This is, of course, an ambiguous phrase. It could refer to how diligently professional investors do their duty to clients, in which case it would mean staying within the guidelines imposed by the client while using every legal means to obtain the highest return for the least risk. But these days, as in other times in the past, “ethical investing” means choosing investments that further some social or moral purpose, possibly forgoing returns to promote certain corporate or national policies or to punish undesirable behavior. For instance, investors who disapprove of Israeli policies might exclude investments in that country from their portfolio. Others, concerned about the fate of human civilization, might emphasize investments deemed to benefit the environment while excluding those they feel would harm it. Millennials, especially, seem to favor such approaches, though they are not the only ones pursuing social and ethical investing.
Approaches to ethical investing have grown in recent years. I won’t go through them here, nor will I judge them from either a moral or an investment perspective. However, there are two investment implications that deserve attention here: one concerns portfolio distortions; the other, fiduciary considerations.
These require a recognition of the biases such investing will build into a portfolio and consequently into its performance. Most investing, especially when done by professionals, measures success relative to an investment index that includes the relevant universe of assets available to an investor for purchase –– what professionals refer to as a “benchmark,” or “bogy.” With American stocks, that benchmark is often the S&P 500 Stock Index, which includes the 500 largest corporations in the country, with representatives in just about every industry. There are broader indexes for American stocks that include smaller companies, global indexes, indexes for other countries, and indexes for regions, say Europe or Asia or emerging markets. Investors can say they have added value to their portfolio if they can produce for their clients a higher return than the relevant index, “outperform” it, to use financial jargon. When, for ethical reasons, an investor excludes certain stocks that are otherwise in the index, or chooses to emphasize others, the portfolio’s performance will deviate from the benchmark for reasons that have nothing to do with the stock’s possible gain or risk.
Some years ago ethical investing excluded stocks of companies that did business in South Africa (as some investors do today with Israel), and the consequent distortions were huge. These ethical portfolios could not buy any major oil company or any major auto manufacturer. They could not own shares in most machinery or appliance producers, defense contractors, and many retailers –– the list was long. Some portfolio managers bought smaller companies to maintain involvement with industries otherwise excluded, but investing in small companies to replace large ones introduced other distortions. When some or all of these excluded stocks did well, the ethical portfolios trailed their respective benchmarks. When these excluded stocks did poorly, the ethical portfolios outperformed their benchmarks. But neither difference had anything to do with investment management abilities. It was entirely an accident imposed by excluding South Africa.
Similar distortions are present in more contemporary ethical concerns. For instance a preference for renewable energy or electric cars would render a portfolio extremely sensitive to fluctuations in oil prices –– perhaps even more so than one with an overweighting in major oil companies. Though renewables and electric vehicles are an alternative to fossil fuels, their business prospects nonetheless rise when oil becomes more expensive and the public seeks alternatives, and fall just as dramatically when gasoline and fuel oil become more affordable. Some investors, though eager to support renewables, feel uncomfortable with this exaggerated sensitivity to oil prices. They might exclude oil companies from their holdings in order to blunt the volatility. Such a decision might also fit with the ethical convictions built into the portfolio. Whatever the individual tolerances for volatility or available investing offsets, investors wanting to pursue such ethical mandates need to know these implications.
Distortions can affect portfolios that exclude Israel or defense issues or timber production or any of a host of corporations that might bear, favorable or unfavorably, on ethical implications. With each decision, investors must consider the potential effects on their portfolios and whether the proposed ethical stand is worth it to them. The decision may involve soul searching about the extent of their conviction. For those who invest on another’s behalf, especially professional investors, there is also a fiduciary consideration.
Anyone who invests for others carries a measure of fiduciary responsibility to do the best they can at the least financial risk while also considering the preferences, tolerances, and objectives of those on whose behalf they are investing. The law is explicit about who is a fiduciary, but the responsibility devolves to anyone thus involved. This, too, involves ethics. If you informally advise family and friends, your legal responsibility is limited, but your moral responsibility remains. Your legal responsibility grows when you are paid for advice, and especially when arrangements empower you to buy and sell on another’s behalf.
If “clients” –– whether formal clients of a broker, or just friends and family to whom you’re giving advice –– have not brought up special ethical considerations, then it’s best to proceed without regard to your own personal convictions. If they have expressed ethical considerations, have them state them as explicitly as possible: Put them in writing. This will protect you from blame or lawsuit if the “ethical portfolio” disappoints. Having the client’s considerations in writing will also guide your professional investing decisions, keeping in mind that an ethical overlay on a portfolio is not in the professional investment manager’s area of expertise. For example, if someone wants to punish Israel for its policies, find out if they want simply to avoid investing in Israel or if they want also to avoid corporations from other countries that do business in Israel. If the client wants to buy “green” stocks, make sure the word “green” is well defined. You don’t want to buy timber because it is a renewable energy source only to discover that your client wants nothing to do with any activity that cuts down trees. It would also be useful for you to brief the client on the possible distortions involved. You should document that briefing as well.
A perfect example of the potential troubles surrounding ethical investing involves South Africa during its apartheid era, when the boycotts of that country in the 1980s led many U.S. foundations and municipalities to impose restrictions on their investment managers. Because foundations usually have boards that are both in control of the foundations and responsible for their actions, the choice to boycott seldom caused trouble, except for managers who had failed to alert the foundations ahead of time of how the restrictions could affect their portfolios’ relative performance.
With the municipalities, however, matters were more complex. The pools of money that municipal politicians and bureaucrats control are usually funds set up to support pensions obligations. When those in control imposed the ethical restriction (whether from conviction or to get votes) they had neither an easy way (nor a desire) to consult the beneficiaries of the pension schemes. If the ethically imposed distortions benefitted the portfolio and it performed well against its benchmark, there was seldom a complaint. But when the portfolio underperformed its benchmark, participants in these pension schemes sued, sometimes individually but usually as a class. In every case the courts found against the municipalities. However admirable the municipalities’ ethical commitment, it imposed a hardship on those who had no say in the decision but whom those decision-makers were legally bound to protect. The courts ordered that the municipalities involved make up the difference. Then, of course, the taxpayers suffered, though they could not sue for compensation.
A Last Word
As is so often the case with investing, every move imposes a risk, a potential cost. When such a move, in this case an ethical one, results in serendipitous advantages, no one complains. But the story is almost always different when the decision imposes costs. Those investing, for themselves or as agents for others, owe it to all involved, investors and their clients, to strive to become fully aware of the implications of their decisions.