Exploring the up- and downsides of ethical investing and how investors can deal with social and environmental considerations.
In a changing world investments are exposed to political and societal issues which may impact the outcome for the investor. As a result investors have to find a way of dealing with them and bringing them in sync with their own beliefs. This post discusses different perspectives on ethical investing, ESG investing and how to find a personal balance.
The world is changing and not just for the better. Issues like climate change, human rights violations, systemic discrimination and a growing gap between the wealthy and the poor are just some problems humanity has to face. In the past companies have just been businesses that maximized their return on investment for higher profits. However in today’s environment its hard to avoid these topics for most almost any publicly traded company, even the ones with the best intentions. In fact many people nowadays expect public companies to have a stance on controversial political and societal topics. Being silent on them risks losing customers, reputation and possibly even employees.
This change in expectations for publicly traded companies also has an impact on investors. Many of them ask themselves how these topics and public opinion about them will impact their investments. They also have to understand for themselves what investments they are willing to make and which they want to avoid. Some people even question the system entirely and ask themselves whether they should participate in the stock market at all.
The definition of ethical investing is highly related to the moral compass of different people. As a result every investor will have a slightly different perspective on it. In general the goal of ethical investing is to invest into companies which leave a positive impact on society or the environment.
In the past this has been relatively simple, for example by avoiding investments into gun companies, gambling businesses or tobacco producers. However nowadays this is usually being perceived a lot more nuanced and ethical investing has become more sophisticated.
“[…] every company must not only deliver financial performance but also show how it makes a positive contribution to society.”
Considering social and environmental aspects when investing has positive and negative aspects. On one hand sustainable practices might make companies less vulnerable to issues like ethics scandals or environmental disaster caused by them. On the other hand it also limits the pool of available investments and good bargains might not match the required social and environmental criteria.
One example of ethical investing approaches are environmental, social and governance rankings (ESG) which rank companies on a number of criteria to assign them a total score. The idea is to rank companies based on environmental, social and governance criteria to understand the impact of an investment on society as well as the environment. However it is not a standardized classification system. Instead every ranking agency uses their own criteria to calculate a total ESG score.
While the underlying idea sounds great ESG investing has some serious pitfalls. As a result investors cannot solely rely on ESG scores for possible investments. Instead they still have to perform additional due diligence to verify ESG rankings before making an investment based on them.
One issue with ESG is that the spectrum of ESG criteria is very broad. For example MSCI, a world leader in asset classification, is classifying companies based on 37 total issues. These include environmental issues like climate change, natural resources, pollution and waste and environmental opportunities, social issues like human capital, product liability, stakeholder opposition and social opportunities and governance issues like corporate governance and corporate behavior.
Overall many companies have high total ESG scores. However when looking into the detailed scores the broad classifications can lead to misleading results. While a company might have consistently high scores in most categories it might lack in a few specific ones. Therefore the high total score can be misleading as it masks underlying issues in specific areas an investor might care about. These scores can be further misleading as companies are ranking against their peers. As a result a oil company might be categorized as a leader in environmental protection simply because it does more than its competitors.
One possible solution to avoid this issue is to narrow down possible investment by looking into specialized thematic funds, for example a fund focused on clean water. However these funds usually come at a cost with higher fees which will lower the return of the investor.
While ESG criteria become more important to access funding and garner public support they so far have not been native to fundamental analysis of a company. In the end the purpose of a business is to generate earnings for its shareholders and political and societal issues are usually not reflected on the balance sheet or an income statement.
However these issues can still have an indirect impact through customer behavior and public goodwill. As a result there is a false incentive to publicly support political and societal topics without actually meaning it in the hope to raise new money or gain new customers. These companies might just be voicing favorable opinions but are not acting upon it. Hence it is important to verify that high ESG scores are actually reflected in the actions of a company.
Protest divestment describes the intentional selling of assets which violate social or environmental values in order to provoke a positive change. By divesting their assets investors hope to convince the management of a company to change their policies and move towards a better future.
One example of protest divestment is the end of apartheid. Students were pressuring their schools to divest from companies doing business with South Africa from their their endowment funds. While these sell offs itself had neglible impact it raised awarness to the issue which companies wanted to avoid. In the end many other organizations and pension funds followed suit leading to sanctions by the US government leading to companies and money leaving the country.
Even the best companies can be linked to social or environmental issues. Apple Inc. is putting in tremendous effort into producing environmentally and privacy-friendly devices. Yet their products are manufactured under questionable labor conditions in Asian factories. Google on the other hand gave the world quick and easy access to more knowledge than anyone can ever digest while invading the privacy of billions of their users. Oil companies provide raw materials for the production of plastics, their oil keeps people warm in winter and it moves them from A to B. At the same time the oil they drill leads to global warming and catastrophic side-effects on our climate while the plastics accumulate in the ocean and endangers wildlife. Lastly real estate owned by investors leads to rising housing prices and land speculation while it also provides apartments to people and passive income to retirees.
Given how companies can be fundamentally good but selectively bad in how they rank on societal and environmental issues the selection of ethical investments is highly subjective. Yet going agains the flow and investing into companies which fare badly on specific issues can be subject to widespread criticism by the general population. As a result investors have to ask themselves whether they want to be contrarian investors and invest into controversial companies or if they want to go with the flow and only invest into “acceptable” ones.
One point of view is to ask whether it is even possible to avoid these issues? Even if someone might not invest into a specific company it does not mean they are completely out of touch with it. In a global world it is increasingly hard to track relationships and assess the impact of even simple interaction. For example someone might fundamentally reject big oil companies but their landlord might still use oil to heat the apartment. Or they buy products for which the producer bought the raw materials from a questionable supplier.
While many people often complain about issues our societies face being an investor gives them a unique chance to do more. As investors are partial owners of a company they have direct influence on its management and the direction it takes. Therefore rather than opposing the company it might make sense to instead invest into it. This will allow them to profit from a product or service they have to use anyways. At the same time their shareholder rights give them the opportunity to influence the business and steer it into a better direction.
Another more pragmatic solution is to invest into companies without considering common opinions on social and environmental criteria at all. In our modern world it is almost impossible to find nobody that disagrees with yourself. As it is impossible to please everyone investors could rely on their own intuition and pick investments purely based on their own values and opinions.
The downside of this approach is that many companies are still subject to common opinion. Therefore it is not possible for investors to completely detach themselves from social and environmental considerations. On the other hand being open minded might also open up new opportunities for example by investing into companies with depressed prices due to temporary social or environmental issues.
In the end the best approach is the one that fits the individual values of the investor. If an investment makes an investor uncomfortable they should probably avoid it. They also have to consider if they can live with negative pressure due to contrarian investments which might violate public opinion.
Learn more about fundamental investing concepts in this recommended post.