Do ethical funds harm your wealth?

Investing only in ethical companies naturally appeals to many people, says Adam Jourdan. But are you sacrificing the best returns?

The notion of ethical or socially responsible' investing has been around for some time. It involves screening stocks for a range of factors, from how companies treat their staff, to their environmental impact. The idea of investing in companies that do good' or at least do no harm' naturally appeals to many people.

But what does it mean for your returns? The answer is, not a lot. "Modern portfolio theory says that [your returns] should hurt, because anything that makes an investment universe less diversified results in a lower expected return for a given level of risk," says David Kathman of research group Morningstar.

Yet, in practice, experts have failed to show any significant difference over the long term. Separate studies in 1993, 2000, 2002 and 2005 all concluded that there was "no significant difference in the risk-adjusted returns of socially screened versus unscreened mutual funds".

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In the latest study, from 2011, published in Journal of Investing, authors Lloyd Kurtz and Dan DiBartolomeo looked at the performance of the KLD 400 Social Index against the S&P 500 between 1992 and 2010. The performance of the KLD Index which excludes many energy and industrial stocks for environmental reasons, and is usually heavier than the broader market in technology stocks, which tend to score well on environmental, diversity, and employee-relations measures was "essentially indistinguishable" from the S&P 500 index, after accounting for sector weightings and its slight growth bias.

It's perhaps not surprising. Managers of socially responsible funds at least have to exercise some stock-picking skills, rather than simply finding ways to hug an index. But what the research really shows is that socially responsible funds are just like any others: and that means that, on average, by investing in any given fund you're almost certainly overpaying for the privilege of underperforming the broader market. Overall, we'd rather stick with cheap trackers or investment trusts following our favourite markets (such as Japan), then top up with individual stocks (where you can exercise your ethical judgement as you see fit).

If buying a socially responsible fund does still appeal, do your research. The label covers a wide range of funds, from those based on religious beliefs to green' funds. Ethics being what they are, you may well find that what some investors consider acceptable (buying an oil firm that's trying hard to be greener') strikes you as an unacceptable cop-out.

Adam Jourdan

Adam is a former journalist at MoneyWeek, writing about global economies, equities, politics and general news stories for print magazine and online. SInce then, Adam has worked at Thomson Reuters for more than 10 years, starting off as a graduate trainee and worked up to Bureau Chief, South Latin America. He also has experience leading teams of reporters in China.