For many investors, what their money is used for may be as important as how much profit it makes.
There’s a large segment of the investing public that’s interested in the impact of companies on their communities and the environment. Such investors prefer an investment approach that incorporates social values in the security selection process. This approach was known as ethical investing for a long time. Then the initials SRI were applied to it, standing for socially responsible investing. More recently it has become ESG investing, which stands for environmental, social and governance investing.
Whatever you call it, ethical investing used be be fundamentally negative in its approach. That’s because it meant avoiding investments in companies that engaged in what was considered to be negative behaviour such as profiting from gambling or the production of alcohol, tobacco, pornography and military weapons.
Today, ethical investing is still about avoiding companies that engage in negative behaviour. But it has also evolved to include a more positive dimension. For instance, the ethical investor may actively seek out companies that demonstrate leadership in environmental practices and are committed to complying with environmental regulations, that respect employees’ rights and promote equal employment opportunities, and that follow strong corporate governance practices.
When bad is not so bad
By emphasizing companies with positive behaviours, ESG investing doesn’t necessarily rule out investments in companies whose activities, say, have a negative impact on the environment. Take resource companies, for example. Resource extraction normally produces some adverse consequences for the environment.
But if you were to eliminate resource stocks from your investment portfolio altogether, you would reduce its diversification and possibly underperform the market for long periods of time. The ESG investor gets around this problem by following a ‘best-of-sector’ investment methodology.
With regard to resource stocks, this consists of identifying those with the best environmental practices. To the ethical investor, sound environmental policies allow a company to develop a sustainable, profitable business model. Companies that engage in unsound practices, however, will not be able to sustain their business over the longer term and profitability, as a consequence, will suffer. For instance, ignoring environmental concerns can lead to accidents such as oil spills, which in turn hurt a company’s profitability, as it falls prey to lawsuits and the costs incurred to clean up its mess.
Advocates of ethical investing, therefore, often argue that it produces superior returns to the traditional investment process. But there is no convincing evidence to suggest that its long-term investment results are significantly higher or lower than the traditional approach (see below). The good news, then, is that you won’t necessarily have to sacrifice returns to invest ethically. We recommend RBC Vision Canadian Equity Fund for ethical investing.
What’s the difference?
One of the criticisms levelled at ethical investing over the years is that it reduces the number of available investment opportunities by its exclusionary process. That, in turn, leads to lower investment returns than you would get with traditional investing.
Ethical investors, however, fire back with arguments similar to the one noted above‚ namely, that socially responsible practices lead to sustainable and, therefore, more profitable business models.
But the research to date suggests the data is mixed. While evidence exists that companies with really poor ethical track records often underperform more socially responsible companies, that does not mean the latter deliver superior results to the overall market.
This is an edited version of an article that was originally published for subscribers in the May 28, 2021 issue of Money Reporter. You can profit from the award-winning advice subscribers receive regularly in Money Reporter.
Money Reporter, MPL Communications Inc.
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