Ethical investing: the unlikely route to alpha?

Ethical AlphaAlthough some will assume that ethical and sustainable portfolios have higher risk and lower returns than their conventional counterparts, research suggests that this is not necessarily the case and actually they can outperform the wider market, with this article we investigate the ethical alpha.

Quintin Rayer outlines the results of some academic studies showing outperformance by a number of different ethical strategies over different periods.  While such studies into ethical alpha offer no guarantee of future performance, they should serve as food for thought for those who assume it is ‘obvious’ that ethical portfolios must underperform the wider market.

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Q G Rayer (2018), Ethical investing: the unlikely route to alpha? Citywire New Model Adviser®, issue 585, p25, 26 March 2018.


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If you heard of an investment strategy that generated significant alpha, you would want to know more, wouldn’t you? Even better if it was not merely above the market, but risk-adjusted outperformance, allowing for investment style, stock capitalisation, market trending and was statistically significant to boot. Several academic studies suggest such a strategy is available and currently neglected by mainstream funds.

The studies in question covered periods from eight to 27 years between 1984 and 2011, using sub-strategies of the core approach. Alphas of 1.3-5.2% per year relative to the market were obtained for long-only portfolios. Using the Carhart four-factor model to allow for the effects of market risk (beta), underlying company capitalisation, value-growth style bias and momentum (or trending) effects, these alphas proved statistically significant.

Historical analyses can be challenged on the basis they offer no guarantee of future performance.  And market conditions may be different looking ahead. One would expect profitable alpha-generating anomalies to be exploited away as they become widely adopted. But this core strategy is, at most, used by only around 1.26% of assets under management at December 2017, suggesting it is hardly mainstream. Even if the past is no guide to the future, the results should stimulate interest.

What is this strategy? The answer may surprise many: ethical or sustainable investing. The accepted wisdom says ethical funds must underperform. The argument is that ethical investment requires screening, reducing investment choice and diversification, resulting in worse returns, higher risk, or both. Another difficulty is whether some fund providers have only a superficial ethical commitment.

Actually, there are fundamental reasons for believing ethical investing can generate superior returns, the ethical alpha, based on risk and competitive advantage.

Considering risk, harmful corporate behaviours eventually lead to negative consequences, damaging growth and share price. These can include sector emissions constraints, community opposition, increased insurance premiums, decreased access to capital markets, damage to reputation, and litigation threats. Essentially, unethical companies have risks not well reflected in share prices.

Ethical companies have a competitive advantage. They avoid the above problems, while also attracting customers by having a good reputation. Enhanced trust with similarly ethical trading partners also reduces costs and increases business opportunities. They can attract the best staff, find new revenue streams from novel environmental technologies and access capital markets on better terms.

Academic studies suggest various ethical approaches do indeed result in outperformance, with portfolios of more ‘ethical’ companies outperforming the broad market. The table outlines examples of long-only ethical strategies that generated positive alpha. These analyses over various time-periods use different criteria to define which companies are more (or less) ethical.

Alpha, per year Period analysed Ethical criteria
1.3 – 4.0% 1995-2003 Environmental
2.3 – 3.6% 1992-2004 Environmental, social
2.3 – 3.8% 1984-2011 Employment quality
3.5% 1990-1999 Governance
3.7 – 5.2% (estimated) 1990-2003 Governance
Table: Studies showing outperformance by ethical strategies[1]

Ethical might be an outperforming investment strategy regardless of moral considerations, reassuring advisers that selecting ethical funds and searching for ethical alpha for clients is unlikely to be detrimental to portfolio performance.

The analyses above should serve to give pause for thought for those who are tempted to assume it is ‘obvious’ that ethical portfolios ‘must’ underperform the wider market. And it can help allay any dilemma faced by advisers considering discussing ethical investing with their clients.

[1] The table presents the results of the following analyses: J. Derwall, N. Guenster, R. Bauer and K. Koedijk, “The eco-efficiency premium puzzle,” Financial Analysts Journal, vol. 61, no. 2, pp. 51-63, 2005; A. Kempf and P. Osthoff, “The effect of socially responsible investing on portfolio performance,” CFR Working Paper, no. 06-10, 2007; A. Edmans, “The link between job satisfaction and firm value, with implications for corporate social responsibility,” Academy of Management Perspectives, November 2012; P. Gompers, J. Ishii and A. Metrick, “Corporate governance and equity prices,” Quarterly Journal of Economics, vol. 118, no. 1, pp. 107-155, 2003; and  L. Bebchuk, A. Cohen and A. Ferrell, “What matters in corporate governance?,” The Review of Financial Studies, vol. 22, no. 2, pp. 783-827, 2008.

About Dr Quintin Rayer

Quintin is a Chartered Fellow of the Chartered Institute for Securities and Investments, a Chartered Wealth Manager and holds a Physics degree from Imperial College London and a Physics doctorate in atmospheric physics from Oxford University and is a Fellow of the Institute of Physics.