Does socially responsible investing make financial sense?

Charles Kelton

by , Team PensionBee

at PensionBee

30 June 2022 /  

Green economy jar with money and growing plant

This article was last updated on 15/02/2023

Socially responsible investing has been growing rapidly in recent years. Social and environmental interest groups have come together over the last few years to prick the national conscience and spur society, at all levels, into action on environmental, social and governance issues. When it comes to the businesses we interact with as individuals, there’s been a push to try and hold them to account to ensure they don’t prioritise profit at the expense of the planet and people.

But while for many people supporting businesses who share the ethical standards they hold is an attractive way of investing, does sustainable investing actually make financial sense? Are socially responsible funds as profitable as others? And does investing ethically mean sacrificing fund performance?

What is socially responsible investing?

Socially responsible investing (also referred to as sustainable or ESG investing) is the idea of investing in companies which behave in ethical ways in order to bring about societal and environmental benefits. These can range from the way in which a company treats the environment to how it treats its own employees whether that’s in terms of paying a living wage or working standards. The idea of what may be deemed an ethical practice will vary from one investor to another. For example, one investor may be keen to support some businesses who may emphasise one ethical practice over others.

Many companies receive an Environmental, Social and Governance (ESG) rating from ESG Rating Agencies such as FTSE ESG. There are two essential points worth explaining.

Firstly, a common misconception about ESG ratings is the belief that they’re a measure of how well a company is performing in these non-financial areas. This means that a company’s ESG score doesn’t necessarily indicate whether they are actually making a positive difference to society or the environment or even their own employees. Rather, an ESG rating can be thought of as how well a company is managing the risk that not addressing environmental, social and governance issues may have on the business’s long term financial performance.

Secondly, ESG ratings are not currently regulated. As there is no standardised way of formulating ESG ratings, each ratings agency uses their own criteria in assigning a score to a company. Additionally, they may change their scoring criteria at any time. As many investors look to ESG scores as an indication of a company’s long-term sustainability and even its profitability, regulation should bring improved consistency and transparency to help investors more clearly understand the risks and opportunities associated with an investment in their decision making.

In recent years there has been pressure on companies to incorporate these scores into their business plans as investors are increasingly using these scores as a means to deciding their investment strategy, choosing to invest in companies more in line with the values they hold.

What are the financial benefits of socially responsible investments?

Investing in socially responsible companies is increasingly becoming not just an ethical choice, but one that may see positive long-term financial results. Here are some key benefits which may make socially responsible companies a good financial investment.

1. Minimising exposure to risk

Companies with strong ESG scores and socially responsible practices are typically seen as having thoroughly considered their future business strategy. By preparing to more effectively embrace the opportunities socially responsible practices can bring they put their businesses in a more sustainable position over the long-term.

2. Potential to reduce costs

Socially responsible practices have the potential to reduce overall company costs and may even increase profitability by reducing the amount of resources they require to operate. Such cost savings could be reinvested into the company to help it continue to grow.

3. Demand from investors

There has been increasing demand across all age groups, though most significantly from those considered to be Millennials (roughly 25- 40 years old) investing in sustainable assets. Though every generation has campaigned on all manner of societal issues, it’s now much easier to actually invest in line with the things we value.

A sustainable pension is one way to invest in a socially responsible manner. At PensionBee we’ve also seen demand from our customers for a sustainable pension and responded by offering a Fossil Fuel Free Plan in December 2020 and an Impact Plan in February 2023.

4. Market reaction

The markets typically react well to companies that take social responsibility seriously and negatively to those which don’t or fail to live up to what they say they’re going to do, which may impact the value of their share price. More socially responsible companies may find it easier to raise capital, and improve their brand image which may positively impact on their business performance.

How have socially responsible investments performed?

Generally speaking, responsible funds haven’t typically underperformed against traditional funds over the long-term. In fact, reporting by Morgan Stanley showed that during 2020, sustainable equity funds outperformed their traditional peer funds by 4.3 percentage points. Even when taking a look over a longer time period (10 years) investment in socially responsible funds have not only grown but again, by and large, outperformed their traditional fund peers. In addition, it showed that investors in socially responsible funds were less likely to miss out on investment returns compared to those who had invested in traditional funds.

Are there any downsides to socially responsible investing?

Like all investments, fund performance in part comes down to the individual stocks which make it up. There are numerous factors which affect how well an individual stock will perform and this isn’t simply based on its ESG score. Other factors could include government policies, interest rates and how well managed it is among others.

Additionally, changes in market conditions can impact the performance of some stocks differently to others. For instance, during the Covid-19 pandemic tech companies performed particularly well, seemingly regardless of their social responsibility commitments. Even more recently socially responsible funds have underperformed compared to traditional funds though this is in part because globally rising energy costs have increased the value in oil and gas stocks. However, analysts remain optimistic that in the long term performance of socially responsible investments remains positive positive.

It’s also important to be aware that although ESG scores provide a useful guide, they don’t provide a black and white picture of how well a company is actually doing in terms of its socially responsible practices. For example, an ESG score may indicate that a company has a particular socially responsible policy in place but doesn’t necessarily show how well it is actually applying it.

Is a socially responsible fund a good investment?

To date, the evidence of positive market performance and the general upbeat sentiment of investors shows that socially responsible funds can be good investments. However, as with all investments, socially responsible funds are subject to changes in market conditions so their value may go down as well as up. It’s always important for investors to do their due diligence and understand how their fund is made up.

Of course, for many the primary attraction of such funds are that they seek to invest ethically as well as for long-term financial gain. The evidence suggests it’s possible to make a positive impact with your investment choices including with a sustainable pension. But even if the evidence indicated that socially responsible funds are less profitable than traditional funds over the long term, ultimately, you may be willing to accept lower returns in the knowledge that you’re making the right ethical choice.

Risk warning

As always with investments, your capital is at risk. The value of your investment can go down as well as up, and you may get back less than you invest. This information should not be regarded as financial advice.

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