On the off-chance that you’re one of the few people who read the information sent out by their superannuation fund, you might have noticed that in recent years they’ve added an Ethical Investment option. Now the exact labelling of that option will vary – it might be called Socially Responsible, Sustainable, or just Responsible, all of which are interchangeable terms for ethical investment options. So given these options are popping up like mushrooms in a wet cow paddock, what do they mean, what’s happening under the hood that makes then different to other investment options, and bottom line – should you care? Each year the Responsible Investment Association of Australasia (RIAA) produces a Benchmark Report which tracks the adoption of ethical investment options, and their performance. In their most recent report (2017) they found that funds adopting a “core” responsible investment approach outperformed their peers over the longer term, both in the Australian share and International share space. That superior performance doesn’t happen every year, but the RIAA data has found fairly consistently over the years that when measured over the medium to long term, an adoption of an ethical investment approach has delivered improved returns for investors. And so it is for this reason primarily that ethical investment options, once an extremely niche offering that was expensive and little understood, has broken into the mainstream. In fact RIAA found that 44% of all of Australia’s assets under management are now being invested through some form of responsible investment strategy. Now there’s two interesting paths to wander down at this point. The first is what does it mean to invest “responsibly”, and the second is, why is the adoption of this approach leading to improved returns. What does Ethical Investment mean? As you might guess from the number of inter-changeable terms used to describe this investment process, there is no single definition of what makes an investment an Ethical one. This is hardly surprising, since ethics is something formed by an individual, and whilst in society there is likely to be much commonality on what is “ethical”, there will also be considerable room for disagreement. In a broad sense, ethical investment means considering “ESG” factors when contemplating an investment. ESG stands for Environmental, Social, and Governance. So in considering these factors, fund managers or investors are thinking about a business in a broader context than just the profit and loss statement and balance sheet. The adoption of the consideration of ESG factors by professional investors has been where the bulk of the growth in this space has occurred. But of course, just because you’ve considered these factors, doesn’t necessarily mean that you won’t still decide to invest in a coal mine or a weapons manufacturer. The next tier up is what RIAA defines as “Core” responsible investment funds. They define this subset as: “Core responsible investment approaches apply at least one of the following primary strategies: negative, positive or norms-based screening; sustainability themed investing; impact investing, community finance; or corporate engagement.” I’d suggest that if you’re someone who finds the idea of ethical investment interesting, then this definition and the fund managers that fall within it, are what you are seeking. So let’s unpack that definition a little because there’s plenty of jargon in there. Negative screening means that the fund might have certain industries that they undertake never to invest in. The most common are fossil fuel mining, tobacco, and weapons manufacture. Here’s an example from one of the more stringent local listed funds: (Companies invested in) can’t be materially associated with a range of activities that could be deemed inconsistent with responsible or ethical investing. These activities include, among others, the production or financing of fossil fuels, gambling, junk food, tobacco, pornography, armaments, alcohol and animal cruelty. So if you chose to invest your money with that fund manager, you can have confidence that your investment will never have holdings in those sectors. Many ethical funds stop at that negative screen point. Some go on to apply positive screens as well though, so they look especially favourably for example, on companies that develop medical solutions to improve people’s lives, or are creating solutions to improve the environment. Other funds don’t use screens at all, but instead have an overarching investment philosophy around investing for the long term and considering sustainability as a primary factor when evaluating a business. There have been some global share funds that have adopted this approach that have generated outstanding returns for their investors in recent years. You might also be interested in a short piece I wrote some time back “What do Ethical fund managers do?”. Given the different “flavours” of ethical investment, there is a definite challenge around “green washing”. That is, the practice of promoting an investment as ethical, sustainable, or whatever, for the positive connotations that those words hint at, but then when you look under the hood at what they invest in, it’s little different to a standard investment fund. The worst case of this that I’ve seen was a fund created for the Australian share market that had the word “ethical” in its name. When you looked at the fund description, it informed investors that it would invest in companies in the ASX200 (an index of the top 200 companies on the Australian stock exchange), excluding those involved in the production of armaments and tobacco products. The problem was, no companies in the ASX200 are involved in these industries! So in practice, the fund was no different to a regular, non-ethical investment. But they charged a higher fee! Why the outperformance? The next thing worth exploring is why has the research found that ethical investment tends to out-perform over the medium to longer term? One simple explanation could be that the funds operating in this space tend to have more of a weighting to the mid-cap sector, ie. not the largest companies, and not the really small companies either. There is some research that points to this area being a bit of a sweet spot for investors – the companies in this space tend to have lots of room to grow, perhaps unlike some of the really large companies, and yet they’re not so small that they lack quality management and oversight. Another explanation is that the adoption of considering factors beyond the financial statements has a strong basis in logic. Take a tobacco manufacturer for instance. The numbers might tell an analyst that this is a profitable business. But pulling your head out of the numbers, and thinking a bit more broadly, do you really want to be investing in a product known to kill people? Even if you don’t have a moral issue with that, do you want to be in a business where governments are working hard to dissuade people from buying your products, such as Australia’s very successful plain packaging legislation? Mining companies are another sector often excluded by ethical investment funds, and in Australia, these businesses form a significant part of our investment universe. Ethical investment advocates would argue that these are not sustainable businesses – you can only dig the resource out of the ground once. On that basis alone, they make a poor investment. Add to that the damage done to the surrounding environment, and the knock effects of then using the extracted resource, such as the carbon dioxide released when burning fossil fuels, and many, myself included, would consider these companies to be unattractive investment options. If enough people come to the same conclusion, then price appreciation of their shares won’t occur, or at least won’t occur to the same extent, and businesses may even become starved of capital. Compare that to a business developing a vaccine for a common, serious disease. If they’re successful, governments around the world may buy or subsidise the sale of their product. In total contrast to the tobacco industry, governments and the community will put “wind in the sails” and propel the business towards success. Doesn’t that sound like an investment you’d want to be in? So next time you’re considering investment options, whether in your super fund, or your ordinary savings, give some thought to whether an ethical investment option might be suitable for you. Just be sure to have a read of what they interpret that to mean and ensure it aligns with your expectations. This may well be an area where some expert advice is warranted. A great resource is RIAA’s find a planner tool . Another resource that you might find of value is a book recently published by a good friend of mine Stuart Barry called The Rich Greenie. Important Information: This information is of a general nature only and has been prepared without taking into account your particular financial needs, circumstances and objectives. While every effort has been made to ensure the accuracy of the information, it is not guaranteed. You should obtain professional advice before acting on the information contained in this publication.