Investing

Ethical investing unpacked

10 September 2020 | Posted by Anna Panayi
question

Do good with your money by channelling it into ethical investing.

What’s it all about?

Ethical investing is putting your money into 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 while investing their money. And there is increasing evidence that ethical investments can outperform other investments in the longer term, so it’s something to consider.

What will you learn?

You’ll discover the main types of ethical investments, how they work and what to think about if you want to begin investing.

What is ethical investing?

Ethical investing means making investment decisions based on your ethical principles. Essentially, it’s investing for financial returns while staying true to your values. Whether you care about the environment, driving social change, or how a company conducts itself.

There are different strategies and associated terms used to describe ethical investment. And these include environmental, social and governance practices (ESG), socially responsible investing (SRI), and impact investing. If you find the terms confusing, that’s because they are often used interchangeably to cover a broad spectrum of goals and strategies.

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

How do ethical investment strategies work?

You can start by excluding companies and industries that don’t reflect your values from your investments. And only include companies and industries that reflect your values. This is known as negative and positive screening.

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

Think of your ethical investment decisions as either:

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. Or 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. But if you’re making company-driven decisions, you will look at how a company conducts itself, including its business model and activities.

This chart shows where some of the most common ethical investing strategies fall:

ESG integration

The environmental, social, and governance practices of an investment are referred to as ESG.

If you’re using ESG integration to make investment decisions, you’ll combine ESG-related risk and opportunities with the traditional ‘fundamental’ analysis:

  • Fundamental analysis is where you look at the company’s financial statements, its competitors, the market it operates in and the economy.
  • ESG should help you understand the future opportunities and risks of a company. 

ESG integration as a strategy means that you base your investments on your ethical and social concerns. But your primary objective is still financial performance. 

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

The environmental component considers the company’s impact on the earth. For example, what effect is it having on climate change? Common considerations include carbon emissions, water and energy consumption, pollution and waste management.

The social part relates to how companies treat people and the contribution it makes to society. You might want to consider how a company treats its 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. This could include how a company deals with the independence of the board, board structure, conflicts of interest, executive compensation, and shareholder rights.

ESG sustainability looks at how companies, industries or markets can operate within their means and stay stable over the long term. Because of this, they are considered ‘sustainable’ when economic performance intersects with high ESG ratings.

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

If you want to use this strategy, have a look at the ESG ratings in the fund prospectus or company profile. 

Socially responsible investing (SRI)

The oldest form of ethical investing, SRI, means screening investments according to specific ethical guidelines. It’s all about avoiding ‘sin stocks’ or funds that invest in such stocks.

Sin stocks include companies that are associated with activities including gambling, alcohol, or the production of weapons. This approach tries to balance financial returns with social outcomes. But despite the impressive growth of SRI, it can bring smaller gains compared to other ethical investing strategies.

To use this strategy, look into the companies included in funds you are considering investing in, and avoiding investing directly in sin stocks.

(Ethical) thematic investing

Thematic investing identifies long-term trends so you can 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. Because ETFs can come with ESG ratings, it makes it easy for retail investors to start thematic investing without having to pick individual companies. 

Impact investing

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. So instead of negatively screening organisations that cause 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 looks to align a company’s long-term strategy and day-to-day management with shareholders’ interests.

There are lots of 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. Whereas stewardship is a less confrontational approach to promoting change. It works by creating 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 general meetings.

What to consider when deciding between different ethical investment strategies

You’ll probably have noticed some overlap between the different ethical investing strategies. Whatever you call your strategy, it’s helpful to consider how much sway your financial goals or ethical considerations have. It’s also wise to think about whether you want to make a difference at an issue-level or a company-level.

The good news is that more and more companies and funds are beginning to report on their ethical credentials. This makes it easier to take ethical investment decisions.

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

The most important thing is to research 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 started with ethical investing

You can pick up ethical investment products, or the underlying assets, from:

  • An online stockbroking service or platform
  • A financial adviser
  • A bank or building society
  • A broker, or
  • Directly from a fund manager.

Key takeaways on ethical investing

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.
You can make issues-driven decisions that look at cross-sector challenges. Or you can make company-driven choices based on a company’s business models or activities.
Ethical investment options are growing in popularity, and ethical investment ratings make 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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