Options for Ethical, Responsible & Sustainable Investments
The Financial Adviser Standards and Ethics Authority (FASEA) Code of Ethics comes into force on 1 January 2020. This will be the new minimum standard of conduct for Australian Financial Advisers.
One of the more interesting new standards is as follows:
Standard 6:
You must take into account the broad effects arising from the client acting on your advice and actively consider the client’s broader, long-term interests and likely circumstances.
The Explanatory Note for this standard includes this sentence:
You will also need to consider whether your product recommendations should be limited to “ethical” or “responsible” investments.
So Financial Advisers will be obligated to consider recommending ethical investments unless directed by the client not to do so. Some will find it amusing that this comes into force at the same time that the Government has decided that they want to prevent boycotts of mining companies.
How do Ethical Investments work?
Ethical funds typically employ negative and positive filters on their portfolios. A negative screen means that they exclude specific companies that are widely considered to be unethical (alcohol, tobacco, gambling, weapons etc.).
A positive screen means that they will actively seek to include companies that are in sustainable industries (e.g. clean energy, recycling etc.) or are market leaders in setting higher benchmarks for environment standards or ethical conduct. For example Rio Tinto & Westpac might be included because they are setting higher standards than their competitors.
Sometimes Ethical Funds will hold shares in a significant company so that they can pressure the directors to make improvements in their business. An example of this would be BHP. The largest companies that represent significant percentages of the market index might also be included even if they don’t qualify under a positive screen as a way of reducing the volatility of the fund relative to the index.
What ethical funds are available?
Australian Ethical Investment and Dimensional Fund Advisors offer a number of wholesale funds that seem to meet a high ethical standard. These funds include Australian Shares, Global Bonds and Global Shares.
We also have funds from AMP, Vanguard and others that are labelled as Ethical Funds but generally only exclude Tobacco and some weapons manufacturing.
What are the downsides of ethical investing?
1. Returns may be lower.
Tobacco companies have been the best performing investments on any stock exchange anywhere. When all your customers are addicted to your product and will buy it regardless of the price you will always make money.
2. Fees are higher.
An index fund will charge a management fee of around 0.2% per annum. Ethical funds can be up to 1% per annum more expensive.
3. Portfolios are less well diversified.
Australian ethical portfolios tend to be heavily weighted towards banks. Global ethical portfolios are heavily weighted towards large IT companies. If those companies under-perform going forward your portfolio will suffer disproportionately.
4. Some of the companies included won’t meet your personal definition of ethical.
Apple, Alphabet (Google), Amazon & Facebook have generated significant controversies regarding privacy, working conditions & misinformation. They are among the largest holdings in all of the global ethical share funds we have available. Some ethical funds still include Resource companies (coal mining, oil etc.).
Is there any other option?
If you have a large enough amount of money it is possible to construct your own individual portfolio of direct shares. You can choose to include or exclude companies based on your own personal preferences.
The downsides of this are:
- It will be more expensive than using a professional fund.
- Diversification of the portfolio is likely to be worse.
- You don’t have access to the research to know which companies meet your requirements.
- Managing the portfolio over time will be more difficult.
Whilst the available ethical funds are not perfect they do send a message to company directors that investors have expectations about these issues. When it is an institution that controls billions of dollars and owns a significant shareholding they tend to pay attention which should result in improvement over time. This is much more powerful than what a single individual shareholder can achieve.
If you would like to discuss this with me in more detail please get in touch.