Ethical (ESG) investing: what is it and how do I get started?

Ethical investing is a growing investment strategy that involves selecting investments based not only on potential performance but also on how that company acts and treats its employees and the environment. An investor will choose to invest in companies that are deemed to be ethical, although this will mean different things to different people. For example, some people only want to invest in companies that don’t do animal testing, that doesn’t produce alcohol or tobacco, or that treat their employees well, or focus on those that have a low carbon footprint. They try to avoid investing in companies involved with fossil fuels, instigating climate change, unsustainable environmental practices, gambling, corruption, bribery and human rights violations.

Ethical investing balances portfolio returns with a social responsibility investment strategy. Ethical investing is also referred to as environmental, social, and governance (ESG) investing or socially responsible investing (SRI).

Ethical investors favour companies that are good to people, society, and the environment. Using these factors, investors can evaluate a set of investment criteria to try and determine how ethical a company is, though some socially conscious funds have their own formal guidelines.

Negative screening is the practice of avoiding companies involved in certain industries or with unethical practices. Positive screening is looking for the firms that are the best in their field in terms of environmental, social, or governance (how they run the company) factors. Either approach can be used to ethically invest.

Ethical investing has a long history, dating back to the early 1900s when the Methodist Church invested in the stock market but avoided companies associated with alcohol and gambling. The Quakers did the same thing around this time, also avoiding weapons companies.

Due to the Vietnam War, the first ethical fund popped up in the US in 1971, which avoided companies associated with the conflict. Ethical funds were approved in the UK in the 1970s as well. By 2000, it was UK law that pension fund managers had to declare whether ethical factors were taken into consideration when investing.

Fast forward to modern times, and there are hundreds of ethical stocks and ETFs​​ (exchange-traded funds) trading on exchanges around the world, typically under the previously mentioned headings of SRI or ESG. Ethical investing, SRI, and ESG are terms often used interchangeably.

Ethical investing is based on a person’s values, which could be religious, moral, and/or social. Based on this, ethical investing can be divided into several groups with various values, including:

Between 2015 and 2020, ethical investing (that can be tracked) grew tenfold. According to Morningstar, ethical investors put $51bn into ethical funds in 2020, compared to $5bn in 2015. In 2019 alone, more than 500 US funds added the term ‘ESG’ to their prospectus. However, this means it’s unclear whether investors actively sought out ESG funds or just ended up in one.

That said, the sheer number of funds that are associated with ethical investing indicates this field has grown and continues to grow. In the first quarter of 2021, global inflows into ethical funds were $185bn, according to Reuters.

One of the key drivers of growth has been the climate change discussion, which has encouraged people to at least consider better environmental choices. People are also seeing the need to consider social issues and how companies act and treat their employees.

Ethical investing has several advantages, both personal and societal, such as:

Ethical investing also has some drawbacks compared to conventional investing. Conventional investing is less concerned with how a company acts and is more concerned with how the company performs.

Whether ethical investing works depends on what the goal is. Here, we’ll consider whether ethical investing has an impact on companies and society, and then we’ll look at whether it works in terms of returns/performance as an investment strategy.

Ethical investing may succeed in making an investor feel satisfaction that they are only invested in ethical companies with positive ESG factors. ESG factors are criteria for assessing how ethical a company is, such as not polluting, high labour standards, respecting human rights, and anti-bribery/corruption, for example.

But buying ethical stocks/funds does not mean that a company will necessarily be more ethical. Buying shares of a company just means buying the shares of someone else who is selling.

Therefore, from an impact investing point of view, ethical investing doesn’t do much for helping ethical companies or hurting unethical companies. What does directly impact companies is choosing to use their product or services or boycotting their product or service. This directly impacts their sales and bottom line.

As for returns, ethical investing can work. Between 2018 and 2021, many ESG funds/ETFs have performed similarly to major index ETFs in their respective country. And in some cases, they have outperformed the major indexes (the S&P 500 and FTSE 100, for example) according to data from S&P Global. These include the Vanguard ESG US Stock ETF, the Ariel Fund, and the Global X Conscious Companies ETF, among others.

This indicates that ethical investors are not giving up much in terms of returns. It also shows that research doesn’t need to be intense. Ethical investing can be as simple as buying an ETF – just make sure the fund aligns with your values.

There are different levels of ethical investing, depending on how passionate an investor is about their values.

For those looking to get into ethical investing and willing to let someone else decide if a company is ethical not, then ETFs could be a good choice. Each ETF has a prospectus that outlines what the ETF invests in, what it doesn’t invest in, and how it makes that determination.

Search SRI, ethical, and ESG ETFs to see which ones suit your basic values. Most ETFs have general criteria, such as avoiding oil companies and only investing in companies with high ESG scores. While these criteria are vague, such funds provide an investment vehicle that is at least somewhat screened to only hold ethical investments.

Another option is for investors to seek out stocks to buy based on how the company is run. This is research-intensive, as companies often have many operations and work in multiple countries. Here are some things to research:

There are many ethical investment funds in the UK listed on the London Stock Exchange, although most don’t have a lot of daily average trade volume. The following data is sourced from Yahoo Finance and is up to date as of November 2021.

Here are some of the current top-weighted holdings in the ETFs mentioned above, up to date as of November 2021. Note that each fund has different parameters, and these may not necessarily align with an individual investor’s values. That said, these are companies with high ESG scores and low carbon emissions. These stocks are all listed on the London Stock Exchange.

Green bonds are issued to raise funds for environmental projects, such as renewable energy, conservation, combating climate change, clean water, sustainable energy, or other ‘green’ projects. The investor receives interest, and then their initial investment is paid back when the bond matures.

Green bonds are issued by governments and corporations, with the UK government having regular green bond sales. The funds received from the bonds will help the UK reach its 2050 goal of having net-zero carbon emissions. Funds can be purchased through the National Savings & Investment site.

Ethical investment bonds are issued by ethical companies with high ESG scores. An individual can buy ethical investment bonds from companies they like, or they can purchase an ethical bond (or green bond) ETF.

Lyxor Green Bond ETF [CLIM] is a passive fund that invests in green bonds from high-grade companies.

The Franklin Liberty Euro Green Bond ETF [FVUG] is actively managed. The fund manager believes that since green bonds are a relatively new concept, the fund can achieve higher returns with an active trading approach.