Ethical Investing; Fifty Shades of Green

Key points:
• Socially responsible investing (SRI) is increasingly popular and prominent.
• Investing using an SRI strategy may not compromise risk-adjusted returns.
• Care must be taken to examine the credentials of SRI funds, rather than taking the label at face value.

Ethical investing is just one of the many monikers of an investment strategy that aims to look at more than just financial returns. It takes a ‘look under the bonnet’ of a company or fund to check its credentials as a contributor to positive change. ’Socially responsible investing’ (SRI) is no new kid on the block either; the increasingly popular approach has roots in centuries-old investment principles (cf. Jewish, Shari’a, Methodist and Quaker investments)1

This heterogeneously-named investment strategy has been growing steadily since the turn of the century, as evidenced by the rising number of: UN Principles of Responsible Investing signatories2, funds incorporating ESG (environmental, social and corporate governance) principles3, value of products with ESG links4 and number of ESG indexes5. SRI is no fad, no (pure) ego-massaging exercise nor a get rich quick scheme. It’s a reflection of the changing currents of social conscience, a focus on quality (not just quantity) and ultimately a desire to ameliorate the world we live in, even if only for posterity.

The rise of SRI. There have been consistent increases in: searches for sustainable investing news articles (grey line), UN PRI signatories (dark blue line) and assets invested in ESG products in Europe (light blue line). Source: Schroders.

At what cost?

Our pre-research preconception about SRI was that it must be more costly, in the same way that organic vegetables are more expensive than their pesticide-laced cousins. Being selective about the nature of investments would naturally have a corresponding impact on the cost of such products and/or their returns. We’re not alone in this thought process; concerns about investment performance represented nearly a fifth of the deterrent to investing in ESG funds (although we note that it caused less consternation than: a lack of viable options, a lack of qualified expertise and concerns about greenwashing)3

We could reconcile this cost as the price of ‘responsible’ investments, although underperformance would provide a relative FI quandary. Plump for SRI, accept poorer returns yet take solace in the tan you develop basking in the sun at the top of the ethical high ground? Or attach the blinkers, select whichever strategy provides the best returns and gallop to the FI finishing line, knowing you may’ve trampled on Mother Earth a bit in the process? Fortunately, there’s an increasingly large body of research attempting to answer the pertinent question: does SRI underperform compared to an unhindered investing approach?

The exponential rise of ESG in Europe; a 123% increase in funds incorporating ESG principles since 2013. The proportion of retail investors using an SRI approach grew 9x over the same time period. Source: Eurosif 2018 Report
The rise of ESG in the USA; an 18x (or ~14% annual) increase in SRI assets since 1995. Source: US SIF 2018 Report

SRI vs. Conventional Investing – Fight!

Socially responsible companies appear to perform better financially. One paper did find ethical banking to be less profitable than conventional banking6, although another found companies with stronger ESG credentials perform better than their lower-scoring counterparts7. Companies with better sustainability credentials demonstrate comparatively better operational performance8, 9, less volatile stocks10 and exhibit less risk11. Prudent sustainability practice has a positive impact on investment performance8, and a literature review found positive correlations between a company’s sustainable activities and its financial results12.

Negative screening, i.e. excluding companies not deemed to have the appropriate level of SRI credential, is the largest ESG category worldwide4. One analysis of negative screening looked at indexes of the original ‘sin stocks’ (alcohol, gambling, tobacco, weapons, adult entertainment and nuclear power) and found that applying an ethical screen didn’t significantly impact on investment performance13. These results for the ‘Sextet of Sin’ were echoed in a later study14, however applying broader screening to exclude other ESG issues did result in portfolio underperformance compared to an unscreened portfolio. 

Comparison of the performance of the FTSE4Good Global Index (blue line; +21%) vs. the FTSE All-Share Index (red line; -6%) over the past five years. Caution is required, however, as the FTSE4Good index still includes companies in the Oil & Gas, Mining and Gambling sectors, which aren’t necessarily in keeping with an SRI approach. Source: London Stock Exchange.

How do SRI investments perform compared to their ‘conventional’ alternatives? There are some conflicting reports about whether an SRI approach is more likely to under- or over-perform, for both the UK and globally7, 15. One analysis found there were reduced returns when investing ethically16; another suggests that the higher fees which usually accompany SRI funds will impact on overall returns17.

A meta-analysis found that, comparing SRI to conventional investing, the occurrences of outperformance (40%) or similar performance (43%) were much higher than underperformance (17%)12. A 2020 Credit Suisse report concludes that there’s no strong of evidence of ESG fund/index under- or over-performance4. Multiple analyses support the idea that an SRI approach performs no better or worse than a conventional investment approach, and that risk-adjusted returns could be expected to be similar4, 7, 12, 15, 17-20.

Within recent memory there’s been the 2008 Global Financial Crisis (GFC) and the 2020 Covid-Crash; it’d be naive to think there’ll be anything other than plenty more downturns in the years ahead. How does SRI do in a downturn? Studies have found that Islamic indexes (i.e. investing according to Shari’a principles) outperformed conventional indexes during the GFC21 and that Islamic mutual funds even outperformed other SRI funds (2005-2015)22. SRI funds may also be more resilient during other tumultuous times23. Morningstar’s analysis of how ESG ETF’s performed in the Covid-Crash demonstrates that the majority weathered the downturn better than an equivalent non-ESG fund24

A drive towards sustainability may improve future investment returns given that data suggests the rising global temperatures will have a deleterious effect on world GDP25, 26. Overall, the evidence we reviewed would suggest that an SRI strategy would historically not have significantly compromised risk-adjusted investment returns.

In Practice

Many investors will choose to invest passively in low-cost, global equity, index-tracking funds as the mainstay of their portfolio. The ever-popular Vanguard have recently launched two new ESG funds: the ESG Developed world all-cap and the ESG Emerging markets all-cap. With fees of 0.20% and 0.25% respectively, both track the corresponding FTSE All Cap ex. Controversies/Non-Renewable Energy/Vice Products/Weapons Index. How do they stack up compared to their non-SRI equivalents?

The relative performance of the iShares MSCI World SRI (red line), MSCI World ESG-Enhanced (blue line) and Core MSCI World (green line) ETF’s since October 2019. Although all three lost value during the Covid Crash, the two SRI-type funds appeared to weather the storm slightly better. Graph adapted from: Yahoo finance.

The closest comparison to the new ESG Developed world fund is the FTSE Developed World ETF. It’s cheaper (0.12%), an ETF and does not contain small-cap companies. There are also some minor differences between the two when it comes to the geographical and sector weightings. Interestingly, Morningstar’s assessment of the sustainability of the two funds is near identical. It’s a similar story with the Emerging Market non-SRI equivalents; the Emerging Market index fund (0.23%) and FTSE Emerging Markets ETF (0.22%).

Blackrock’s iShares funds represent another cadre of popular investment choices. Their MSCI World SRI ETF and MSCI World ESG-enhanced ETF are both SRI options. Although their OCF is the same as an iShares’ non-SRI equivalent (0.20%), their sustainability ratings are far superior. Their performance appears to be slightly better too (see graph above).

We’ve chosen to highlight only a few of the plethora of available SRI investment products. The expanding breadth and availability of such vehicles mean that it’s increasingly possible to replicate the low-cost, globally diverse, passive portfolios of which many FI(RE) proponents are so fond.

Fifty Shades of Green

What about the holdings within these funds? The top 5 in any of the aforementioned SRI funds are a combination of: Apple, Microsoft, Amazon, Facebook, Alphabet, P&G, Roche, Home Depot and NVIDIA. The associated links demonstrate that none of these companies are exactly squeaky-clean when it comes to ethics, be it Roche pricing the less wealthy out of new drugs or the ever-controversial Facebook being booted from S&P’s ESG Index.

We’re not suggesting that SRI should involve only investing in companies that have never been involved in any sort of controversy, you’d be left with a shamefully small pool of choices! As fellow blogger FIREvLondon highlights, there are “dubious activities” in all spheres of industry – companies aren’t ‘green’ or ‘not green’, responsible or irresponsible, ethical or unethical; it’s a spectrum. What this does demonstrate is that just because a fund has SRI, ESG, Green or some other synonym shoehorned into its name, it doesn’t automatically make it so. It’s important to do your due diligence when it comes to choosing an appropriate SRI fund, rather than buying one that merely pays lip service to the idea.

It’s not all sunshine and lollipops when it comes to SRI; there are still various issues afflicting the strategy. Perhaps foremost, the lack of a standardised definition and inconsistent terminology is confusing for both institutional and retail investors. This opacity creates difficulty in understanding the comparability of SRI vehicles, especially given a lack of governance and poorly correlated ratings systems4. The scene is set for nefarious salespeople to slap SRI labels (and higher fees) onto products, in a bid to appeal to the values of the sustainability-conscious investor. Despite the evidence above, it’s also important to remember that the comparable performance of SRI funds in recent (<10yr) history might reflect other economic or geopolitical factors, rather than their ‘SRI-ness’ per se.

Time to Make a Change?

The winds of change are gusting. SRI is on the rise and, in time, may become the new minimum requirement for investments as the public conscience pushes inexorably in a sustainable direction. The broadening choice of socially responsible investments are increasingly compatible with a variety of portfolios/strategies and the arguments against them are dwindling. For those wishing to FI(RE) and keep the planet in good enough knick to enjoy that early retirement, SRI may be the perfect way to go.


Mr. MedFI

1 – The Origins of Socially Responsible Investing. 2020. The Balance. Available here.
2 – UN Principles for Responsible Investing Annual Report 2019. UNPRI. Available here.
3 – European SRI Study 2018. Eurosif. Available here.
4 – Credit Suisse Global Investment Returns Yearbook 2020 Press Release. Credit Suisse. Available here.
5 – 30 Years of ESG Indexes. MSCI. Available here.
6 – F Climent. Ethical Versus Conventional Banking: A Case Study. Sustainability 2018, 10(7); 2152
7 – AJR Traaseth & UE Framstad. Ethical Investing – A Study of Performance. Copenhagen Business School. 2016. Available here.
8 – GL Clark, A Feiner, M Viehs. From the Stockholder to the Stakeholder: How Sustainability Can Drive Financial Outperformance. University of Oxford and Arabesque Partners. 2015. Available here.
9 – M Khan, G Serafeim, A Yoon. Corporate Sustainability: First Evidence on Materiality. The Accounting Review 2017, 91(6); 1697-1724. Available here.
10 – Why ESG? Arabesque Partners. 2020. Available here.
11 – DD Lee, RW Faff. Corporate Sustainability Performance and Idiosyncratic Risk: A Global Perspective. The Financial Review. 2009, 44(2); 213-237. Available here.
12 – M von Wallis, C Klein. Ethical requirement and financial interest: a literature review on socially responsible investing. Business Research. 2014. 8; 61–98. Available here.
13 – S Lobe, C Walkshäusl. Vice vs. Virtue Investing Around the World. 2011. Available here.
14 – PJ Trinks, B Scholtens. The Opportunity Cost of Negative Screening in Socially Responsible Investing. Journal of Business Ethics. 2017, 140; 193-208. Available here.
15 – R Morgan. Socially responsible investments cement longer term outperformance in market turmoil. Charles Stanley Direct. 2020. Available here.
16 – Y Belghitar, E Clark, N Deshmukh. Does it pay to be ethical? Evidence from the FTSE4Good. Journal of Banking and Finance. 2014, 47; 54-62. Available here.
17 – Y Yang. How do socially responsible portfolios perform? Nutmeg. 2020. Available here.
18 – C Revelli, J-L Riviani. Financial performance of socially responsible investing (SRI ): what have we learned? A meta‐analysis. Business Ethics; A European Review. 2015, 24(2); 158-185. Available here.
19 – J-C Plagge, DM Grim. Have Investors Paid a Performance Price? Examining the Behavior of ESG Equity Funds. The Journal of Portfolio Management Ethical Investing. 2020, 46(3); 123-140. Available here.
20 – SJ Niblock et al. Risk-Adjusted Returns of Socially Responsible Mutual Funds II: How Do They Stack Up in Australia? The Journal of Investing ESG Special Issue. 2020, 29(2); 80-97. Available here.
21 – O. Al-Khazali, HH Lean, A Samet. Do Islamic stock indexes outperform conventional stock indexes? A stochastic dominance approach. Pacific-Basin Financial Journal. 2014, 28; 29-46. Available here.
22 – E Castro et al. Relative performance of religious and ethical investment funds. Journal of Islamic Accounting and Business Research. 2020, 11(6); 1227-1244. Available here.
23 – S Arefeen, K Shimada. Performance and Resilience of Socially Responsible Investing (SRI) and Conventional Funds during Different Shocks in 2016: Evidence from Japan. Sustainability. 2020, 12(2); 540. Available here.
24 – B Leitao. How ESG ETFs Have Performed in the Sell-Off. Morningstar; ETF Research & Insights. 2020. Available here.
25 – International Monetary Fund. 2017. The Effects of Weather Shocks on Economic Activity: How Can Low-income Countries Cope? World Economic Outlook Chapter 3, 117-183. Available here.
26 – ME Kahn et al. Long-Term Macroeconomic Effects of Climate Change: A Cross-Country Analysis. 2019. CESifo Working Paper, No. 7738, Center for Economic Studies and Ifo Institute (CESifo), Munich. Available here.

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