What Is Ethical Investing? – Motley Fool

What Is Ethical Investing? Motley Fool

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Interested in promoting good corporate behavior with your investment dollars? You may be an ethical investor at heart. Ethical investing is the practice of incorporating personal values and principles into the investment process.

What is ethical investing?

Ethical investors still evaluate technical metrics such as price-to-earnings and debt-to-equity ratios. But, in an additional layer of analysis, ethical investors evaluate a company’s actions relative to their own moral code. Companies not in alignment with the investor’s values, principles, and ethics would not be candidates for investment.

This style of investing is gaining popularity. Over the past several years, ESG assets under management have grown roughly 30% annually. ESG is a type of ethical investing that evaluates companies on their environment, social, and governance practices. A 2021 Bloomberg analysis projects ESG assets may reach $53 trillion by 2025 — about one-third of projected global assets under management.

Companies, researchers, and investment managers are responding to this trend. Today, more companies are embracing transparent reporting. Researchers are developing ways to track and score corporate behavior. And investment managers are launching mutual funds and exchange-traded funds (ETFs) that cater to principled investors.

Ethical investing vs. ESG: What’s the difference?

The rise of ethical investing as a discipline has also led to a rise in buzzwords. Do a bit of research into ethical investing and you’ll likely see these related terms:

These are offshoots of ethical investing, and most have loose, subjective definitions.

ESG investing is the most concrete of these terms, mainly because there are defined ESG ratings systems and documented ESG standards.

ESG investors believe good corporate behavior benefits the bottom line. As such, the evaluation of a company’s performance on environmental, social, and governance initiatives is a nonnegotiable part of the ESG investor’s decision-making process.

Ethical investing. Relative to ESG, ethical investing is less clear-cut and more personal. When you invest according to your ethical code, you personally set the standards. You might screen out companies that make weapons, while someone else might avoid casino operators. You might prioritize corporate actions over profit growth, while another ethical investor might not.

Socially responsible investing is similar to ethical investing. You decide what “socially responsible” means and invest accordingly.

Sustainable investing, clean investing, and green investing usually have an environmental slant, although this can vary by context. Some use “sustainable investing” as a synonym for ESG investing, for example. Others use these terms interchangeably to mean investing in renewable energy companies.

How to build an ethical portfolio

Ready to build your ethical portfolio? Here’s a walk-through of the process:

1. Set your investment objectives. The first thing to know is that enforcing ethics standards in your portfolio does not require a financial trade-off. You can invest in companies you respect that will also generate strong financial returns.

To make that happen, define what you want — financially and ethically. A realistic financial objective, for example, might be to earn market-level returns over the next 10 years.

Your ethics objectives can define the corporate actions you will support and those you won’t. For instance, you might feel good about investing in companies with women CEOs and businesses actively reducing their carbon footprint. But perhaps you don’t want to fund companies involved in tobacco or coal mining.

Think through the positive and negative implications of your ethics standards. Documenting what you want and don’t want in your portfolio should streamline your research.

2. Define your target allocation. Asset allocation is the composition of your portfolio across different asset types such as stocks and bonds. This composition heavily influences the amount of risk you’re taking on. You should know your target allocation before building any portfolio, whether or not your ethics play a role.

Your investment timeline and risk tolerance are factors here. The longer you can leave your money invested, the more aggressive your allocation can be. This is because the market can be volatile from year to year, but it usually averages out to growth over periods of 10 years or more.

A reasonable allocation for a 20-year timeline, for example, would be 70% stocks and 30% bonds. If your timeline is shorter, you might prefer a 60-40 or 50-50 split.

3. Research your options. You can build your ethical portfolio from one or more mutual funds or ETFs. Or, you can invest in 20 or more individual stocks. Funds provide immediate diversification but may be harder to match to your exact ethics requirements. Stocks give you greater control, but they’re harder to manage.

To find acceptable funds, search for ESG, socially responsible, or impact funds. ESG and socially responsible funds are more general in their approach. Impact funds support a specific cause such as renewable energy or women in leadership.

You’ll find hundreds of fund options across the ESG, socially responsible, and impact fund landscape. Two examples are iShares ESG Aware MSCI USA ETF (NASDAQ:ESGU) and PAX Ellevate Global Women’s Leadership Fund (NASDAQMUTFUND:PXWEX).

To evaluate prospective funds, read the fund’s documentation and research benchmark indexes. The documentation will describe how the fund selects companies for its portfolio, as well as the fund’s expense ratio, performance history, and holdings. If the fund tracks an index, reviewing the composition of the index will provide more insight into the stock selection process.

You can also use funds and indexes to find ethical and ESG stocks. You can then lean on ESG scores, company reporting, and news briefs to evaluate your options.

4. Look out for greenwashing. Greenwashing is the practice of promoting eco-friendly characteristics in a misleading way. As an example, Coca-Cola (NYSE:KO) is under fire for hyping its sustainability practices while being one of the world’s largest plastic polluters.

Funds practice greenwashing by investing in stocks that don’t align with the stated investment approach. ProShares S&P 500 Ex-Energy ETF (NYSEMKT:SPXE) is an example. By the name, you might think this fund wouldn’t include any energy companies in its portfolio. Still, the fund invests 4.3% of its capital in fossil fuel stocks. That may not meet your requirements for an ethical investment.

To protect yourself against greenwashing, review recent headlines for prospective stocks or funds — and their leaders. You can also research funds using the Invest Your Values tool by AsYouSow.com.

Financial returns on your terms

The underlying value proposition of ethical investing is this: As an ethical investor, you can make the world a better place as you increase your net worth. That’s a pretty exciting pair of outcomes.

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