Investing

Ethical investing unpacked

10 September 2020 | Posted by Anna Panayi
question

Do good with your money.

What’s it all about?

Ethical investing is investing in financial products, companies or other types of assets based on your ethical principles.

Why should you care?

More people are looking for ways to make a positive difference to things they care about while investing their money at the same time. And there is increasing studies that ethical investments can reduce risk and outperform other investments in the longer term.

What will you learn?

In this pack you’ll learn about the main styles of ethical investments, how they work, and what to consider if you want to begin investing.

What is ethical investment?

Ethical investing means making investment decisions based on your ethical principles. This allows you to invest for financial returns while staying true to your values, whether you care about the environment, driving social change, or how a company or country conducts itself.

There are different strategies and associated terms used to describe ethical investment, including environmental, social and governance practices (ESG), socially responsible investing (SRI), and impact investing. Investors can find the terms confusing because they are often used interchangeably to cover a broad spectrum of goals and strategies, and the line between them is blurred. 

The good news is that ethical investing is becoming increasingly important to investors. This will lead to greater demand and more ethical investment opportunities.

How do ethical investment strategies work?

In its purest form, you can exclude companies and industries that don’t reflect your values and include companies and industries that reflect your values in your portfolio—referred to as negative and positive screening.

Deciding what to include or exclude from your portfolio will depend on your ethical investment strategy. 

You can think of your ethical investment decisions in two types:

Values vs value driven
Issue vs company driven

Values vs value: On the values-driven side, you will make investment choices based on your ethical considerations, while on the value-driven side, you will focus on financial outcomes.

Issue vs company:  If you are making issue-based investment choices you will look at cross-sector challenges for example, whether your investment options are directly tackling climate change. If you’re making company-driven decisions, you will look at how a company conducts itself, including its business model and activities.

The chart below shows where some of the most common ethical investing strategies fall against these categories.

ESG Integration

The environmental, social, and governance practices of an investment are referred to as ESG. ESG integration is a strategy that combines ESG related risk and opportunities with the traditional ‘fundamental’ analysis, to make investment decisions. 

Fundamental analysis is where you look at the company’s financial statements, its competitors, the market it operates in and the economy at large. 

In principle, ESG should provide a more comprehensive understanding of the future opportunities and risks of a company. 

ESG integration as a strategy means that you combine your ethical and social concerns into your investment portfolio, but the primary objective is still financial performance. 

It is possible to give ESG scores to individual companies, investment funds, or entire markets.

The environmental component considers the company’s impact on the Earth, such as climate change or the impact on the physical environment. Common considerations include carbon emissions, water and energy consumption, pollution and waste management.

The social component relates to how companies treat people and the contribution it makes to society. Investors could consider how a company treats their employees, customers, consumers or others in their supply chain. It also considers how well the company business or operating model deals with human rights, child labour, health and safety, diversity and inclusion, and stakeholder relations. 

The corporate governance component looks at the quality and robustness of a company’s internal structure and practices. The measures could include how a company deals with the independence of the board, board structure, conflicts of interest, executive compensation, and shareholder rights.

ESG sustainability describes the features which ensure companies, industries or markets can operate within their means and remain stable over the long term. Sustainability is achieved when economic performance intersects with high ESG ratings.

Typically, a third party rates the ESG credentials of a particular company or fund.

To use this strategy, have a look at the ESG ratings in fund prospectus or company profiles. 

Socially responsible investing (SRI)

The oldest form of ethical investing, SRI means screening investments according to specific ethical guidelines. Avoiding ‘sin stocks’ or funds that invest in such stocks. Sin stocks include companies that are directly or indirectly associated with activities including gambling, alcohol, or the production of weapons. This approach tries to balance financial returns with social outcomes. Despite impressive growth of SRI, it often brings smaller gains compared to other ethical investing strategies.

Use this strategy by looking into the companies included in funds you are considering investing in and avoiding investing directly in ‘sin’ stocks.

(Ethical) thematic investing

Thematic investing is a strategy which aims to identify long-term trends and invest in companies or sectors that stand to benefit from those trends. Themes could include companies or industries working on producing reliable and sustainable green energy.

Exchange-traded funds (ETFs) can provide a selection of themed stocks picked by fund managers. ETFs can come with ESG ratings, which make it easy for retail investors to start thematic investing without having to pick individual companies. 

Impact

Impact investing means investing in companies working to solve social or environmental problems. For example, developing clean energy or increasing the availability of essential services such as affordable housing, healthcare, and education. You can think about impact investing as the reverse of SRI. Instead of negatively screening organisations that do social or environmental harm, impact investment positively screens organisations that provide social or environmental value. 

Governance and active ownership

The governance and active ownership approach seeks to align a company’s long-term strategy and day-to-day management with shareholders’ interest. Within this ethical investment strategy, there are many ways to have an impact.  For example, shareholder activism is where a group of public investors use their shareholdings to apply pressure to the company to change their policies or practices. Stewardship is a less confrontational approach to promoting change, by engaging purposeful dialogue between other shareholders and boards. 

Retail investors don’t tend to exercise any leeway as activist investors, but as shareholders you can express your ethical concerns through your vote at annual and extraordinary general meetings.

What to consider when choosing between different ethical investment strategies

You will have noticed plenty of overlap between the different ethical investing strategies. Whatever you call your strategy, it’s helpful to consider to what extent you are deciding based on financial goals or ethical considerations, as well as whether you want your investments to make a difference at an issue-level or a company-level.

The good news is that an increasing number of companies and funds are beginning to report on their ethical credentials – making it easier to make ethical investment decisions.

Consider that there is no one agreed way to rate ethical investments. This makes comparisons between ethical investments choices difficult. And unfortunately, some companies exaggerate or misrepresent their ESG and ethical credentials; known as ‘social washing’ or ‘greenwashing’.

Research is essential for accurately determining whether an investment or group of investments align with your values, especially when investing in a fund such as a stocks and shares ISA or pension fund.

Where to get your ethical investments

You can pick up ethical investment products, or the underlying assets, from an online stockbroking service or platform, through a financial adviser, through a bank or building society, a broker or directly from a fund manager.

Key Takeaways

Ethical investing means making investment decisions based on your ethical or moral principles.
It’s a way to invest for returns while staying true to your values.
You can make values-driven decisions based on your personal values or value-driven choices related to financial outcomes.
Or you can make issues-driven decisions that look at cross-sector challenges, or company-driven choices based on a company’s business models or activities.
Ethical investment options are growing in popularity, with ethical investment ratings making it easier for retail investors to get involved.

Although ethical investments can potentially perform better, please remember that, as with all investment, capital is at risk.

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