What's good for the soul can be good for returns

Whether it's car makers faking emissions data, dodgy sales practices at pharmaceutical firms, or banks rigging interest rates, almost every month brings a new corporate scandal. So it's not surprising that ethical investing meaning any investment approach that considers the social impact of your investments as well as financial returns is booming. The Forum for Sustainable and Responsible Investment estimates that in the US alone the amount invested ethically has tripled from $2trn in 2005 to $6.7trn in 2014.

There are now more than 100 ethical funds in the UK, according to the Investment Association. Growing numbers of global institutional investors, such as sovereign wealth and pension funds, are making investment decisions on ethical criteria, most notably as part of high-profile campaigns for major investors to sell fossil fuel investments.

However, while ethical investing may be good for the soul, critics says that it's bad for returns. Ethical investors won't invest in certain stocks, meaning that those stocks trade at lower valuations than normal. This can mean worse short-term performance than the wider market, but because investors get to buy them cheap, in the longer term they are likely to do better. Take the tobacco sector, which has been extremely controversial since the 1950s, when the link between cigarette use and cancer became established.

Subscribe to MoneyWeek

Subscribe to MoneyWeek today and get your first six magazine issues absolutely FREE

Get 6 issues free

Sign up to Money Morning

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Sign up

Many investors avoid tobacco stocks altogether, but they have proved highly lucrative for those who don't. UK and US tobacco companies have returned 13.1% per year and 14.6% per year respectively since 1900, compared with 9.4% and 9.6% for the general market, according to Elroy Dimson, Paul Marsh and Mike Staunton of London Business School.

Other investors argue that ethics have a direct positive impact on performance. Cutting corners may pay in the short run, but it eventually hurts the bottom line. They point to the banks, who are still paying large fees for past sins, and BP, where safety failings led to the Deepwater Horizon disaster. These investors seek out firms that care about these issues ("positive" screening) instead of simply rejecting those in unethical sectors ("negative" screening). There is some evidence that this approach leads to stronger returns.

Good for returns

Between the index's start date of June 2011 and April 2016, this index has returned 4.32% per year (including reinvested dividends) compared with 4.19% for the FTSE 100. So ethical investing seems to have resulted in slightly higher returns, but not enough to draw strong conclusions.

In America, the KLD400, the main ethical benchmark, has returned around 10.05% per year since May 1990. That compares to 9.48% for the S&P500 a modest premium, but again not enough to draw any conclusions. In any case, any excess could be eroded by costs: the most popular exchange-traded index tracking the KLD400, the iShares MSCI KLD 400 Social ETF (NYSE: DSI), has costs of 0.5% per year, while cheap S&P 500 trackers have charges of under 0.1% per year.

Of course, opinions on what defines an ethical investment vary, so the main ethical benchmarks won't meet everybody's standards (the FTSE4Good UK includes some oil and gas stocks, for example). Some actively managed funds may have much stricter criteria. Research on the performance of ethical active funds has produced mixed results. A very long-term study by Christopher Geczy of the Wharton School of Business, which looked at performance between 1963 and 2011, found that ethical funds had lower returns than other funds.

However, a review of multiple studies by Phillips, Hager & North Investment Management found that between 1997 and 2005, ethical funds either performed the same, or that any difference could be explained by factors such as risk.

Perhaps most interestingly, a 2012 study by analysts at Deutsche Bank concluded that ethical funds that use positive screening do better than ordinary funds and those that use negative screening. This suggests that it is possible to earn higher returns without compromising your moral beliefs.