Ethical and Sustainable Investing

What is Ethical and Sustainable Investing?

Ethical investing, sustainable investing, impact investing, socially responsible investing, or values-based investing. Call it what you will, but it is a growing trend when it comes to choosing where to invest our money.

And it is a trend that has not escaped the attention of fund manager marketing teams, who have created a multitude of ways to capitalise on this movement.

The promise is no doubt alluring, but is it truly possible to invest with a clear conscience, make a difference to the world, and earn an appropriate return?

Let’s find out.

Why Invest Ethically?

Investors choose to align their investments with their values or ethical stance for a variety of reasons, but there are three main ones:

For religious or cultural reasons;
They want to sleep soundly knowing that they are not profiting from businesses whose products or practices conflict with their morals, values, or ethics; or
They want to use their super or investments to make a difference in the world.

Life Sherpa is a certifed B-Corp, one of a growing number of businesses that commit to meeting high standards of social and environmental performance, accountability, and transparency.

We are dedicated to our mission of delivering affordable, human centred, and evidence based advice to Australians whatever they earn, own, or owe.

In doing so, we help our members invest in ways that let them achieve their goals in a way that works for them.

Terminology

Terms such as ‘Ethical’ come with a moral aspect that means different things to different people.

Meta (the owner of Facebook) and Alphabet (the owner of Google) will both feature heavily in most screened portfolios because they have a low carbon footprint.

However, both have a questionable ethical record because of their impact on the mental health of our youth and the spreading of misleading or harmful content.

ESG (Environmental, Social and Governance) has become a less values laden short hand for all these approaches.

Environmental focuses on a company's impact on the planet, and considers how the business, its operations, suppliers, and customers impact on climate change, contribute to pollution, use resources, and manage waste.
Social focuses on a company's impact on people and society, and considers its labour practices, diversity and inclusion, community engagement, and human rights.
Governance deals with how a company is run, its board structure, executive compensation, shareholder rights, and ethical business practices.

For simplicity, I will use the term ESG-aware investing to encompass any investment strategy where the investor considers these factors other than in ways that directly affect investment risk or financial performance.

History

The concept of investing in line with moral or religious guides is as old as investment itself. In biblical times, Jewish Law forbade usury. The Qur’an set out a wide range of rules which led to Sharia compliant investment.

The 17th and 18th centuries saw the Quakers and Methodists adopt a moral approach to investing which led to the creation of the Friendly Society and some of the big names in finance today (Barclay’s and Lloyds for example).

John Wesley, founder of the Methodists, preached a sermon “On the Use of Money” in 1763 in which he identified a philosophy of "earn all you can, save all you can, and give all you can" which incorporated avoiding investments in sinful activities (often referred to as the 'sextet of sin', although apparently not by Wesley himself) including alcohol, arms, gambling, pawn broking, pornography, and tobacco.

More recent additions to the list of sin-stocks include, companies involved in fossil fuels, mining, genetically modified foods, animal cruelty, and those with poor labour practices, or lacking in diversity.

It is extraordinarily difficult to definitively identify ethically good or bad companies in a way that meets everyone's needs.

The community holds wildly differing views on many of these issues. So it should be no surprise that the wide range of ESG research houses often come to contradictory conclusions.

Tesla is considered good by many of them, because of its contribution to the electrification of the world's car fleet. But considered bad by others because of it's labour practices and poor corporate governance.

Investing decisions are only as good as the research that underpins it. Good research is expensive. So, you should expect that ESG investing (all other things being equal) to cost more.

A large and growing trend

More and more investors, from individuals to giant foundations, are implementing ESG-aware portfolios.

Consistent standards make accurate tracking of the precise level of investment but it is large and growing.

Globally, in 2024 ESG-aware managed assets surpassed $30 trillion in 2022 and are on track to surpass $40 trillion by 2030 or more than a quarter of the projected $140 trillion assets under management (AUM) according to Bloomberg Intelligence.
In Australia, the Responsible Investment Association Australasia reports that in 2023 responsible investment assets grew to $1.6 trillion, up 24% from 2022, and represent 41% of the $3.9bn in managed funds.

How you can incorporate ESG investing in your portfolio?

ESG investing can be implemented through various strategies, such as:

1. ESG Integration

In contrast to strict ESG Investing which is more heavily weighted towards values or interests that target sustainability, social and governance impact, ESG Integration aims to deliver competitive financial returns and reduce investment risks by considering ESG factors, opportunities, and risks.

This approach is based on the unarguable position that ESG factors can affect the risk and return of investments and the somewhat more controversial position that these factors are not fully reflected in asset prices.

It would be rare that an active fund manager would ignore these factors completely; but the extent to which they are considered beyond their direct impact on risk and returns varies.

Index managers who seek to slavishly track common diversified indexes (such as the SP500, ASX200, or MSCI) clearly cannot incorporate such factors.

2. Positive or Negative ESG Screening

The original approach to ESG investing, referred to as Negative Screening, was to exclude specific companies, industries, or activities. Most commonly this was applied to so-called sin-stocks – gambling, alcohol, usury (high interest lending), pornography, and weapons manufacture. More recently this has been extended to fossil fuels, labour standards, and diversity issues.

A newer alternative is Positive Screening, where a manger will focus instead on companies with strong ESG performance, such as renewable energy or recycling.

A variant on this is a Best-in-class approach of selecting, for each investment sector, the assets with the most positive scores (or least negative) on relevant environmental, social, and governance ESG criteria.

3. Stewardship or Activist Investing

Activist investment managers seek to use their rights as a shareholder to influence the actions of the company in a way not possible for no-shareholders.

They do this by serving on or nominating directors to a company’s board, promoting shareholder resolutions, voting at shareholder meetings, and engaging with management and other stakeholders.

They may also promote others such as litigation funders, industry bodies, public discourse, or policy and lawmakers to bring about positive change.

The distinction between activist investing and stewardship is blurred.

Broadly, Stewardship can be considered using the influence to protect and enhance overall long-term value for investors and society.
Activists may more commonly be seen to use their influence to promote short-term performance of individual investments or companies, without regard to overall societal impact. stewardship.

4. Impact

Impact investors seek to generate positive, measurable social or environmental impact alongside a financial return. The relative weight applied to impact and returns varies. In most cases, these investments deliver a sub-market return that may be supplemented by Government incentives or subsidies and are difficult and expensive to deliver at scale.

Many fund mangers heavily promote these activities even though they make up a small part of their overall portfolio.

Aware Super for example heavily promotes its investment in affordable housing. It doesn’t disclose the value of this investment beyond claiming that it “is now projected to reach $1.5 billion on completion”.

The reality for investors is different.

The Aware High Growth Socially Conscious investment option has just 1.73% of its assets allocated to unlisted real estate. Aware Real Estate Management (the holder of its affordable housing investment) represents a small (but undisclosed) portion of this and it has significant investments in industrial, office, and retail property and just 470 “essential worker leased apartments”.

Identifying what you are getting takes a lot of work and the information needed is not always readily available.

5. Thematic Investing

Fund manager marketing teams are adept at creating products to tap into market zeitgeist.

There is no end of funds focused on specific aspects of ESG, such as renewable energy or sustainable agriculture.

The pitch is that these funds allow investors to benefit from a focused portfolio of companies meaningfully exposed to a chosen theme, while at the same time reducing stock-specific risk.

The reality is that it is extraordinarily difficult to distinguish between a fad or fashion and a genuine trend. Great ideas only make great investments at the right price and these funds tend to proliferate as these themes reach peak fervour and disappear after a short life.

Reaping the Benefits of ESG in your portfolio

Clear Conscience

The clearest benefit of taking an ESG aware approach, is the ability to sleep soundly knowing that you are not profiting from businesses whose products or practices conflict with your morals.

Be clear what you want

Establishing precisely what you are or are not invested in, takes a fair bit of sleuthing. Exchange Traded Funds disclose their holdings in full publicly and the construction of the indexes they track is public information. Our super funds are much less forthcoming. They will usually disclose direct listed share holdings, but unlisted assets and those held by other managers are less transparent.

Your views may not align with that of the manager. So find one that does align (this may be tougher than you think).

FAIR (Betashares Australian Sustainability Leaders ETF) offers a rigorously screened index provided by Nasdaq that exclude companies with direct or significant exposure to fossil fuels or engaged in activities deemed inconsistent with responsible investment considerations. It doesn’t hold any of the big-4 banks. The only members of the ASX top 10 that make it into the FAIR top 10 are blood products company CSL and Telstra. It does, however, own Infratil (part owner of Wellington airport) and travel agents WebJet and Flight Centre, all of which are part of a global travel industry that contributes 9% of global carbon emissions. More controversially, it invests in family safety app maker Life360 which has come under fire for its dubious privacy record.
Aware super offers a screened indexed Australian share option that excludes tobacco, thermal coal and controversial weapons, and exclude, or have a reduced weighting to, the most carbon intensive companies. It’s top 10 holdings include all the big 4 banks, BHP, (oil and gas producing) Woodside, and (coal mining) Wesfarmers. It also has holdings in pokies maker Aristocrat and bookmaker TabCorp.
Unisuper, which loudly proclaims its environmental investing credentials, has come under fire from the Environmental Defenders Office for its holding in Transurban. It also has investments in Auckland and Sydney Airport.

This is not intended as a criticism of these managers or funds, rather it is an illustration of how extraordinarily difficult it is to definitively identify good or bad companies.

The wide range of research houses often come to contradictory conclusions.

Investing decisions are only as good as the research that underpins it. Good research is expensive and needs to be critically analysed as to how it aligns with your objectives to ensure you can confidently invest with a clear conscience.

Making a Difference

Whether your investment choice makes a difference or not is a much more complex question.

You are not giving your money to the company

Unlike your decisions as a consumer, where your spending goes directly to the company, the money you invest goes mostly to an existing owner of the shares you buy, not to the company.

For example, the SP500 (the 500 largest companies by value in the USA) has a market capitalisation of USD$43.3 trillion, but typically annual secondary issues (where the company raises more capital) are only $80 billion (according to SIFMA). This means that just 0.18% of the money invested goes to the company.

The company will generally be indifferent to your trade. A concerted push by a wider group of investors, however, may push down the price of the company’s shares potentially limiting its ability to raise more money and hurting executive bonuses.

Perversely, this will increase the returns to future shareholders because the company must pay them more for their capital. This in part explains why Altria (formerly Philip Morris) has delivered a higher shareholder return over its listed life than any other company listed on the US market ever.

Active Shareholders can change businesses

Investor pressure on companies can change the behaviour of the company.

BHP for example has divested its petroleum and thermal coal businesses partly in response to shareholder pressure. Neither sale, however, resulted in lower production or consumption of fossil fuels, so it will have zero impact on climate change.

Woolworths divested its gambling and liquor business by splitting the company and issuing shares in Endeavour Drinks to its shareholders in 2019. Shareholders not wishing to invest in liquor or gaming could choose to sell this holding on the ASX. Woolworths disposed of their final interest in Endeavour in late 2024. This transaction had no impact on the sales of liquor or gambling turnover, but at least it meant that shareholders had a choice as to whether they would participate.

On a potentially more positive note, AGL shareholders led a revolt against the proposed demerger of its coal generation assets in favour of a new strategy to more rapidly transition to renewable energy generation. How effective, the new board will be at managing the transition to clean energy remains to be seen. But almost two years later, AGL remains Australia’s biggest emitter of CO₂.

This power rests with shareholders – so only by being a shareholder and exercising your right to vote, can you seek to have this influence.

Performance

Different action, different result

If you do something different, you should get a different result. But how different?

And is it different good or different bad?

The evidence on performance is mixed. There is little evidence to support an argument that ESG investing leads to sustainably higher or lower performance.

Much of the difference can be attributed to the relative performance of resources and industrial companies.

Resources is a highly cyclical sector. When resources do well ESG underperforms, when resources do poorly ESG outperforms.

In recent times, the dominant performance of the so-called magnificent-7 (Alphabet, Amazon, Apple, Meta, Microsoft, Nvidia, and Tesla) has flattered ESG funds which tend to be overweight in these companies.

In Australia, FAIR has underperformed an unscreened equivalent (IOZ) since it was launched by more than 1.3% annually. It has also exhibited higher volatility.
Globally, VESG (Vanguard Ethically Conscious International Shares Index ETF) and VGS (Vanguard MSCI International Shares Index ETF) have delivered statistically indistinguishable returns at similar volatility.
ETHI (BetaShares Global Sustainability Leaders ETF) a more concentrated ESG portfolio delivered significant outperformance from inception to the COVID period. Its performance since has been more muted with a five-year return broadly similar to the unscreened VGS but 1- and 3-year returns well below that of the benchmark.

Costs

The additional work required to complete the ESG research comes at a cost. Investment decisions are only as good as the research that underpins them and good research is expensive.

Costs have been coming down with wider adoption. FAIR is significantly more expensive (at 0.49%) than its unscreened equivalent, IOZ (at 0.05%). Internationally, the difference is smaller with both VGS and VESG having annual fees of 0.18%, although ETHI is more expensive at 0.59%.

Impact on security selection

Unarguably, applying screens will lead to a different portfolio than an unscreened equivalent. Most ESG-aware portfolios will be overweight technology, financials, and healthcare, and underweight materials and utilities.

At the individual company level, high ESG scoring companies tend to be larger and more profitable on average than low scoring companies. I suspect that this more correlation rather than causation.

Big profitable companies tend to have the resources to complete the questionnaires from research houses. Big companies tend to underperform small companies, while profitable companies tend to outperform unprofitable companies.

A constrained optimum cannot be greater than an unconstrained optimum

The more constraints you place on the available investment options, the greater the likelihood that it will deviate from an optimum outcome financially. If the ESG aware approach were the optimum than all investors would drift to that conclusion in an efficient market and prices would adjust accordingly.

How should you consider ESG and how can you apply it to your specific circumstances?

Think about what you are seeking to achieve and the trade-offs you are prepared to make.

Sleeping easy

If your goal is to sleep easy with an easy conscience and you are comfortable with the portfolio construction, cost, and performance implications, the answer is clear.

The challenge is to find a fund that delivers the portfolio you need. This analysis is complex and takes time and resources. It is unlikely that you will find a fund that perfectly aligns, so you may have to accept a least worse option.

To build a perfectly aligned portfolio (at least in equities), it is likely that you will need to do this with individual stocks. Doing this for Australian equities is possible, but will likely require a large sum to invest and incur high management costs. Doing so globally is more complex.

For other asset classes it is even more complex. Is it even possible to construct an ESG-aware infrastructure investment? These basic societal needs play an important role in portfolios by delivering high quality stable returns with low risk. But utilities, airports, roads, pipelines, and to a lesser extent railways are all significant contributors to global emissions. Are you to simply exclude an entire asset class?

ESG-aware real estate funds are readily available, but most focus on the environmental performance of the building and ignore the tenant. Is a green building leased to an oil company something you want to invest in?

Gold is by its nature relatively pure. Gold plays an important role in portfolio construction especially for investors living in commodity currency countries (Australia, South Africa and Canada for example). Gold production represents only 4% of global stocks, so almost all gold investments will be in existing gold. Gold miners are of course a different question.

Bond portfolios largely consist of bonds issued by Governments and are relatively easy to screen. Most ESG-questionable regimes don't have the credit rating to make it into most bond portfolios which focus on investment grade bonds. Corporate issuers are more difficult. Green bonds (issued to fund environmental or other socially beneficial projects) will often depend on Government incentives to generate a return to investors and a lower cost for the issuer. High demand has often meant these deliver poorer returns to investors.

A good adviser with inhouse investment skills will help. Be prepared to pay more for this advice compared to more conventional portfolio construction and management.

Keep in mind that many advisers outsource their portfolio construction to research houses or model portfolio providers who may not be able to meet your specific needs. Other advisers only deal with insurance.

Making a difference

If your goal is to make a difference to the world, the question gets a lot tougher. Start by thinking about what you do with the rest of your life decisions.

Do you buy organic locally sourced food?
Do you buy green energy?
Have you adopted a vegan or low meat diet?
Do you drive an electric car (or better walk, cycle or use public transit)?
Do you offset the carbon emissions when you fly?

If the answer to these questions is yes, then you have demonstrated a willingness to trade off action for cost and convenience – a strong indicator that you may be willing to make similar trade-offs when to comes to investing.

If the answer is no because it is more costly or less convenient or harder work, then you should question why you are seeking to impose these trade-offs on future you when current you is not willing to make them. Especially considering that the impact on the environment or society generally is likely to be lower.

You may be able to make a difference without impacting your entire investment. The most direct impact you can have as an investor is to get involved as a shareholder.

Choose the cause that most engages (or enrages) you and allocate a small portion to a company grappling with that issue. Many individuals bought a minimum parcel in AGL in 2022 to help defeat the demerger proposal and in turn hope to lead to a lower carbon future for AGL.

Allocate a small sum to a company grappling with an issue that bothers you where you can make a real difference and invest the rest of your super or investments in a broadly diversified portfolio.

Of course, these options are not mutually exclusive, you can choose either, both or none.