The 'ABC' Of Ethical Investing

The origins of ethical investing

Ethical investing has its genesis with religious based organizations such as the Quakers in America which wanted to avoid investing in the “sin” industries such as tobacco, alcohol, gambling and defence, which were in conflict with their member’s personal values and beliefs.

By eliminating certain industries from their pool of potential investments, these religious based investment funds were applying what is now commonly referred to as “negative” screens. Negative screens typically screen out around 5% - 10% of all the possible investments in publicly listed companies.

In the last couple of decades ethical investing has become more sophisticated, and there is a diverse range of ethical investment products (offered by investment funds) in the market. Besides applying negative screens, some ethical funds now apply “positive” screens. Positive screens are designed to identify the type of companies the ethical fund wants to invest in. Examples of positive screens might include companies involved in either renewable energy or public transport.

When an investment fund applies both negative and positive screens to its investment process, it could be screening out as much as 60 - 80% of all possible investments in publicly listed companies (and this is before financial screens are applied)*. So it is a much more stringent criterion and leaves the investment fund with fewer potential investments.

Approaches to ethical investing

Investment funds use different approaches to ethical investing. Some of these are:

Pale Green – Pale green fund managers normally only apply negative screens** in their investment screening process. By applying negative screens, these funds will probably only screen out around 5% to 10% of all possible investments. This will allow them to invest in approximately 90% to 95% of all available listed companies on the market. Because a “pale green” fund is only screening out a small portion of investment options, it still retains a large pool of potential investment alternatives.

Best of Sector – Best of sector funds choose the most ethical company within a sector to invest in. For example, a “best of sector” fund will invest in the most ethical bank, mining company, building materials company, insurance company, publishing company and so forth. “Best of Sector” funds will have an exposure to every sector in the market, even the mining and financial sectors, two of the largest sectors in the Australian stock market. By having an exposure to every sector in the market, these funds investment returns should move more or less in line with the overall market. For example, the Australian mining sector has been booming for the last couple of years due to high commodity prices. “Best of Sector” funds should have benefited by having some exposure to the mining sector. Whereas other types of ethical funds, which might exclude mining companies from their portfolios, may not have benefited directly from the boom in the mining sector.

Sustainable – some funds are focused on the environment exclusively and invest in companies that are working to improve the environment and tackle climate change. These funds would probably invest in companies involved in renewable energy, water, and plantation timber, to name but a few.

Deep Green – Deep Green fund managers invest in the most ethical publicly listed companies. A Deep Green fund would normally apply both negative and positive screens to its investment screening process. Deep Green fund managers would typically be invested in companies involved in renewable energy, waste management, recycling, organic / natural foods, and public transport, etc.

Industry specific – Industry specific funds are funds which will invest in just one sector, for example the “water” sector or the “renewable energy” sector.

Shareholder activism – these funds invest in companies that are doing “bad” things and then engage with management in an effort to change the company’s specific business practices. An example of this in Australia would be where an ethical fund invests in Gunns’ Ltd of Tasmania. Gunns’ is involved in the logging industry and an ethical fund might invest in the company so it can pass resolutions at shareholder meetings seeking to ban its logging of old growth forests.

*Financial screens are used to screen out any company which is financially “weak”.

**As mentioned, the typical negative screens are alcohol, tobacco, gambling, and defence stocks

© 2008 Michael O'Brien