Ethical investing: the price of your principles

Sin stocks tend to beat the market – but that doesn’t mean ethical investing must always lead to below-par returns.

Investing ethics are a very personal decision. I tend not to invest in tobacco: my view is that smoking is always harmful, and that tobacco firms’ business is based on trying to make us forget that. Still, I write about tobacco in MoneyWeek when it’s relevant, because tobacco users have a choice. But I won’t generally write about private prisons, because prison users don’t get a choice where they serve their sentence and the evidence suggests that giving for-profit companies too much control of the justice system creates all sorts of moral dilemmas and leads to worse outcomes. I have no problem with the idea of investing in countries such as Iran because I think engagement is a better way to bring change than sanctions. However, North Korea would be difficult, because the regime’s control of the economy means that it would be the main beneficiary.

The wages of sin

Most MoneyWeek readers are going to disagree with me on at least one of these points. As that shows, the idea of ethical investing (or ESG – ethical, social and governance investing – as it’s sometimes called more broadly) means something different to all of us. This makes it hard to measure how ethical decisions affect investment performance. But one way to think about this is to look at returns from sin stocks – a list that includes tobacco, alcohol and gambling, as well as niche categories such as sex and pornography (where there tend to be few listed companies), and sometimes weapons.

Studies show that sin stocks tend to beat the market over the long term, which implies that ruling them out might lead to lower returns. Yet that’s not necessarily the case, according to analysis by Elroy Dimson, Paul Marsh and Mike Staunton in the Credit Suisse Global Investment Returns Yearbook 2020. Sin stocks are a small part of the global market: alcohol, tobacco and gambling each make up less than 1% of the FTSE All World index. You could leave them out of a diversified portfolio without much effect. Some of the sectors now under scrutiny are bigger – oil and gas accounts for 5% of the FTSE All World. But surprisingly, the Dimson, Marsh and Staunton data shows that excluding any single sector would have had only a small effect on long-term returns in the US from 1926 to 2019. 

That said, the narrower the market, the bigger the effect could be. Tobacco is about 5% of the FTSE 100, while oil and gas is 13%. Leaving some of those out could have a much larger effect. So whether you are picking individual stocks or buying a tracker or an active fund with an ethical angle, the key is to make sure that the universe of stocks is wide enough that you won’t miss the sector you want to exclude.

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