The Four Deadly Sins Of Ethical Investing (2024)

An article in The Economist suggests ethical investing is one of the “hottest investment trends” in the market. Investment can take the form of private or public equity and can have markedly different intentions. As increasingly popular as it may be, consistent definitions can be hard to find: Ask 10 people about ethical investing and you will get 10 different responses. However, most would agree that consideration of non-financial objectives along with financial ones – whether to do social good or gain an investment edge – is part of the definition.

Whatever it is, ethical investing is not new. The prior boom for so-called “cleantech” stocks in the mid-2000s ended in a bust with countless investors losing massive amounts of money a few years later. Today’s ethical investors should ask themselves what they can learn from those past mistakes to avoid a similar fate as markets inevitably wax and wane.

Many of those prior investors fell victim to a consistent set of errors, or “sins” as they are called here. Just as ancient religious teachings show how the seven deadly sins of pride, envy, gluttony, lust, anger, greed and sloth can be a barrier to achieving salvation in the afterlife, the “sins” described below pose risks to ethical investors achieving their proclaimed objectives. Today’s ethical investors should take note.

Sin #1 – Unclear Objectives: Unclear or unrealistic goals on financial return, investment edge, social alignment and impact

Ethical investing, by definition, considers non-financial objectives. Sometimes this is done as an end goal itself. For example, investing in a manner aligned to one’s personal values (e.g., SRI, or socially responsible investing). Other times it is done as a means to an end. For example, utilizing these factors to achieve outsized financial performance (e.g., many ESG approaches that use environmental, social or governance criteria).

Some of these objectives can be seen to be in conflict with one another. For example, how can your potential return not be muted in some way if you are limiting your investment universe? Therefore, the objectives need to (a) be clearly defined and (b) realistic given the investment approach taken. Too often, approaches fail these common-sense points. Four key areas should be clearly defined:

• Financial Return: Are you aiming for a market return or better? Or are you willing to sacrifice return for some other social objective?
• Values Alignment: Do you wish for the investment portfolio to be aligned to positive societal values? If so, how exactly?
• Investment Edge: Is the ethical component designed to gain an investment edge of some sort, leading to better returns over time (e.g., ESG)? Is the claim realistic given the approach?
• Social Impact: Do you wish that the capital is invested in a manner that creates some sort of positive social impact that might not have otherwise occurred?

As one might expect, there is no right answer. Some investors desire one, a few, or all of the above. The key “sin” is in not clearly defining these criteria, or providing unrealistic expectations around what might be achieved.

Sin #2 – Stubborn Beliefs: Confusing what should happen – or what you want to happen – with what will happen

Just because you think something should happen doesn’t mean it will happen. And, even if it eventually comes about but your timing is far off, you risk losing a lot of money. Good investors know this but some myopic ethical investors forget it, especially when markets seem to be going their way.

Especially as it relates to public equity investing, investors have limited control about what will happen in the future related to the fundamentals and valuation of their investment. Chess is a good analogy for quality decision-making. One should emotionlessly analyze what the board is giving you and make moves appropriately. What should have happened, or what you would have preferred to have happen, is irrelevant.

The last cleantech boom and bust highlights this risk. There were several very loud investors publicly stating that the world needed to move to a low-carbon future and that cleantech stocks would be great investments regardless of the short-term ups and downs. A short time later, 80% of solar companies went bankrupt as the sector proved to be prone to massive booms and busts. The point? Having an inflexible thesis based on what you think should happen versus what will happen can be very costly.

Sin #3 – Weak Process: Lack of integration of ESG into a robust investment process

ESG investing (the use of environmental, social and governance criteria in making investment decisions) is an area of substantial interest in the market. ESG can be considered many things – a set of criteria, unique data, or a strategy – but it is not an investment process. Failing to fully appreciate this has led some investors commit the “sin” of poor integration of ESG into a more robust investment process.

For example, many ESG investors run regressions to show how certain factors lead to outsized returns over time. Some of the results are quite interesting, identifying factors such as investment in employees or R&D that lead to subsequent financial returns. Yet, key questions remain. For example, how does the factor perform in bull versus bear markets? How will you know when the validity of the factor as a stock signal decreases? How sensitive is the portfolio to non-ESG factors, such as momentum and value styles? There are countless other considerations: Are you constructing a portfolio that looks great on paper to well-intentioned clients but really is simply a short call on oil? Which, in effect, is a big call on the Chinese economy? When a drawdown happens, how do you manage it?

Too many times, ESG-focused investors fail to develop a robust investment process that can deal with these types of questions. Most great investors are, at their core, great risk managers – and most great risk managers have robust investment processes. Put another way: ESG is not an investment process on its own, but incorporating ESG into a robust investment process has the potential to make it even better.

Sin #4 – Static Thinking: Misunderstanding how and when ESG drives stock prices

Many factors influence stock prices: for example, the macroeconomy, industry fluctuations, company positioning and the ever-present emotions of the market. ESG factors (environmental, social, governance) play a role as well. Unfortunately, some ESG investment approaches fail to appropriately understand following:

• How important the ESG factor is in driving the stock price relative to numerous other factors; sometimes ESG factors are critical, other times they are not
• When the factor is most important to the stock price; for example, ESG factors can remain latent for quarters or years but then, all of a sudden, present risk and opportunity

Much of today’s ESG research is static and based on point-in-time mathematical regressions. Researchers find a historical relationship between investment in employees or good governance and the subsequent stock price. While some of the work is insightful, the static, point-in-time, nature of the analysis is limiting.

There are other, more dynamic, methods to understand how and when these factors are building in real-time and gain insight into their ultimate impact on fundamentals or valuation. Of course, there is no one analysis or approach that holds the “answer” in a dynamic market. However, an over-reliance on static analysis limits insight into how and when ESG drives stocks. The result will be worse investment decisions and financial performance.

“Our sins are more easily remembered than our good deeds.” - Democritus, Greek Philosopher (460BC to 370BC)

Many ethical investors often desire to “do well and do good” – an honorable goal. But, good intentions that are poorly executed often lead to bad, unintended consequences. If well-intentioned investors realize unforeseen losses, the entire industry will be worse off.

Good investors – with an ethical bent or not – are maniacally focused on identifying and managing what can go wrong. The sins described above are what drove a lot of investors to lose money in the past and are likely to be the reason why some will face a similar fate this time around. However, for those ethically-oriented investors that manage to avoid these sins, they stand a better chance of having good results match good intentions.