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Ethical Investing Fundamentals

By Luke Kidd 

Ethical investing, also known as socially responsible investing (SRI), is an investment strategy that seeks to generate financial returns while also delivering social or environmental benefits. For investors, superannuation holders and retirees in Australia, ethical investing can be a meaningful way to align their investments with their personal values while working toward achieving their financial goals and objectives. 

Understanding ESG Criteria 

Environmental, Social, and Governance (ESG) criteria are the cornerstone of ethical investing. ESG criteria evaluate a company's operations based on three key factors: 

  • Environmental: This includes a company's impact on the planet, such as its carbon footprint, waste management practices, and use of renewable energy. 

  • Social: This assesses how a company manages relationships with employees, suppliers, customers, and communities. It includes labour practices, human rights, and community engagement. 

  • Governance: This examines a company's leadership, executive pay, audits, internal controls, and shareholder rights. 

For example, a company that prioritizes reducing its carbon emissions, promotes fair labour practices, and has a transparent governance structure would score high on ESG criteria. These criteria help investors identify companies that are not only financially sound but also responsible corporate citizens. 

Impact Investing 

Impact investing goes a step further by actively seeking to create positive social or environmental impacts alongside financial returns. This approach involves investing in companies, organizations, or funds with the intention of generating measurable social or environmental benefits. 

A real-world example of impact investing is investing in a company that develops affordable solar energy solutions for rural communities. Such an investment not only aims to provide financial returns for its shareholders but does so by addressing poverty and promoting sustainable development. 

UN Sustainable Development Goals 

The United Nations Sustainable Development Goals (SDGs) (1) provide a global framework for addressing pressing social and environmental challenges. Ethical investors often use the SDGs as a guide to align their investments with broader global objectives. For instance, investing in companies that contribute to clean energy (SDG 7), decent work and economic growth (SDG 8), and climate action (SDG 13) can help investors support sustainable development while achieving their financial goals.

Portfolio Transparency and accreditation 

Transparency is a critical aspect of ethical investing. Investors need access to detailed information about the companies they invest in to ensure alignment with their values. This aids in research and accountability, enabling investors to make informed decisions and hold companies accountable for their actions. 

This information can be difficult or time consuming for retail investors to obtain and so investors can refer to ESG accreditation groups such as the Responsible Investment Association Australasia (RIAA) (2) to aide their research. The RIAA certifies investment products that meet strict ESG standards. This certification provides investors with confidence that the investment products they choose are genuinely committed to ethical practices and helps investors avoid "greenwashing," where investments are falsely advertised to be environmentally friendly or socially responsible. Unfortunately, greenwashing is a growing concern, attracting increased scrutiny from the corporate regulator ASIC (3).  

Performance and Outcomes 

One common concern among investors is whether ethical investing can deliver competitive financial returns. Research has shown that ESG funds can have the ability to outperform their peers as their focus on sustainability and responsible business practices helps to identify good quality businesses and sectors to invest in (4). However, if excluded industries such as fossil fuels experience strong periods of growth, a sustainable investment strategy will miss out on these returns and potentially underperform relative to the index during this period (5). 

As with any investment portfolio, it is important to maintain the investment fundamentals such as setting investment timeframes, building an appropriate strategic asset allocation, thorough diversification and professional ongoing management. These important factors will help ethical investors mitigate and control risk and meet their long term performance expectations. 

Conclusion 

Ethical investing offers an exciting opportunity for superannuation holders and investors to use their wealth to make a positive contribution to global sustainability. As this theme grows in popularity in funds management in Australia, investors should make careful and well informed decisions by understanding ESG criteria, exploring impact investing, and prioritizing portfolio transparency. Working with a financial advisor can help ensure that you are able to simultaneously pursue your personal investment goals while contribute toward a more sustainable and equitable world.

Luke Kidd