Does it pay to be an ethical investor?

Ethical investing is a bone of contention among fund managers. Matthew Partridge looks at the arguments for and against.

Ethical investing also called socially responsible investment (SRI) is an approach that attempts to balance financial return with social good. Perhaps surprisingly, it's one of the most controversial topics in fund management today in part because experts are divided about whether ethical funds do better or worse than the overall market.

One group argues that shares in companies that act responsibly should outperform on average, because they tend to be better run. Their opponents argue that stocks in despised sectors are likely to provide better returns to compensate for the "stigma" of holding them.

A recent study by Elroy Dimson, Paul Marsh and Mike Staunton for the Credit Suisse Global Investment Returns Yearbook implies that the cynics are right. The researchers found that the Vice Fund (VICEX), a US-based fund that focuses on "vice" sectors, such as defence and tobacco, has consistently outperformed the Vanguard FTSE Social Index Fund, which tracks the FTSE4Good US Select index.

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An initial investment of $10,000 in the Vice Fund in 2002 would now be worth $33,655, while the same invested in the Social Index Fund would be worth $26,788. The performance of the S&P 500lay roughly halfway between the two.

However, you could argue that it's unfair to compare an active fund to an index that essentially just strips what it sees to be the worst ethical offenders out of the S&P 500 as a test for SRI as a whole. And supporters of ethical investing can point to the Friends Life Stewardship Fund.

This launched in June 1984 as the UK's first ethical fund and has done very well. From launch to the end of 2014 it returned 2,408%, around a third better than the UK largecap market over the same period.

More broadly, indices that select firms that actively try to be responsible have a reasonable record. For example, the KLD 400 (a US index of socially responsible firms) has returned 10.54% a year since it was created in May 1990, compared to 10.18% from the wider MSCI USA.

The MSCI World ESG has returned 3.88% a year since September 2007, versus 3.86% for the MSCI World. We'd argue that it's hard to invest truly ethically without getting deeply involved in your own stock-picking, as everyone has a different idea of what's ethical.

However, the data suggest it's possible to opt for SRI without crushing your returns. One low-cost ETF is the UBS MSCI World Socially Responsible UCITS ETF (LSE: UC44), with a total expense ratio of 0.38%.

Dr Matthew Partridge

Matthew graduated from the University of Durham in 2004; he then gained an MSc, followed by a PhD at the London School of Economics.

He has previously written for a wide range of publications, including the Guardian and the Economist, and also helped to run a newsletter on terrorism. He has spent time at Lehman Brothers, Citigroup and the consultancy Lombard Street Research.

Matthew is the author of Superinvestors: Lessons from the greatest investors in history, published by Harriman House, which has been translated into several languages. His second book, Investing Explained: The Accessible Guide to Building an Investment Portfolio, is published by Kogan Page.

As senior writer, he writes the shares and politics & economics pages, as well as weekly Blowing It and Great Frauds in History columns He also writes a fortnightly reviews page and trading tips, as well as regular cover stories and multi-page investment focus features.

Follow Matthew on Twitter: @DrMatthewPartri