Your how-to guide to ethical investing
Investors looking to align their morals with their money could turn to ethical investing.
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Ethical investing is a strategy where an investor makes their money in an ethical or socially responsible way.
Ethical investing means different things to different people, but as a basic rule it is aligning personal values with your money, for example some investors might be keen on sustainable energy. Others might want to simply exclude investments making a negative impact, like the coal industry. Investors who have an ethical focus will invest based on environmental, social and governance (ESG) criteria.
Based on these metrics, investors will choose companies that align with their values and exclude those that do not align based on these metrics.
ESG terms explained
Environmental criteria investors usually screen for energy use, waste, pollution, treatment of nature, resource conservation and treatment of animals.
Social is how the business works with its suppliers, charitable organisations, its community and how it treats its workforce.
Good governance goes a little further than simply avoiding controversy, with investors likely to want transparency on key issues including social and political stances.
Due to ethical investing "being the right thing to do", ESG investing is also known as:
- Sustainable investing
- Impact investing
- Responsible investing
- Socially responsible investing
But really the terms are interchangeable.
How to ESG invest
ESG investing is a combination of prioritising financial returns alongside a company's impact on the world.
Investors who choose ESG are looking at companies that behave ethically from an environmental, social and governance point of view.
In order to gain an accurate measure of a company's ESG performance, investors can usually look into 2 main sources:
1. Company reports
2. Third-party sources
A company has to release its full operations twice a year. This will allow investors to gain a snapshot of the business's operations.
Businesses will also host an annual general meeting (AGM). During this time, investors hear from the board of directors as well as engage with them.
It is not mandatory in Australia for businesses to comment on their ESG ratings when they are releasing reports or during an AGM, but most businesses that are doing the right thing look to highlight this. As a result, investors could gain a bit of information as to whether or not the business is following ESG practices.
While it's important that investors do their own research, looking into what the company is saying and what it's doing is a great place to start.
Secondly, there are a number of key resources that can help investors choose more ethically based companies.
In Australia organisations including the RIAA can help investors make more informed ESG decisions.
How to ESG screen an investment
At its core, ethical screening goes beyond just the financial performance of a business. Instead, it focuses on what the company is doing and how it makes its money.
Screening is done in 2 ways:
Most commonly used by investors when picking individual shares, negative screening is actually the earliest method of socially responsible investing.
Negative screening simply means an investor will exclude companies that fail ESG metrics.
This can vary from investor to investor and what you personally choose to negatively screen is completely up to you. Most commonly, negative screening will exclude companies with poor environmental records or products that do societal harm such as gambling or tobacco.
Improvements in share analytics and reporting on ESG metrics have allowed investors to create greater insights when it comes to negative screening.
- Military contracts
- Controversial behaviours
- Adult entertainment
- Human rights abuses
On the flipside, positive screening is choosing investments with high ESG scores.
Investors who positively ESG screen believe they can gain strong returns by focusing on good environmental, social and governance practices. As such, these investors actively look for companies with a superior ESG record.
Whether that is notable work for the environment, strong social causes or good governance, positive screening involves rewarding "good" companies.
Both negative and positive screens are done relative to their peers, with the investor judging companies against their peers based on ESG characteristics.
Regardless of screening chosen, investors might focus on some or all aspects involved in ESG, such as:
- Clean energy sustainable products
- Strong inclusion processes for employees
- Innovative technology
- Aged care
- Green products
- Energy efficiency
One of the key ways to ESG invest is through individual stock picking.
Given ESG investing means different things to different people, the best way to gain control over what you buy is through picking your own stocks. This is because investors who choose to individually stock pick can have greater emphasis on what is important to them.
Most investments unfortunately will not cover all ESG metrics. So, investors who have a particular focus or passion might be better off choosing individual stocks.
If an investor is choosing to pick individual stocks themselves they should heavily research the company from both ESG and performance points of view.
For investors looking to purchase their own stocks, they can compare brokerage accounts below.
We update our data regularly, but information can change between updates. Confirm details with the provider you're interested in before making a decision.
Important: Share trading can be financially risky and the value of your investment can go down as well as up. Standard brokerage is the cost to purchase $1,000 or less of equities without any qualifications or special eligibility. Where both CHESS sponsored and custodian shares are offered, we display the cheapest option.
ESG investment products
According to the MSCI the top 5 US ESG stocks include Salesforce, Nvidia, Microsoft, Best Buy and Pool.
ESG investing comes in many forms and it purely depends on what the individual is looking to screen out. Also, an investor needs to understand that all businesses are not perfect and that they may need to trade off between certain ESG aspects. Take for example a business such as Tesla. While its clean technology may rank highly on the E in ESG, the company may fall in other areas such as safety and how it treats its staff.
A second consideration could be the olive companies – those that are emitters of fossil fuels today but are likely to be part of the green solution tomorrow.
How do you ethically screen the market?
John McMurdo, CEO and MD of Australian Ethical:
"Every investment decision made at Australian Ethical is guided by an Ethical Charter that sets out our high-level principles and creates very clear investment parameters.
"Our in-house Ethics Research team then develops frameworks that contain a mix of quantitative and qualitative criteria to set out how the Charter principles will apply to any given industry or on a specific issue. These are updated as the world and our understanding of it changes.
"In developing these bespoke frameworks, we conduct deep research and analysis which includes data from multiple ESG providers, civil society, industry association reports, NGOs, CSIRO and science journals.
"We conduct consultations. Australian Ethical looks at international standards. We think about issues from different angles and grapple with contentious issues.
"Our investment team can then focus on getting the best returns from this investable universe, while also driving change through active company engagement. As a result, we have found ourselves organically specialising in areas such as healthcare, technology and renewables.
What are my other ESG options?
So far, this guide has focused on individual shares that investors can purchase through negative and positive screening but there are alternate ways to invest ethically.
If you're looking to invest in companies that align with your values but find individual shares overwhelming, you could try ethical exchange traded funds (ETFs) instead.
Australia has more than a dozen ethical-themed ETFs listed on the Australian Securities Exchange (ASX). Each of these follow their own set of ESG criteria.
Much like any other form of screening, ethical ETFs do different things. While some focus on sustainable practices, others prioritise social impact such as weapons, tobacco or gambling.
If you want to learn more about what are Australia's ethical ETFs see our separate guide.
For those who are unsure of what share or ETF to invest in, they could invest socially through robo-advisors.
Robo advice uses computer algorithms to build and manage an investment portfolio for you.
As robo advice continues to grow, it is creating specific niches for different investors' needs, with one being ethical-based portfolios.
With superannuation being one of, if not the largest asset you own, investors who are looking to make an impact can also move their superannuation to a more ethically based fund.
An ethical super fund is one that invests its members' money in an ethical or socially responsible way.
Again, ethical can mean different things to different people depending on your personal values, with superannuation funds following their own ethical guidelines. However, the majority will follow the same basic guidelines. They will purchase companies in sectors known to have a positive impact and exclude those that have a negative impact on society.
Notable examples include, Australian Ethical Super, AustralianSuper-Socially Aware and Aware Super's Diversified Socially Responsible Investment fund.
You can learn more about ethical super funds with our separate guide.
Pros and cons of ESG investing
Like any form of investing, there are pros and cons when it comes to choosing to invest in an ESG manner.
Pros of ethical investing
While returns can never be guaranteed and past performance is not indicative of future performance, studies have revealed ESG investors can get ahead despite the stereotypes of underperformance.
According to a Morningstar analysis of 745 sustainable funds against 4,150 traditional funds in 2020, sustainable funds actually outperformed.
The findings show ESG investing can actually outperform traditional investing. In fact, the average annual return for a sustainable fund investing in large global companies has been 6.9% a year, compared with traditional funds that have returned 6.3%.
A separate study by MSCI found portfolios that integrated ESG factors as well as financial analysis actually had lower risks and outperformed over time.
"Higher index concentration together with the higher average ESG index scores ('ESG scores') led to higher performance," the report said. "The two most concentrated indexes with the highest index-level ESG scores, the MSCI ACWI SRI and MSCI ACWI Focus Indexes, outperformed other ESG indexes. Lower concentration led to less pronounced ESG effect and a reduction in active returns."
Downsides to ESG investing
While ethical investments can provide strong returns, these investments also throw up more challenges than traditional investments.
Here are 5 potential dangers with ESG investing:
- Lack of universal standards. ESG and what an investor wants to exclude is a personal decision, meaning there is not a universal agreed-upon standard. This leads to inconsistencies when it comes to ESG portfolios and funds.
- Greenwashing. Companies currently self-report their sustainable data. This leads to issues including greenwashing where a business enhances its environmental impacts without delivering any real-world benefit.
- You may pay more in fees. Typically ethical investing comes with higher fees than competitors' standard mutual funds. This is especially true if you compare a passive exchange-traded fund to an actively managed ethical fund. Overall, higher fees can significantly erode returns, hurting investors' longer term outputs.
- Limited options. By screening out companies you could remove winners from your portfolio.
- Lack of potential. While investors might want to invest in products that have the most impact on society, they might not necessarily lead to greater returns. Even in a growing sector, say climate change, not all ideas or businesses will outperform, even if the sector as a whole does. Investing in ideas that have limited commercial potential might lead to poorer performance.
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