbon footprint, efficient energy use, or excellent waste management practices.

Similarly, an ESG fund prioritising social factors might favour companies with strong labour standards, equal employment opportunities, and positive community impact.

The integration approach allows investors to balance their desire for profitability with their concerns about social and environmental issues. It provides a way to invest in companies that are making a positive impact in these areas while also seeking competitive financial returns.

By considering ESG risks and opportunities, integration can potentially improve the risk-adjusted returns of investment portfolios. This approach recognises that companies with strong ESG practices may be better positioned to manage risks, enhance their reputation, and maintain their long-term sustainability, which can positively impact their financial performance.

However, it's important to note that the integration approach focuses on selecting companies with strong ESG practices within their sector, rather than solely on the basis of ESG criteria. This means that portfolios constructed using this approach will still include a diverse range of companies from various sectors, even if they all meet certain ESG standards.

Overall, integration is a strategy used by ethical investment funds to improve the risk/return profile of their portfolios by incorporating ESG factors into investment decisions, allowing investors to align their investments with their values while also seeking competitive returns.

Impact investing

Ethical investment funds are a way for investors to put their money into companies that align with their values and beliefs. Ethical investing is sometimes used interchangeably with socially conscious investing, but the two are distinct. While socially conscious funds typically have one set of overarching guidelines that are used to select the portfolio, ethical investing brings about a more personalized result.

Impact funds place equal importance on fund performance and ethical outcomes. They aggressively seek to create ethical changes and support companies that provide certain products and services. Impact funds are suitable for investors who are socially responsible but also want good returns.

As with any ethical investment, impact investors should be aware that the fees for these funds can be higher due to the research involved in identifying the right investments. It is also important to note that ethical investing may not provide optimal returns, so investors may sacrifice financial gains for an ethical approach.

When considering an impact investment fund, investors should carefully examine and document which investments to avoid and which are of interest. Research is essential for accurately determining whether an investment or group of investments coincides with one's ethics, especially when investing in an index or mutual fund.

Socially responsible investing (SRI)

SRI has grown in popularity in recent years, with more funds and pooled investment vehicles available for retail investors. According to a 2019 Morgan Stanley survey, 85% of individual investors are interested in sustainable investing. This shift in investor behaviour is also reflected in consumer behaviour: according to KPMG, 37% of American consumers consider environmental sustainability when making a purchase, and 33% consider social responsibility.

SRI can be understood as a type of ESG (Environmental, Social, and Governance) investing. However, while ESG investing uses a financial materiality lens, SRI is based on specific values. There are two broad approaches to SRI: negative screening and positive screening. Negative screening involves avoiding companies that are seen as not socially beneficial, such as those involved in weapons, defence, tobacco, or fossil fuels. Positive screening involves actively choosing to support companies with positive social and environmental policies, such as those contributing to decarbonisation, financial inclusion, or health and nutrition.

When building an SRI portfolio, investors should be aware of the potential drawbacks of an exclusionary approach. Excluding certain industries may lead to underperformance if the excluded industries experience strong performance. Additionally, simply excluding certain industries does not guarantee that the remaining portfolio is aligned with the investor's values. To mitigate these risks, investors can incorporate a comprehensive analysis of ESG factors into their decision-making.

Despite the potential challenges, SRI can be both morally upstanding and profitable. In 2022, the Morningstar U.S. Sustainability Index outperformed its non-SRI parent by 0.6% and the S&P 500 by 0.7%. A meta-analysis by the NYU Stern Center for Sustainable Business also found that 59% of studies focused on risk-adjusted attributes showed that sustainable options performed as well or better than conventional approaches.

Some examples of SRI in practice include community investing, which provides funds to organisations with a track record of social responsibility and helps improve the quality of the community by reducing its dependency on government assistance. Another example is racial justice investing, which leverages institutional and retail dollars to advance anti-racist causes.

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