Ethical investing: The good & bad - Pt 1

Before running down the rabbit hole of ethical investing, let's dispatch the easiest issue first. You're reading Intelligent Investor Share Advisor; you invest in stocks, presumably to make a profit. So we're going to assume you don't find profiting from capital inherently unethical. [Will the Marxists up the back please lower their hands?]

Things become tricky only when one runs a finger down the list of Australia's top 20 stocks. Woolworths, one of our long-standing buy recommendations, delivers high quality food at reasonable prices. With a business model based around volume, it passes on cheaper prices to customers and supports local schools and community groups. What could be unethical about that?

Well, aside from ditching the iconic checkout chick in favour of self-service machines, Woolworths also happens to operate Australia's largest network of poker machines, which suck in the savings of pensioners and encourage gambling addiction. Then there are the 'healthy' breakfast cereals that contain 30% sugar, the upshot of which is being unable to get out of a Jetstar seat.

What about the banks? The Commonwealth Bank financial planning scandal counts it out. Meanwhile, ANZ Bank is providing a $1.2bn loan facility to Whitehaven Coal for its Maules Creek development, a huge open cut coal mine on the edge of a national park. Carbon emissions from coal mined here will equal those of New Zealand.

NAB and Westpac were last year rated as two of the world's most ethical companies, but so was Alcoa, an aluminium producer ranked the 15^th biggest airborne polluter in the United States. And both these banks make loans to coal and coal seam gas developers.

Limited choice

Even resources stocks like Rio Tinto and BHP Billiton pose problems, although of a different nature. Most mining stocks fail the 'ethical investment' test. But without the iron ore provided by these companies, would China have reduced poverty and hunger from one third of the population in 1979 to one tenth now? Even the dirty, careless British Petroleum, responsible for the Deepwater Horizon disaster, invested $8bn in alternative energy between 2005 and 2013.

After scratching the banks (lending to miners), the retailers (making us fat), miners (warming the planet), and Origin Energy for increasing energy prices when demand is falling, only a handful of insurers and CSL remain on our Top 20 list. To build a diversified portfolio we must consider smaller stocks.

How about Cochlear, an ethical no-brainer if ever there was one? The company's implants give hearing to the profoundly deaf at a cost of about $30,000, allowing the company to earn a gross profit margin of over 70% and EBIT margins of about 25%. Wouldn't it be more ethical to lower the price, making the technology more accessible, and build a volume rather than a margin-based business?

Perhaps now you can see why we gave up on our ethical portfolio over 10 years ago. Investing ethically is an intensely personal and almost entirely subjective matter. Who are we to judge what you might consider ethical or not? [Needless to say, this minor point won't stop us from pontificating in the second part of this story tomorrow – Ed]

There are two fundamental approaches to ethical investing. The first operates on a 'negative screen', or as Google would put it, 'Do no evil'. If you deem a company's activities substantively detract from the sum total of human, animal or environmental happiness they should be avoided.

For many, this means that alcohol, mining, gambling and resources stocks are out but almost everything else is in, even if these businesses have a neutral social impact. The second approach is 'do good', or, in the lingua franca of ethical fund managers, a 'positive screen'. Here, a portfolio is constructed from stocks actively beneficial to society and the environment.

Inevitably, many ethical fund managers end up with a combination of the two. To use only the second approach leads to a portfolio heavily focused on renewable energy, recycling and healthcare, breaking the fundamental rule of diversification. Compromises are thus inevitable, although that need not lead to poor performance.

No performance penalty

According to the Responsible Investing Association Australasia's 2013 Benchmark Report, the 10-year per annum performance of the average Australian shares ethical fund to 31 Dec 12 was 11.3% compared with an average fund's 8.2%. That's a 3% out-performance. Table 1 shows how a handful of leading ethical funds have fared.

Ethical investors have a few points to weigh up. The first concerns performance and what you pay to get it (or not). Many international studies (a meta study can be found here) compare the performance of ethical investing versus 'ordinary' investing, with no clear conclusion. In general, if you do pay a performance penalty to invest ethically, it isn't large and some studies indicate ethical investing aids outperformance. So don't let the idea of poor performance dissuade you from considering ethical funds.

The cost issue is more settled. Ethical funds tend to be more expensive. Hunter Hall's Global Equities Trust, which employs a negative screen, charges an entry fee of 4% (all of which may be rebated), a management fee of 1.8% and a 15% performance fee of any return greater than the MSCI World Index. Against that, Perpetual's Ethical SRI Fund management fee of 1.175% and buy/sell spread of 0.15% seems quite reasonable.

Higher costs

Ethical investing should cost a little more because it expands the research process to include judgments on the company's impact on society and the environment. That process also necessarily reduces the pool of cheap stocks in which one can fish. It's one thing to find an undervalued company, quite another to find one that's cheap and socially responsible.

This list of stocks from Australian Ethical indicates how the research process differs from ordinary value investing and demonstrates how one's ethical opportunities are restricted in a small market like Australia, especially if one wants to positively screen.

Which brings us to the final point. With the Government set to dump the carbon tax and renewable energy target, Australia's renewables industry is on hold. That means the pool of potentially cheap positively screened stocks like Infigen and Energy Developments is likely to become even smaller over coming years.

If you do want to invest in companies that actively make the world a better place it may be better looking offshore where Europe, the US and China have more developed renewable and SRI sectors. With the Australian dollar failing to respond to the RBA's jawboning, why not take advantage of it by investing in an overseas ethical fund where fees tend to be cheaper and choices broader? The alternatives are internationally focused funds run by the likes of Australian Ethical and the international options in Table 1. And if all that sounds a little too hard, tomorrow we'll present our very own negatively-screened ethical portfolio, constructed from ASX-listed stocks.