The idea that returns must be sacrificed in order to invest ethically or sustainably is deeply entrenched in the thinking of many private and professional investors. However, as public awareness of responsible investment principles grows and funds specialising in the area gain longer track records, this assumption is increasingly being challenged.
Studies produced by institutions such as global benchmarking firm MSCI and Oxford University suggest that, in fact, adding an ethical, socially responsible investment (SRI) or environmental, social and governance (ESG) overlay to portfolios enhances rather than diminishes returns.
For fund managers in the sector, better ethical, social and corporate governance leads to stronger companies overall, while firms that focus on meeting future global challenges have superior growth potential. The idea that investors must give up profit for their principles is one that ethical, SRI and ESG managers face daily.
AM I SACRIFICING RETURNS?
Paul Robinson, founder and chief executive of ESG investment specialist Alquity, says: 'We get very positive feedback on our model, but the question is always: "Am I sacrificing returns?" For some reason, in this industry, everyone thinks that if you do something ethical, you're going to pay for it - we face that all the time.'
He adds that this perception colours the way performance in the sector is judged. Many people blame underperformance on a touchy-feely approach, while outperformance is seen as a fluke.
Several studies have tested such assumptions by analysing the effect an ethical approach has on portfolios. One recent study conducted by MSCI examined the effect an ESG 'tilt' had on two theoretical model portfolios between February 2007 and March 2015.
The results showed that the tilt did not have a negative effect. The model portfolios actually outperformed the MSCI World index by 1.1 per cent a year in one case and 2.2 per cent in the other over the period.
A similar study, analysing close to 200 different sustainability studies, was conducted by Oxford University in partnership with Arabesque Asset Management. It found that in 80 per cent of cases, stock price performance was positively influenced by good sustainability practices.
For many managers active in the space, such studies are a welcome vindication of their investment strategies. George Latham, chief investment officer at SRI-focused firm WHEB Asset Management, has argued for a number of years that sustainability-focused companies outperform because of their policies, not in spite of them.
He says: 'We invest in companies providing solutions to sustainability challenges because we think they will deliver superior growth compared with the market as a whole over the long term. For us, the sustainability strategy is the means to an end, rather than an end in itself.'
Latham refutes another accusation often made about the sector: that in reducing the potential investment universe, the potential for returns is also reduced. WHEB's principal investment fund, WHEB Sustainability, is a global equity vehicle benchmarked to the MSCI World index. However, its process reduces its investable universe by around 80 per cent.
On why this isn't a sure-fire way to hinder success, Latham says: 'I would turn that on its head and ask whether a global benchmark is a good starting place to construct a portfolio. I would say far too many investors use a benchmark to define their portfolio, and I don't think that's a good approach.'
Latham may have a point. The global benchmarks that are largely used to build fund portfolios are often constructed on the basis of market capitalisation and the prominence of a particular economy, rather than any fundamental analysis of companies, particularly their risk potential.
By adding an ethical, SRI or ESG overlay, Latham argues, managers are able to weed out companies that add risk through poor governance and avoid the kind of financial crisis the big banks dished up in 2008.
Managers such as Robinson argue that reducing the investment universe is the primary purpose of an active investment manager anyway. It is what investors pay them to do.
A common assertion about the ethical and sustainable investment space is that the sector tends to be more volatile, which makes it unsuitable for cautious investors.
However, there is little evidence to support this assertion and some evidence that it is incorrect: an Oxford University study found a link between poor ESG policies and increased share price volatility.
Alquity's fund range is particularly interesting here. The firm has five funds that invest in frontier and emerging markets, including markets in Africa, Asia and Latin America. Yet, despite investing in these high-risk areas, these funds have some of the lowest volatility scores among funds in their sectors.
According to Robinson, over the five years the Alquity Africa fund has been operating, it has delivered its returns with 4 per cent less volatility than the MSCI Emerging Markets index and 2 per cent less volatility than the US's S&P 500 index. Its Latin America fund is one of the least volatile and best-performing funds specialising in the region.
Like Latham, Robinson attributes this to the inherent qualities of the companies he invests in. 'Because we're not following benchmarks and because of our ESG approach, we're not going to touch the likes of a Petrobras, which most Latin American funds own.
'Some might underweight it, but we think that's crazy. It's essentially saying: "OK, I'm going to own it, but I hope it falls, as then I'll look better than the peer group",' he says.
PLENTY OF SCOPE
For those looking for more mainstream exposure than that provided by Alquity, the good news is that there are close to 90 ethical and sustainable investment funds managing more than £13.5 billion of assets currently available to UK investors (a full list of these can be found here). More importantly, however, many of these funds boast long and impressive performance records.
The UK equity sectors - where the majority of mainstream ethical and sustainable funds available to UK investors are housed - include EdenTree Amity (formerly Ecclesiastical Amity), Kames Ethical Equity, Royal London Sustainable Leaders (formerly CIS Sustainable Leaders) and Standard Life Investments UK Ethical.
All these funds have returned first- or second-quartile returns over one, three, five and 10 years to 31 July, easily outperforming the average fund in the Investment Association's (IA's) UK all companies sector in each period.
The mixed-investment sectors are another hot-spot for top-performing ethical and sustainable funds. Money Observer Rated Fund Kames Ethical Cautious Managed is a particular star, having delivered first-quartile returns over six months, one year, three years and five years to 31 July.
Over the latter period, the fund is the best performer in the entire 141-fund IA mixed investment 20 to 60 per cent shares sector. Manager Audrey Ryan has outperformed the average fund by more than 34 per cent.
Alliance Trust Investments also runs a suite of top-performing multi-asset SRI funds in this space: the ATI Sustainable Future Cautious Managed, Managed and Defensive Managed funds. All these have delivered consistent first- and second-quartile returns since their launches.
The global equities sector also boasts ethical and sustainable stars. F&C Responsible Global Equity - which was launched way back in 1987 - and ATI's younger offering, Money Observer Rated Fund ATI Sustainable Future Global Growth (launched in 2001), delivered some of the strongest returns.
Fixed income is a further strong area for ethical funds. Money Observer Rated Fund Rathbone Ethical Bond was the strongest performer in the 98-fund IA sterling corporate bond sector over three years to 31 July.
Fellow Rated Fund Royal London Ethical Bond has been a consistent first-quartile constituent. In the strategic bond sector, EdenTree Amity Sterling Bond has delivered solid second-quartile, sector-beating returns over one, three and five years to 31 July.
The performance of this cross-section of ethical and sustainable funds available to UK investors tends to counter the long-held belief that investors must sacrifice profits for principles.
Meanwhile, a growing body of industry research suggests that companies that integrate good ESG, SRI and ethical principles into their investment models are more likely to survive and thrive over the long term.
As the environmental, social and business landscape continues to evolve, companies must adapt. Savvy investors will back the companies best-equipped for this challenge.