Taking an ethical stance with your investment choices doesn’t condemn you to under-performance. While there’s a long-held misconception that ethical investors pay dearly for the privilege of favouring companies committed to ESG (environmental, social and governance) principles, nothing could be further from the truth. Given that assets invested according to ESG-related strategies reached $30 trillion globally in 2018, Intelligent Investor senior portfolio manager Nathan Bell reminds investors that ethical investing can no longer be dismissed as a short-lived fad.

Here in Australia, Rainmaker research reported a 76 percent annual growth in ESG products (to $1.8 billion) in the three years to 30 June 2020 – almost three times the growth experienced by the rest of Australia’s exchange traded products market.

Investors don’t need to make a binary distinction between ESG and returns. Taking account of environmental, social and governance considerations in an investment process is not only important, it can improve investment outcomes.

ESG linked to returns

There’s now irrefutable evidence of a clear link between ESG investing and more informed investment decisions, plus better risk-adjusted returns in the long run. A renowned meta-study of 2,000 academic studies, reveals a 90 percent non-negative link between the incorporation of ESG factors and corporate finance performance, while 63 percent identified a positive link.

Fast forward to 2020, and the Coronavirus and its aftershocks have put a greater spotlight on the importance of ESG issues, including income inequality, diversity and inclusion, social justice, employee welfare and climate change to name a few.

While some investors assume that ESG-investments are synonymous with sub-par returns, to date these fears have been unsubstantiated. For example, a recent study also reveals that in first quarter of 2020, over 90 percent of sustainable indices out-performed their parent benchmarks.

What sceptics can take from this data is a clear reminder that if done right, ESG investing can be immensely profitable.

Intelligent Investor has top performing Ethical Share Fund

One ethical fund to out-perform its benchmark is the Intelligent Investor Ethical Share Fund (ASX: INES). Morningstar figures show that with a total return of 7.14 percent, INES is the number one ethical fund compared to 100 similar ethical managed funds benchmarked to the ASX/200 in the 12 months to 30 June 2020.

As the fund manager of INES, the fund’s out-performance during one of the toughest markets in history, can be attributed to its heavy focus on owner/manager businesses. Focusing on owner-managed companies, where the person running the business has most of their personal wealth invested – right alongside clients’ savings – is one of the most statistically reliable ways to out-perform the market. The out-performance of technology and healthcare stocks, both at home and abroad, can be attributed to the founders’ ability to increase their competitive advantages during a downturn.

The decision by weaker rivals – worried about refinancing debt and losing customers – to pull back on critical investments and marketing during COVID, has reinforced the market positions of the better run insider-owner businesses. By offering superior service when it matters, insider-owner businesses have been instrumental in taking market share off their competitors.

Given the concentration of technology and healthcare stocks – which have performed well during COVID – within ESG portfolios, the market attention they’ve attracted in the last six months isn't surprising.

Ethical funds by nature push investors into high quality businesses, which due to their strong growth trajectory, and robust balance sheets are often economically immune from cycles. All that pays off in a crisis, which is why those stocks recover the fastest.

Filtering for better returns

Listed in June 2019, INES is an active ETF designed for investors seeking a diversified basket of Australian companies with growing sustainable profits. The 20-plus stocks held within the fund, including the top five – Frontier Digital Ventures Ltd, Audinate Group Ltd, Seek Ltd, Pinnacle Investment Management and Carsales.com Ltd – are selected due to both their discount to valuation and their low risk of interruption from mounting threats linked to ESG factors.

Much of the fund’s out-performance is due to only selecting from the ASX-300, stocks that pass the ESG filters – including a commitment to addressing environmental, social and governance challenges.

The fund generally won’t invest in companies that make most of their profits from non-ESG sources, like tobacco, gambling, alcohol and resource companies.

But what’s important to note, is that by taking up this [ESG filter] process, investors are not giving up returns.

When we applied the ESG negative screen to the 420 BUY recommendations made by Intelligent Investor since 2001, the average return from the companies that passed (the ESG screen) was 14.8 percent annualised, compared to 10.1 percent for those that didn’t.

Really good businesses aren’t resource companies, they’re the ones that can produce consistent long-term profits, control product pricing and this is why we’ve made such good returns.

Nathan Bell is Nathan Bell is Intelligent Investor senior portfolio manager.