The long-held consensus that hard-nosed funds offer a much more reliable route to outperformance than ethical or socially responsible alternatives is crumbling.
Ethical, socially responsible, green, sustainable or impact investing: call it what you will, there’s never been a greater choice of investment products designed to help your money make a positive change in the world.
Not that long ago the received wisdom was that you had to be willing to give up the best returns when you invested ethically, because the ‘sinful stocks’ were historically the best performers. Not any more. It has been five years since we last looked at the relative performance of our saints and sinners line-up of blue-chip UK stocks, so let’s delve into the numbers to see what has changed.
Using the ethical FTSE4Good index series (about which more later) as an admittedly pretty rough proxy for ‘saintly stocks’, we compared its performance against the FTSE 100 and the FTSE All Share indices over one, three and five years. We then stripped out those stocks that feature in the FTSE 100 index but not in the FTSE4Good index, to create a ‘Sindex’ of sinful stocks.
We found that the FTSE4Good index outperformed over every period considered. The last time we ran this data, back in 2014, the saintly stocks outperformed the sinners on a fiveyear view (up 71.6% versus 61.3%) but lagged significantly over 10 years (up 38.6% versus 110.5%).
In 2019 the saints just pipped the sinners over five years in terms of share price gains (up 8.3% versus 8%), but that was almost double the 4.8% return from the FTSE 100 index.
However, on a shorter-term view, the disparity is much more pronounced. Over one year to the end of January 2019, the Sindex was down by almost 12%, while the FTSE4Good index made a small positive return, so clearly the absence of Sindex companies in the FTSE4Good index would have given it a big uplift in relative performance over the longer term.
Interestingly, this year’s Sindex of 17 listings is much shorter than the list of 29 five years ago, which suggests that some Sindex companies have worked on their environmental, social and governance (ESG) policies since then.
If we look more closely at the FTSE 100 index on a sector basis, comparing the performance of the largest stocks in those sectors often eschewed by ethical indices and portfolios – mining, gambling, tobacco and defence firms as well as banks – we can see clearly how avoiding these sectors might have contributed to outperformance. It’s important to note, though, that the FTSE4Good index includes several stocks from these sinful sectors, because of its screening process (more on this later).
Udit Garg, head of wealth management at Sun Global Investments, says the structural, regulatory and other challenges facing these industries have dampened their share price performance.
Miners have had a tough time, owing to movements in the dollar and commodity prices, and some big players have produced feeble returns over five years. Gambling and tobacco stocks, meanwhile, face much tighter regulation, while the low interest rate environment has put pressure on banks’ interest margins, leading the top five banks to post negative returns over the period.
“I was quite surprised that the average share price returns across these five sectors are negative over the past five years, losing around 4%, whereas ethical investments have gone up by well over 10%,” Garg says. “It is interesting to note that the performance of this group would be far below the performance of any ethical fund you pick up.”
Top five FTSE4Good index constituents by market cap
|Royal Dutch Shell A||6.7|
|Royal Dutch Shell B||5.5|
Source: FTSE Russsell, as at 31 January 2019
Bankrolling green projects
Certain oil and gas firms and banks are included in the FTSE4Good index. If we were to take these out, we would be likely to find that the ethical index outperformed the FTSE 100 index by an even greater margin. In 2014 stripping out the banks from the saints index reduced five-year returns, but today their removal would probably help performance. “HSBC’s stock price over five years has gone up by 2p, and that’s it,” Garg comments.
Although banks are often to be found in ESG portfolios, however, they are no saints. Indeed, you might expect the sector – which has been the target of regulatory fines and litigation for rate-fixing and mis-selling – to be a hard swallow for most ethical or ESG-focused investors. Banks are easy to demonise, and banker-bashing is fashionable, but Garg (an ex-banker himself ) says they are “a necessary evil”. He explains how the Nordic banks are lending a lot of capital to the green and renewable energy sector. He says: “The banks are important to the industry in daily life because they are the funnel for growth capital.”
The inclusion of banks in some ethical portfolios is a reminder that every ethical fund will measure stocks against its own specific criteria. Part of the problem with ‘saintly’ investing is that there is no standard definition of what it is. The FTSE4Good index doesn’t reveal in detail why each of its constituent companies are included, just that it screens them according to a number of ESG factors, and excludes pure play coal, tobacco and weapons companies. So what purpose does the index serve beyond helping investors avoid the most overtly ‘sinful’ industries?
Saints and sinners indices performance
|Index||1yr TR (%)||3yr TR (%)||5yr TR (%)||3yr ann return (%)||5yr ann return (%)|
|FTSE4Good UK 50||-0.7||30.7||30.4||9.3||5.4|
|FTSE4Good UK relative to FTSE All Share||2.1||1||2.1||0.3||0.3|
|FTSE4Good UK 50 relative to FTSE 100||2.8||1.4||0.6||0.6||0|
Notes: TR = total return. Source: FTSE Russell, as at 31 Jan 2019
Julia Dreblow, founder of sustainable investing research site Fund EcoMarket, says the FTSE4Good index is useful as a tool for institutional investors to screen out companies with below-par corporate governance, but it doesn’t really work as an ethical benchmark for retail investors. She makes the point that these are FTSE 100 companies and, as such, should by definition be reasonably well-managed.
Persimmon, the housebuilder, is an interesting example. It didn’t feature in the Sindex five years ago, but it does today, probably because of recent controversy over its former CEO’s pay. Boss Jeff Fairburn left the company by mutual agreement at the end of last year after criticism of his £75 million pay award surfaced. The company had performed exceptionally well, but there was a public outcry over the size of the award (reduced from more than £100 million) and the fact that Persimmon’s success was partially due to government subsidies in the form of Help to Buy scheme funds. “The FTSE4Good index would be uncomfortable with something like that, but that doesn’t make Persimmon a bad company,” says Dreblow, pointing to its record-breaking £1 billion profit for 2018.
Conversely, Paddy Power Betfair is included in the FTSE4Good index, even though gambling stocks often don’t pass the screens for ethical or socially responsible investing (SRI) products, again underlining the fact that investors need to decide their ethical criteria for themselves.
“That’s the problem,” says Dreblow. “[The index] is very forgiving, and there are, for example, well-managed gambling firms. But a lot of end investors will look at the gambling sector and say: ‘Well, gambling causes real hardship, so we don’t want that’. It is very much head versus heart.”
She adds: “The FTSE4Good index doesn’t necessarily reflect what individual investors want. It’s there for institutions – if they are tracking it – to help them ensure they are dropping companies with poor governance, where there is a high risk that these firms may be being managed badly. [This approach] is quite different from the principled one you get with an ethical fund.”
Dreblow says retail investors might want to exclude some stocks that the FTSE4Good index excludes, but they will often want to go further to find an actively managed fund with a specific mandate to cherry-pick the best companies – on the basis of their environmental policies or social impact, for example. She adds: “Individual investors will be more likely to pick funds that reflect their personal opinions, but they all have different opinions. You can’t standardise the things people care about.”
The Sindex: FTSE 100 firms not included in the FTSE4Good index
|BATS.L||British American Tobacco|
|DLGD.L||Direct Line Insurance Group|
|WG.L||Wood Group (John)|
Source: Datastream from Refinitiv, as at 21 February 2019
Why good is great
Let’s now take a step back to try to answer the big question: if a ‘good’ portfolio outperforms a ‘bad’ one, is that a function of its inherent goodness or of the wider macroeconomic environment? Is it almost circumstantial when an ethical index outperforms: simply the result of it holding underperforming cyclical businesses or those operating in challenged sectors? Or is it the case that the sustainability ethical firms build into their business models makes them more profitable over the long term?
Garg says ethical fund outperformance is down to combination of both these factors, plus the fact that ethical portfolios tend to include service-oriented industries that have relatively low carbon footprints. Moreover, many of these firms are technology companies, which have performed incredibly well over the past two years. All this helps tip the balance of performance in favour of ethical or ESG investment products.
Vanguard’s head of ETF product management for Europe, Mark Fitzgerald, says it’s important not to oversimplify and assume that a saintly portfolio has outperformed because of its ethical stance. He adds: “I would caution people against taking a simplistic approach and just saying: ‘well this ethical fund has outperformed this so-called non-ethical or broad fund because of its ethical drivers’. The outperformance could be due to something else going on at the macro-economic level or in the geopolitical environment.”
Saintly alternatives and a big sinner
M&G Positive Impact
MSCI ACWI Low Carbon Target Index
Pictet Clean Energy
Rathbone Ethical Bond
Triodos Sustainable Pioneer
Invesco High Income
Thankfully, we seem to have finally moved beyond the tired old trope about sacrificing profits for principles when we invest ethically. David Harris, head of sustainable investment at FTSE Russell, which runs the FTSE4Good index, notes that ESG factors are hugely important to modern investors and that ethical investing doesn’t necessarily entail performance taking a hit. He says: “Today investors routinely consider ESG factors when assessing companies, and there is growing recognition that they don’t need to sacrifice performance.”
Fitzgerald points out that just how far your returns on ethical products will differ from returns in the wider market will depend on how far down the rabbit hole you go, as saintly investing is a spectrum.
You might, for example, start with negative screening, where you just exclude the most objectionable firms – such as those making weapons, breaching labour standards or paying bribes. He says: “At that level, you’re still able to construct a portfolio that gives you a broader-market return – you might call this approach a lighter shade of green.”
You might then move to darker green by investing in the water or clean energy sectors, for example, which would give you much more stock- and industry-specific risk; “That’s what we would call active risk,” Fitzgerald says.
You could also use positive screening to select best-in-class companies based on your ethical or ESG criteria or, at the furthest end or the spectrum, try impact investing. Fitzgerald says: “You might, for example, say to yourself: ‘I see that there’s an opportunity to invest in some offshore wind farms on the northeast of England, and I want to help fund that. It’s highly specific, and I want to be able to measure the output from that investment in creating clean energy’. However, the more specific you become, the more risk you take and the more likely it is that your performance will deviate dramatically from the broad market over time.”
Whatever your interests and preferences, there will be an option in the saintly investment space to suit you, whether it’s from a mainstream or a specialist provider. Many leading fund houses now offer ethical, green, SRI and ESG products.
M&G recently launched a positive impact fund, while Janus Henderson and Liontrust both offer funds that focus on sustainable and responsible investing, but also seek out future disruptors and change-makers rather than just avoiding the worst firms. Kames Capital and Rathbones have well-established ethical bond funds.
Vanguard offers SRI index tracker funds covering global and European equity markets. Sun Global Investments uses the MSCI ACWI Low Carbon Target Index fund in portfolios, which has returned 8% a year on average since 2010.
Specialist impact investors such as WHEB Asset Management and ethical banks such as Triodos offer small- and large-cap sustainable investment funds.
Funds such as the Templeton Shariah Global Equity and the S&P 500 index’s Catholic Values ETF will screen out industries they deem unethical on religious grounds. A halal robo-adviser called Wahed Invest invests in ethical stocks and Islamic bonds.
If you’d rather back sinners, look at the UK equity income sector, as many sinful stocks are also big dividend payers: Mark Barnett’s £7.7 billion Invesco High Income fund, for example, counts Imperial Brands, British American Tobacco and BP among its top 10 holdings.