The problem with traditional ethical funds

Ethical investment inflows have doubled in 2019. But, the Wall Street Journal highlights a problem near to my heart: ethical investing is not the same to everyone.

Funds with a focus on socially responsible investing are enjoying a record year of inflows. But many such portfolios aren’t as clean as investors might expect.

Eight of the 10 biggest U.S. sustainable funds are invested in oil-and-gas companies, which are regularly slammed by environmental activists, according to a review of the funds’ public disclosures.

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Vanguard Group’s FTSE Social Index Fund is meant to track an index excluding companies with “significant controversies regarding environmental pollution or severe damage to ecosystems.” Both that fund and another large ESG fund operated by Xtrackers include Occidental Petroleum Corp. , which in 2015 paid Peruvian indigenous villagers an undisclosed sum to settle a suit accusing it of contaminating the Amazon.

What do you get when you buy an ethical fund?

There is a lot of confusion over what you are getting when you by an ethical fund. There tend to be three main approaches ethical funds use to select stocks:

1. Positive ethical investing: This involves finding companies that are actively contributing to causes that you feel strongly about. It might mean investing in a solar manufacturer, a biotech with a potential cure for cancer or an electric car manufacturer.
2. Negative screening: This involves excluding companies that do not meet ethical standards. It may mean avoiding companies involved in tobacco, producing carbon or making weapons.
3. Best-of-breed: This involves ranking companies on a range of metrics and excluding those that don’t meet particular standards. For example, a carbon/global warming strategy may exclude companies involved in brown coal or tar sands. These are the most polluting. It might include companies producing natural gas as gas pollutes less.

Positive investing is difficult. Finding stocks that are both good quality and cheap is hard enough. Say you find a company with very positive ethical characteristics but only average quality and very expensive. Should you buy it anyway, expecting a poor return?

Negative screening needs to be customised, which makes investing in an ethical fund difficult. One investor may think tobacco is a terrible, addictive product, but gambling is an individual’s choice. Another investor may have precisely the opposite view.

Best-of-breed can be similarly problematic. Say you are concerned about global warming. Do you buy a gas producer with the view it is less damaging than coal, and you think you can profit from it? Seems hypocritical.

The problem with positive ethical investing

As I said, finding a company that is good quality, cheap is hard on its own. Needing to find one that will positively benefit society as well becomes incredibly difficult. It is rare to see two of those qualities and so getting all three together is next to impossible.

Many of us are suckers for a good biotech or green technology story. It is hard not to be moved by pictures of the kids who will be saved if the drug/device works. It is hard not to want to be part of a new technology that will produce cheap, clean energy.

Not only will my investment make me money, but I’ll also be saving sick kids/the world from global warming!

Unfortunately, the focus is rarely on the value of the proposition. It is too often about emotion. And that’s a recipe for losing money on an investment.

If there is a cause you are passionate about and you want to support companies in that area, there are four ways you can support that cause (in order of most helpful to least helpful):

1. Make a donation. Are you trying to help or are you trying to make money? If it is the first, then by donating you can feel good straight away. You also get a tax deduction upfront – rather than waiting to book a capital loss when you sell shares! Giving directly to companies is not generally tax-deductible. But if your cause is ethical, then there will be industry bodies that are tax-deductible.
2. Buy the product yourself. Most companies want more customers rather than more shareholders. The ones that don’t, you shouldn’t be investing in.
3. Buy shares from the company in a capital raising. That way, your money will actually support research and development or expansion.
4. Buy shares on the market. This is the least helpful way of helping the company. All you have done is transferred your money to another investor.

Let me make it clear:

You are not a martyr for buying an ethical stock from another investor and then losing money.

Which is best

In my view, investment performance problems with positive investing make it a difficult proposition. And, to me, best-of-breed seems insincere.

Luckily, in recent years investment technology has moved on from the one-size-fits-all ethical funds being the only option.

At Nucleus, we decided the best result for our investors would be to allow everyone to add their own negative screens. For example, some people like nuclear power for efficiency and carbon reduction benefits. Other people believe the risks to the environment and contamination are too high.

So, we run relatively large portfolios in separately managed accounts, and let each investor decide what to exclude for their own portfolio. We then run systems over the top of client investments to make sure that the portfolio is still appropriately diversified. This can even be done in superannuation accounts without needing an SMSF.

Final word

• If you want to make the world a better place using your money, consider other ways first. Would a donation be more helpful?
• If you want to ensure your investments don’t make the world worse, then find a product that avoids stocks that don’t align with your values.
• I’m sure there are plenty of jobs that you wouldn’t do, regardless of how much more money you get paid. Why should your investments be any different?
• Check the fees. Please. It irks me seeing ethical funds sold for unethical fees.