Is New Age Ethical Investing A Good Idea?

The new age ethical investing formula focusses on responsible financial investing. If an investor believes that certain companies are polluting and exploiting natural and / or human resources for the sole purpose of turning a fat profit, the logically responsible decision for her would be to not invest in such a company. If she chooses to go with that logical decision, is it really a good idea to do so? What are the consequences? This article ties to explore answers to that question.

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Disclaimer:

Before you proceed reading, please note that I’m no financial expert or financial advisor. I am merely a deeply curious individual who wishes to discuss interesting financial and scientific topics. No information from this article is to be taken as financial advice. Please use your own discretion to make your own decisions. You, and you alone, are responsible for your decisions.

The Challenge

Why would anyone want to give their money to a company that doesn’t hold up to their values?  Well, the answer to that question is a tad bit complicated. You see, one of the currently fastest growing modes of investing is in the form of passive investing. For one to be successful with passive investing, one needs to protect oneself from ignorance of the intricacies of markets and market elements via diversification. And this diversification is offered to the typical passive investor in the form of basket-instrument-products known as funds. Passive Index Funds and Exchange Traded Funds (ETFs) are two well known version of these basket-instruments on offer.

The index funds and ETFs which have the most proven and trustworthy track record offer a basket based on geographical locations like MSCI World, FTSE Emerging Markets, etc., or based on market capitalization like Large Cap, Small Cap, etc., or on factors such as growth, value, etc. There also exist combinations of already available basket-instruments such as Large Cap Value or Small Cap Growth. The challenge here is that the more parameters that the basket considers, the more specific it gets, and the less diverse it becomes. And the less diverse, the riskier and the more active the strategy becomes.

Based on this knowledge, one could argue that picking and choosing ethical companies by hand and investing in them is a very concentrated and risky strategy. Can this be overcome?

The Opportunity and The Risk

Well, what if one could diversify within the niche of ethical investing? That way, one can also avoid the higher costs associated with picking and choosing single company stocks, and diversify better as well. Cue in ethical investing ETFs like Barclays Women in Leadership ETN or SPDR MSCI ACWI Low Carbon Target ETF. One could pick and choose a niche he or she is into, and the market is ready to offer the product for it these days. This is a far better way to diversify and reduce costs compared to picking ethically sound companies (as per one’s subjective values, it must be said).

However, there still remains a challenge here. By definition, these ethical investing niche ETFs are concentrated by the niche they target. Thereby, they are significantly less passive, and significantly less diversified than, let’s say MSCI World. They are also significantly costlier than their more diversified counterparts.

The Truth

The truth is a bit of a bitter grape here: ethical investing comes at a cost. Historically and economically speaking, ethical investing strategies have underperformed and are expected to underperform their more diversified counterparts in the future. It also logically makes sense from a micro-stand-point. A company that is focused on turning a fat profit at any cost is likely to make more profit than a company that is trying to make a profit whilst operating ethically and responsibly. Add a basket of such ethically operating companies, and you get a basket that is inherently likely to underperform a more diversified basket.

Conclusion

So, armed with all this knowledge from our little analysis, can we say for sure that ethical investing is not a good idea? Well, not necessarily. It really depends on the investor and her or his mindset. If the investor feels that he is okay with (expected) underperformance knowing well that his money is invested ethically and responsibly, why should he not go ahead with such a niche strategy? If the investor, on the other hand, feels that he is likely to feel uncomfortable with the notion of losing out money to more diversified strategies, why should he not consider sacrificing his ego in order to target higher profits? In either case, it is a (relatively) free market out there that caters to almost all possible needs and niches. In a nut shell; ethical investing is possible, but comes at a cost. It is up to the investor to decide whether it is good or bad according to his or her needs and mentality towards investing.

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Further reading that might interest you: Winning The Game of Money – What Does It Take? and How The Economic Machine Works.