How might ethical investments compare with conventional counterparts? Could they tend to underperform? Particularly as ‘ethical’ or ‘green’ labels might be applied for marketing advantage.
Investors often perceive that ethical investing reduces the number of companies available for portfolios. The smaller ‘opportunity set’ reduces diversification possibilities, resulting in worse returns, higher risk, or both. This article proposes counter-arguments challenging this perception by exploring risks, and asking whether sustainable investing can provide a competitive advantage.
Q G Rayer (2020), Ethical investing and performance: the price of conscience, The Private Investor, the newsletter of the UK Shareholders’ Association, issue 205, April, p12-13, 20th April 2020.
Previous articles asked why ethical investment matters [1], introduced sustainable (environmental, social and governance, or ESG) investing [2]; or looked at different approaches [3], [4], including fund selection [5]. This article is the first of two considering the ‘price of conscience’, challenging the view that ethical investments are more likely to underperform. Here, arguments supporting ethical out-performance are explored, while a future article will review studies of actual performance. How might ethical investments compare with conventional counterparts? Could they tend to underperform? Particularly as ‘ethical’ or ‘green’ labels might be applied for marketing advantage.
Investors often perceive that ethical investing reduces the number of companies available for portfolios. The smaller ‘opportunity set’ reduces diversification possibilities, resulting in worse returns, higher risk, or both. This article proposes counter-arguments challenging this perception by exploring risks, and asking whether sustainable investing can provide a competitive advantage [6], [7].
Sustainable Investing and Risk
Proponents of sustainable investing argue that unethical corporate behaviors increase risk [8], [7]. Companies’ harmful actions eventually lead to negative consequences for them, with detrimental effects on growth and profits, leading to underperformance. Essentially running risks that are not ‘priced in’ by markets. Investors excluding these companies remove unrewarded risk from their portfolios. Such practices can increase the likelihood of litigation against the company, cause reputational damage, or make customers take business elsewhere. Other risks may include:
- Weak industry standards could stimulate government regulation, increasing business costs to all companies in that sector [9]. Firms with the least invested in meeting standards will be forced to improve and be harder hit.
- Environmental issues, such as CO2 emissions restraints or carbon permit trading. Companies adopting the appropriate technologies may avoid redesign costs. At the same time, those continuing harmful practices may require investment or to accept higher ongoing business costs.
- Ethical behavior gives a company a ‘license to operate’, as a valued community asset, avoiding resentment about activities [7]. Community opposition can upset projects and damage brands. Oil-spills can cause reputational damage lasting decades.
- Poor sustainability records can raise insurance premiums or increase the cost of capital. Investor concerns can lower share prices and increase the cost of debt through weaker bond issuance.
- Unethical supply-chain partners can tarnish a brand reputation.
- Energy usage reduction and waste minimization increases efficiency and reduces costs.
Other business risks relate to emissions and waste discharges (particularly affecting companies in mining, oil, gas and forestry sectors); balance sheet risks from historical liabilities; and business sustainability risk. Companies may face the intrinsic lack of sustainability of their activities. Examples include coal mining, especially high-sulfur coal producers.
Competitive Advantage
Ethical companies can build a good reputation, bringing financial rewards. Businesses can earn legitimate profits, contributing to society, avoiding coercive, exploitative, or illegal practices. Internationally, some countries have lesser standards for human rights, labor, bribery, and the environment [10].
Trustworthy reputations attract customers and business partners, creating economic opportunities [11]. Not everything immoral is illegal: staying within the letter of the law is insufficient to protect reputation. An organisation’s ethical culture helps protect it from unlawful staff conduct since strong moral principles help limit abuses by staff tempted to circumvent regulation. Further, companies with stronger ethical reputations should command higher PE ratios for their stock and be able to borrow at lower rates in bond markets.
A 2010 study [12] concluded that positive CSR strategies, although initially perceived by analysts as being value-destroying, are now seen as value-creating. Analysts are now more likely to recommend a stock ‘buy’ for strong CSR firms.
Other sources of competitive advantage include [7]:
- Attracting, retaining and motivating top talent.
- Anticipating changes in regulatory and business environments ahead of competitors.
- Generating revenue growth through new products, services and technologies.
- Increasing customer and investor loyalty.
- Improving relations with regulators, local suppliers, communities and key stakeholders.
- Strengthening innovation and adaption within the corporate culture.
How this helps Investors
Individuals increasingly wish to invest ethically and often have specific concerns in mind. Younger people may give this a higher priority than older generations with twice as many 18 to 34-year-olds feeling their pensions should be invested ethically, compared with those above 45 [13]. The Investment Association reports £27.9 billion of assets in the UK responsible funds sector in January 2020, an increase of £3.2 billion since October 2019 [14].
Individuals will wish to be confident that ethical investing is unlikely to be detrimental to portfolio performance. However, the selection of suitable ethical funds is a complex area. So some investors are likely to wish to access the skills of wealth managers who can support them in this important and growing field.
References
[1]
Q. G. Rayer, “Introducing Ethical Investing,” The Private Investor, the newsletter of the UK Shareholders’ Association, no. 199, pp. 12-13, April 2019.
[2]
Q. G. Rayer, “Introducing sustainable “ESG” investing,” The Private Investor, the newsletter of the UK Shareholders’ Association, no. 200, pp. 10-11, June 2019.
[3]
Q. G. Rayer, “Ethical investing approaches: screening and best-in-class,” The Private Investor, the newsletter of the UK Shareholders’ Association, no. 202, pp. 8-10, 18 October 2019.
[4]
Q. G. Rayer, “Ethical investing: portfolio tilting and corporate engagement,” The Private Investor, the newsletter of the UK Shareholders’ Association, no. 203, pp. 12-13, 23 December 2019.
[5]
Q. G. Rayer, “Selecting ethical or sustainable investment funds,” The Private Investor, the newsletter of the UK Shareholders’ Association, no. 204, pp. 10-11, 18 February 2020.
[6]
J. Porritt, “The world in context: beyond the business case for sustainable development,” Cambridge: HRH The Prince of Wales’ Business and the Environment Programme, Cambridge Programme for Industry, 2001.
[7]
M. J. Kiernan, Investing in a sustainable world, New York: AMACOM, 2009.
[8]
C. Krosinsky, N. Robins and S. Viederman, Evolutions in sustainable investing: strategies, funds and thought leadership, John Wiley & Sons, 2012.
[9]
E. Helleiner, I. Rowlands, J. Clapp, J. Whalley, T. Homer-Dixon, J. Thistlethwaite, D. VanNijnatten and A. Hester, “Environmental sustainability and the financial crisis: linkages and policy recommendations,” CIGI Working Group on Environment and Resources, 2009.
[10]
N. Asgary and M. C. Mitschow, “Toward a Model for International Business Ethics,” Journal of Business Ethics, vol. 36, no. 3, pp. 239-246, 2002.
[11]
J. R. Boatright, “The relationship of ethics and the law,” in Ethics and the conduct of business, 6th ed., New Jersey, Pearson Education, 2009, pp. 14-17.
[12]
I. Ioannou and G. Serafim, “The impact of corporate social responsibility on investment recommendations,” Harvard Business School, 2010.
[13]
BBC, “More young savers ‘want ethical pensions’,” 8 October 2017. [Online]. Available: http://www.bbc.co.uk/news/business-41543454. [Accessed 10 September 2017].
[14]
The Investment Association, “Fund Statistics,” January 2020. [Online]. Available: https://www.theia.org/industry-data/fund-statistics/full-figures. [Accessed 16 March 2020].
