The case against ethical investing

Don't get me wrong: I'm a huge fan — to a problematic degree, some might argue — of socially responsible companies. That said, giving up on ‘good' companies and embracing the 'bad' and the 'ugly' has its merits – both from a financial standpoint and an ethical one.

Undoubtedly, there are industries doing harm in the world: oil companies, gun makers, tobacco, gambling, and the rest of them.

A rising number of investors refuse to own stocks or funds operating in these industries, and instead put their money in companies considered to be socially responsible. Ethical investing has boomed over the past decade.

Maybe you sleep better at night knowing that your dividends are paid by solar panel manufacturers rather than cigarettes makers. Fair enough.

However, if you're avoiding the problem children of the corporate world because you're trying to make the world a better place, there are more effective ways to do good – and make more money at the same time.

For one thing, ethical investing doesn't pay well. Mutual funds that target specific stocks have higher fees than broadly diversified index funds and, historically, they have also been slower growers.

The big mama of all socially responsible funds is Vanguard's FTSE Social Index Fund. It's also the lowest cost, with an expense ratio of just 0.22%. Still, that's more than four times the 0.05% fee of the Vanguard 500 Index Fund, which is much larger.

In theory, the social fund could have made up for the extra fees by earning higher returns, but that wasn't the case either: the social fund earned 5.6% a year over the past 15 years, compared to 6.7% for the S&P 500 fund.

The differences seem small, but they add up over time due to compounding. If, say, you put away $5,000 a year over 30 years towards your retirement, your nest egg would be around $394,000 under the social investing strategy, compared to $480,000 using the general index fund.

The question, then, is whether the benefits of ethical investing outweigh the costs of having to save more for retirement and having less money to give to worthy causes.

Poor punishment

The most common argument I hear for ethical investing is that the investor doesn't want to help bad companies do bad things.

Let's talk about what a stock really is. It's a certificate of ownership – a claim on a current set of assets and a future stream of cash flows. If Bad Corp has 100 shares outstanding and you own one share, then you own 1% of every factory, furnace and office chair, and have a claim on 1% of every dollar of profit.

To build a new factory, Bad Corp can either use previous years' earnings, borrow money, or it can raise capital by issuing shares. Most companies favour the first two options and generally only issue new shares a handful of times (typically for large acquisitions).  

But here's the thing. When you buy shares on the ASX, you're buying from another individual investor – not handing money to the company itself. These are secondary transactions. If your friend owns shares in Bad Corp and sells them to you, the cash that changes hands is between you and your friend – Bad Corp doesn't see a penny.

If you're buying shares on the open market, the company has already raised its funds. By all means, don't participate in initial public offerings (IPOs), entitlement offers and share purchase plans – in these cases, you are handing money to the company, which it could then put towards socially irresponsible things. But if you're buying existing shares, the transaction is just between you and another investor.

‘But wait!' I hear you say. If enough investors refuse to buy the stock, the company's share price will be lower, which sends a signal to management and shareholders that the world isn't pleased with their actions. Money grubbers that they are, management will make more socially responsible decisions just to appease the do-gooders and boost the share price.

Not so fast. As mentioned above, the iron law of investing is that each stock is a claim on a future stream of cash flows. Like a seesaw, as the share price goes down, the returns go up.

By boycotting the stock, you're giving those investors who are willing to buy and hold the company a bigger return. You are, in fact, enriching the ‘evil' investors and neutral index funds – and doing so at your own expense. If the bad guys are getting richer than you, faster than you, then their influence in the world is growing. That doesn't seem like a good plan to me.

A better way

So what's an ethical guy or gal to do? If you disagree with a company's policies, you can still vote with your wallet by boycotting the company's product or service. This reduces the company's revenue, which means less cash flow for it to invest in building its business. You could also lobby for a regulatory crackdown. Getting your electricity from ‘green' providers is one thing, but convincing policy makers to ban coal power entirely is far better.

Finally, I think there's actually an argument for investing in unethical companies. Bad Corp will go on existing so long as its product is legal and in demand. That being the case, wouldn't you rather good guys be running the shop?

If Exxon Mobil and Philip Morris will be with us for decades to come, I'd sleep better knowing their owners were a group of environmental and social activists, who could then vote on board appointments and management decisions, as well as direct the company's dividends towards worthy causes. Refusing to own bad companies is like refusing to vote in elections because you don't like current policies. You're giving up your voice.   

When investing, invest to make money. Don't be shamed out of owning companies in sinful industries. Instead, read proxy statements, vote for ethical board members and against managements that do the most harm. Boycott a bad company's products – but happily take its dividends, then invest them in the IPOs and services of responsible companies, or donate them to charites and lobby groups. This, I suggest, will accomplish a ton more – and leave you richer to boot.  

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