Does ethical investing pay off?

Reputation matters in business. If you ever doubted that, you just need to look at the press over the past few weeks.

Barclays’ reputation is in tatters after the Libor-rigging scandal, and it’s unlikely to be the last bank affected. HSBC has been hit with a massive fine after helping drugs cartels,and other dodgy characters launder money due to a weak compliance regime.

It’s not just banks either. Earlier this week, we covered the wider implications of G4S’s failures to provide enough security staff for the Olympics. However, the cost in fines and lost contracts is likely to be huge. Indeed, when the scandal broke, the share price plunged by 15%.

So it’s clear that bad behaviour – or plain incompetence – can hit the bottom line. But what does that mean for your investment decisions?

Let’s be clear, we think that it’s your decision what companies and sectors to invest in. After all, everyone has different views about which businesses are ‘ethical’, and which are not.

What we’re looking at here is whether traditional ‘ethical investing’ – which will usually exclude investing in the likes of tobacco companies and defence stocks, and often environmentally unfriendly companies such as oil stocks, has any financial impact on your portfolio.

Supporters of ethical investing (also called SRI – socially responsible investing) argue that incidents like the scandals above are just one reason why you need to take a company’s ethical credentials into account when investing. They argue that it’s not just about paying lip service to your conscience: companies that try to ‘do good’ are less likely to end up involved in the sorts of governance debacles that can hammer the share price.

However, critics say it has no effect on returns. Some even argue that if you all you genuinely care about is investment returns, then you should deliberately seek out ‘sin’ sectors such as defence and tobacco. As my colleague Merryn Somerset Webb has pointed out before, Imperial Tobacco is one of only a few shares that has always made a positive five-year return since 1993 – though she doesn’t think this will continue.

So does it pay to be an ethical investor? Let’s look at the evidence and find out.

How ethical investing compares to ordinary investing

Rather than selectively picking out individual funds, companies and sectors, there are two ways to look at SRI investing objectively.

One is to compare an index of SRI companies with a market benchmark over an extended period. The KLD 400 is the longest running US SRI index. If you had put $100 into it at the end of June 1992 and held it for two decades, you would have made $382.79 (counting dividends).

The US MSCI 2500 index would have made you $368.82. In annual terms this means a nominal return of 6.94% rather than 6.74%, an extra return of 20 basis points. It’s not staggering, but every little helps.

The UK equivalent, the FTSE4Good Index, has been around for less than twelve years. However, the difference in performance to the main index is also small. In this case conventional market tracking would have made you more money.

In the 11 years from the end of June 2001, the FTSE 100 made a total return of 45.49% while the FTSE4Good made only 40.23%. This means that SRI would have cut yearly nominal returns from 3.47% to 3.12%.

The other approach is to look at the performance of a broad range of ethical funds. A 2007 review by Phillips, Hager & North Investment Management, looked at 17 studies, covering a variety of markets including the US, the UK, the Netherlands, Germany and Canada.

Only two found solid evidence of differences in performance that couldn’t be explained away by other factors. Trouble is, they each came to opposite conclusions – one backed ethical investing, the other conventional market tracking.

What this means for investors

It seems that SRI makes no real consistent difference to returns, compared with investing in a plain old market tracker. Of course it doesn’t mean that ethical investing is completely pointless. Indeed, you could argue that if the returns are roughly the same you might as well put your money in stocks and shares that make you comfortable. However, critics contend that the reduced investment choice and time spent screening a portfolio are hidden costs.

One interesting company with a strong ethical reputation, and that has won several awards for environmental best practice, is May Gurney (LSE: MAYG), which provides infrastructure support services. It is not particularly cheap, trading at 12 times trailing earnings. However, it provides a good income stream with a yield of 3.5%. It should also indirectly benefit from the government’s plans to increase public and private infrastructure spending.

Sue Round, who has run Ecclesiastical Insurance Group’s Amity UK Fund since 1988, likes its business model, which is based around long-term relationships. In her view, this makes it a good defensive share.

On the other hand, for those less worried about SRI shares, we’re also keen on the defence sector – probably the biggest no-no in ethical investing. As we’ve argued in the past, spending cuts will hit personnel numbers, rather than equipment. This means that firms such as Lockheed Martin (NYSE: LMT) won’t be hit as hard as the market thinks, leaving them looking good value right now.