The price of being ethical

If you’ve been reading MoneyWeek for a while, you’ll know that we view ethical investing with a sceptical eye. Strategies that focus on ESG (environment, social and corporate governance as it’s called) often seem to be as much about fund marketing as about pursuing considered investment strategies. As for any touted performance benefits, these have tended to result from a heavier weighting towards small caps (which history suggests outperform in the long run) than their “unethical” rivals.

However, even if you are sceptical about ESG, it’s worth being aware of its growing popularity with big investors. Giant insurer Swiss Re is in the process of switching its entire $130bn portfolio into tracking ethical investment benchmarks, and out of the standard indices. Ultimately, money flow is what moves markets – if institutions continue to follow Swiss Re’s lead, then the types of companies and indices that attract big inflows may change quite dramatically.

As institutional interest picks up, so does the volume of research being produced on ESG. Bank of America Merrill Lynch issued a note last month suggesting that looking for high ESG scores could help investors to avoid corporate bankruptcies. It found that, between 2005 and 2015, investors who had stuck with stocks rated above-average in the “environmental” and “social” areas in particular would have avoided 90% of the stocks that went bust following 2008.

The problem is, it’s a pretty small sample size – only 17 companies in the ESG-rated universe went bust in that time (ESG investors would have avoided 15 of them). So it might be worth making ESG something to check if you’re investing in individual stocks, but it’s tricky to draw wider conclusions from the study, particularly as the impact seems to vary widely by sector. 

However, there is one area where ESG looks a more promising proposition – emerging markets (EM). The MSCI EM ESG Leaders index has beaten the MSCI EM index “consistently since the 2008/2009 financial crisis”, says James Kynge in the Financial Times.

The index excludes companies in “vice” industries, and also penalises those “with heavy state ownership” (which tend to lack transparency and have a poor attitude towards minority shareholders), as well as big polluters and those with poor labour relations. Given how critical good governance is when investing in developing economies, avoiding shareholder-unfriendly companies makes sense. Currently, an exchange-traded fund (ETF) tracking the index is available listed in the US – the iShares MSCI EM ESG (US: ESGE).