Ethical investing: Graham Witcomb Why it doesn’t pay

It may be more constructive to buy a stake in a “bad” company than to avoid it altogether

Don’t get me wrong: I’m a huge fan of socially responsible companies, but I think ethical investing gets it wrong. If ethical investors actually embraced the “bad” and the "ugly"corporate citizens, instead of favouring only the "good", they would achieve more, socially and financially.

Of course, there are industries doing harm in the world: oil companies, gun makers, tobacco producers, gambling stocks and the rest.

Many investors refuse to own stocks or funds operating in these industries, preferring to put their money in companies considered socially responsible. Ethical investing has boomed over the past decade as a result.

Maybe you sleep better at night knowing that your dividends are paid by solar panel manufacturers rather than cigarette makers. Fair enough.

However, if you’re avoiding the bad eggs of the corporate world because you’re trying to make the world a better place, there are more effective ways to do good – and make more money at the same time.

For one thing, ethical investing doesn’t pay well. Mutual funds that target specific stocks have higher fees than broadly diversified index funds and, historically, have been slower growers.

The big mama of all socially responsible funds is Vanguard’s FTSE Social Index Fund. It’s also the lowest cost, with an expense ratio of just 0.22%. Still, that’s more than four times the 0.05% fee of the Vanguard 500 Index Fund, which is much larger.

In theory, the social fund could have made up for the extra fees by earning higher returns, but that wasn’t the case: the social fund earned 5.6% a year over the past 15 years, compared with 6.7% for the S&P 500 fund.

The differences seem small but they add up. If, say, you put away $5000 a year over 30 years towards your retirement, your nest egg would be around $394,000 under the social investing strategy, compared with $480,000 using the general index fund.

The question, then, is whether the benefits of ethical investing outweigh the costs of having to save more for retirement and having less money to give to worthy causes.

The most common argument I hear for ethical investing is that the investor doesn’t want to help bad companies do bad things.

Let’s address that by talking about what a stock really is: a claim on a current set of assets and a future stream of cash flows. If Bad Corp has 100 shares outstanding and you own one share, then you own 1% of every factory, furnace and office chair and have a claim on 1% of every dollar of profit.

To build a new factory, Bad Corp can either use retained earnings, borrow money or raise capital by

issuing new shares. Most companies favour the first two options and rarely the latter (new shares are typically issued for large acquisitions).

But here’s the thing. When you buy shares on the ASX, you’re buying from another investor – not handing money to the company itself. These are secondary transactions. If your friend owns shares in Bad Corp and sells them to you, the cash that changes hands is between you and your friend – Bad Corp doesn’t see a penny of it.

In the case of initial public offerings (IPOs), entitlement offers and share purchase plans, you are handing money to the company for potentially socially irresponsible uses, so not participating makes sense. But if you’re buying existing shares, the company isn’t financially involved.

“But wait!” I hear you say. If enough investors refuse to buy the stock, the company’s share price will fall, which sends a signal to management and shareholders that the world isn’t best pleased with their actions. Money grubbers that they are, management will then make more socially responsible decisions to appease the do-gooders and boost the share price.

Not so fast. Because a share in a company is a claim on future cash flows, as the share price goes down the returns per share actually go up.

By boycotting the stock, you’re giving those investors who are willing to buy and hold the company a bigger return. You are, in fact, enriching the “evil” investors and neutral index funds at your own expense.

If the bad guys are getting richer than you, faster than you, then their influence in the world is growing. That doesn’t seem like a good plan to me.

So what’s an ethical guy or gal to do?

If you disagree with a company’s policies, you can still vote with your wallet by boycotting its product or service. This reduces the company’s revenue, which means less cash flow for it to invest in building its business.

You can also lobby for regulatory interventions and more scrutiny of the company’s activities. Getting your electricity from “green” providers is one thing but convincing policy makers to ban coal power entirely is far better.

But there’s an even more powerful argument: to actively invest in unethical companies.

Refusing to own bad companies is like refusing to vote in elections because you don’t like current policies. You’re giving up your voice.

If Exxon Mobil and Philip Morris will be with us for decades to come, I’d rather their owners were a group of environmental and social activists who could then vote on board appointments and management decisions, as well as direct the company’s dividends towards worthy causes.

This is a different, more active way of thinking about investing in sinful industries. Instead of steering clear altogether, get involved. Read the proxy statements, vote for ethical board members and lobby major shareholders to change personnel.

By all means boycott a bad company’s products – but happily take its dividends, then invest them in the IPOs and services of responsible companies, or donate them to charities and lobby groups. This, I suggest, will accomplish a great deal more and leave you a little richer.

Instead of steering clear, get involved and lobby for changes