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Are ethics really the only way?

Inflows into ethical funds topped £164m in July, up from £101m the previous month, according to the Investment Association1. Lewis Grant, Global Equities Senior Portfolio Manager at Hermes Investment Management, questions what ‘ethical investing’ really means, its implications and dispels investors’ common misconceptions.

Let’s start at the very beginning
When deciding whether to shift to an ethical investment portfolio, investors first need to go back to basics and set a clear definition of what they constitute as ‘ethical’. Since there is no universal definition, it can be surprising how much variation there is between investors.

Exclusion or ‘negative screening’ perhaps offers investors the most direct approach to aligning their money with their morals. It is the oldest ethical investment method, and it’s easy to see why. Carving out entire sectors, companies or countries from a portfolio offers a relatively simple and transparent way for investors to express their particular ethical views and removes subjectivity.

Some exclusions are near universal – tobacco, for example – whereas others can be more controversial. For some investors, ethical exclusions are driven by religious beliefs, but in some cases defining acceptable and unacceptable company behaviour can be less black and white and more shades of grey and the devil really is in the detail. It might be simple to strike out the major gun, tank, fighter jet, cluster bomb and nuclear weapons manufacturers. But what about radar or parachute providers, or producers of other equipment that has both military and civilian uses? Often investors will use a revenue threshold to determine a “significant exposure” to a particular theme, but again this is a very subjective definition.

Investors should also consider how a company evolves over time as few stay completely still. A company excluded as a coal company today may be increasing its focus on renewables and becoming a future leader of the green economy. Investing in a coal company may not fit with many definitions of ethical, while providing the financing to enable a company to develop renewable energy solutions is widely considered virtuous: in some instances these two investments may actually be one and the same.

Investing ethically: The reality
The definition of ethical parameters is only the start. Investors should also consider the impact ethical parameters may have had on historic returns – would their definition of ethical have detracted value? How would they have felt about it then?

The classical view is that by excluding companies from the investment universe the expected return would decrease. For example, the growing cohort of investors who have excluded tobacco over the last ten years may have missed out on very healthy returns, prompting some to reconsider their decision.

On closer inspection, however, we can see that the sector returns have been driven primarily by the defensive, dividend-generating nature of tobacco companies rather than long-term industry fundamentals. Since the global financial crisis, yield-addicted investors have inflated income stocks to historical highs. In the longer term, however, we believe that the tobacco sector is likely to run out of puff: increasingly harsh global regulations and the rise of e-cigarettes, for example, present considerable challenges to the industry. Once the tide truly turns against these companies, investors who have given up tobacco may enjoy a reversal in performance outcomes.

In this example it is not the unethical characteristics of tobacco stocks that impact shareholder returns, but the sustainability of the business. Ethics and sustainability are closely linked and frequently overlap – but they are not the same.

Excluding all others
In order to fully understand the sustainability of a business or to identify whether it will transition from ‘unethical’ to ‘ethical’, each company needs to be evaluated on its own merits. When investing with an exclusionary approach, the focus becomes solely on determining which companies an investor does not want to buy – instead of seeking out the leaders and improvers.

At Hermes we believe that our responsibilities as investors do not stop with a decision to buy or sell a stock, instead, we must act as engaged owners of the companies in which we are invested and the assets that we manage. This means engaging in constructive dialogue and taking action where necessary through our ownership rights. This should contribute to better management of companies and ultimately their long-term success, which, in turn, may lead to wider benefits to society and investors.

  1. 1Monthly Statistics for July 2018 from The Investment Association, https://www.theinvestmentassociation.org/assets/components/ima_filesecurity/secure.php?f=press/2018/stats/stats0718-12.pdf

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