Sunday, January 22, 2006

Ethical investing

Like most people, I have investments, largely in the form of mutual funds. So that means I'm supporting and profiting (at least in the long run) from the companies whose stocks make up the funds. And which companies are those? I haven't got a clue. But what if some of them are tobacco companies? How about companies that are major polluters? Companies that don't treat their workers well (unsafe working conditions, unions not allowed, etc.)? Companies that manufacture weapons or--and this is trickier--weapons components? Obviously the list could go on and on ...

So what to do? Three choices I can think of are (1) don't invest; (2) invest to maximize profits (subject to an acceptable level of risk) and then donate some of the profits to worthy causes; and (3) invest "ethically";

Option (1) doesn't seem sensible. First of all, I don't think I have an ethical problem with investing per se. In fact it seems like a good thing to me. For example, venture capital helps support innovation. Second, I have to plan for the future (my kids' education, my retirement, etc.). Third, are there any good alternatives to investing? For the time being, let's move on to the other two options.

Option (2) is straightforward. Follow conventional financial wisdom to trade off profits and risks. As I noted above, this inevitably means that I'm to some extent complicit in the practices of the companies in which I'm investing. If I contribute some of my profits to worthy organizations, can I compensate for these harms? For example, if some of my profits come at the cost of polluting the environment, can contributions to environmental organizations make up for the damage done?

Option (3) is to invest ethically. For example, I might avoid investing in tobacco companies, companies that I judge to be egregious polluters, and weapons manufacturers. But how am I to do this? I'm not sure I have the time and energy to research the practices of various companies on an ongoing basis. An alternative is to purchase "ethical" mutual funds. A number of such funds exist, with different definitions of what types of practices are unethical. An obvious problem is that "ethical" mutual funds are likely to underperform. Naturally, if ethical considerations are ignored, there's a broader choice of companies in which to invest, and a competent fund manager ought to achieve higher profits. Compounding this, is the issue of management fees. Someone has to do the ongoing research to judge which companies have ethical practices, and this comes with a cost. I've been told that, indeed, "ethical" mutual funds generally don't perform as well as other funds, delivering a long-term absolute rate of return perhaps 2% lower than other funds.

So why not return to option (2), maximize profits, and contribute each year's profit differential to worthy causes? (This would be over and above my normal charitable contributions.) This seems like perhaps the best course of action, except that I have the nagging feeling that it's a cop-out.

So I appeal to you, gentle reader, to disabuse me of my misconceptions or point out what I've overlooked. Can anyone see a way out?
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Blogger Zeno said...

If you invest with an "ethical" mutual fund and realize a lower rate of return, you could reason that the difference is the amount that you would have felt obligated to contribute to worthy causes had you invested with a more worldly operation. Thus option (3) becomes equivalent to option (2).

Of course, this does not fully answer the question, because what is an "ethical" fund? You have to examine your standards versus those of the fund. The Catholic-operated Ave Maria Fund, for example, claims a good rate of return and says it invests in only "pro-family" and "pro-life" corporations. This excludes most pharmaceutical companies as well as any business that offers domestic-partner benefits (automatically defined by Ave Maria as "anti-family"). As such benefits become more common, Ave Maria's opportunities will diminish.

I also noted from Ave Maria's most recent investors' report that it put money in Diebold. For some reason, a manufacturer of notoriously unreliable voting machines is considered an ethical investment. Sure glad I'm not on the Ave Maria Fund's board of directors.

I certainly haven't answered your question, have I?

4:24 PM, January 22, 2006  
Anonymous Mike Anderson said...

If you think of money as fungible, then for many of the larger mutual funds, it's a case of "If you don't invest in it, someone else will." It's hard to see how your participation (or its lack) will make much impact, unless your name is CALPERS. Add to that the problem that Zeno pointed out--"ethical investing" is a vaguely defined practice--and you've set up a pretty hard problem.

My take is to think like Taguchi, and control those things that I can control: my individual stock investments, my charitable contributions, and my participation in obvious scams (e.g. I refuse to buy state lottery tickets). I favor an approach that includes contributions because you can concentrate them where you think it will do the most good; sometimes a few hundred bucks at the right time and place makes a big impact.

One other thing I like--contributions are active, not passive.

11:04 PM, January 22, 2006  
Blogger StephenH said...

Putting aside the subjective nature of ethics, judging firms by some ethical benchmark is itself problematic: How much air pollution is too much? And would you also reject companies that make pollution control equipment because they, in essence, profit from pollution? These matters cloud the investing issues. For now, let's assume that we can agree on a list of unethical practices; this would include all those activities that we don't happen to like because they have a negative impact on us (personally, or as a society). We would like our investing to contribute to reducing or eliminating these practices.

Now, economic models usually assume that agents (people and companies) affect each other only through the price system (if nobody likes a company's product, the product's price and likely the company's share price will fall). Non-price impacts are termed "externalities" (external to the pricing model). So, our list of unethical practices is really a list of negative externalities.

We can think of externalities as arising because there is no market for the "good" in question. For example, air pollution is a negative externality of many manufacturing processes, because there is no market for the right to pollute. Our general, societal response to such market failure is to tax and/or regulate the activity (or possibly outlaw it entirely).

Just for a moment, let's presume that a market does exist for each of the externalities on our list. Companies that need to pollute could buy the right to a quantity of emissions (in fact this is already happening in a limited way in Europe). The cost of these rights or licenses, would, in a free market, reflect their relative levels of supply and demand. A higher price would indicate greater societal aversion. Companies expending monies on such items would have lower profits than they could otherwise earn (which creates an incentive to decrease that activity). (For brevity, I am skipping a few links in my chain of reasoning here...) In such a world, you could invest in all firms without any ethical considerations because all the bad stuff gets balanced out in the markets (product and stock market prices would adjust to reflect ethical concerns.)

In reality, we will always have externalities, and no markets for (most of) them. Still, our societal responses (taxes and regulation) do impose costs on firms and act to diminish undesireable activities. If they could be perfectly implemented (narrow focus to minimize unintended consequences, appropriate tax rate, or quota, etc, etc) these responses would control the activity (that's a BIG "if" ... the collapse of communism bears witness to the triumph of market forces over central planning!) In that case, we could still ignore our unethical activity list and invest based on other criteria.

But, the very existence of our unethical activities list implies that these activities are not adequately discouraged at present. Based on our list we could choose to exclude certain firms from our investable universe (Nick's "Option 3"). This would act as a disincentive to continuing with the negative activity (less investment means capital is more expensive, and that is a real cost to companies). Hence, we achieve our goal of reducing or eliminating the activities. Is this realistic? relies heavily on the assumption that we all agree on the unethical activities list. If only some people refused to invest, it would have only a "marginal" impact on the unethical activity. So, ethical investing is unlikely to achieve our personal goals (reducing the unethical activities we personally dislike).

Option 2 ("invest and donate the difference") strikes me as more activist. First, ignore the externalities list and invest for maximal profit. Then use whatever portion of your gains you deem "ill-gotten" to attempt to undo the harm done by the externalities. You might donate to charities, or lobby government for stricter regulation, etc. In this case, you can target those unethical activities that seem the most egregious to you.

Thus far, Option 2 makes the most sense to me (more later if I get time!)

12:05 AM, January 23, 2006  
Blogger Nick Barrowman said...

Thanks for all the thoughtful comments! Let me try to reply to them.

I agree that the question of what is ethical is not a simple one. If it were, a lot of ethicists would be out of a job. Nevertheless, I suspect that on many issues there would be substantial consensus. Perhaps this sounds implausible, but I think we often focus more on our points of disagreement than agreement.

Mike write that "It's hard to see how your participation (or its lack) will make much impact". Well, sure, but if a lot of people changed their behaviour there could be a large impact. And as I suggested above, I think there's more consensus out there than is often believed. I mean, who thinks dumping industrial waste into the ocean is a good idea? In any case, I think it's incumbent on each of us to try to do what we believe is right, even if it doesn't seem like it will have much impact.

I agree with Mike and Stephen that the active nature of donations is very appealing. But here's what bothers me: what if the damage done is greater than the profit? For example, let's say a profit of $1M is achieved at the cost of polluting a river, the cleanup of which costs $2M. Or consider a landmine that blows off a farmer's leg, causing immense physical and psychological trauma, and robbing his family of 20 years of productivity. Can the profits from the manufacturer of the landmine compensate for that?

Maybe what follows from this line of reasoning is that charitable donations aimed at rectifying the damages of unrestrained capitalism (a.k.a. "externalities") are ultimately inadequate. Perhaps a large part of the donations should be aimed at lobbying government to establish appropriate regulations. But there's a problem here too: we have ample evidence that profitable enterprises often spend vast amounts of money to lobby governments to get rid of such regulations! Maybe I'm being pessimistic, but it seems to me like they're winning: for the most part we haven't been moving in the right direction. Clever approaches, like markets for externalities, may help. But I think it's going to take much more than that.

9:33 PM, January 23, 2006  
Blogger Jordan said...

I agree that it can be difficult to decide what constitutes ethical behaviour in investment. But even if one does not agree with all positions taken by an "ethical" investor, one may find enough of a fit.

Regarding underperformance, I agree that many ethical mutual funds seem to have underperformed (I had to bail out of one recently) but I do not think you can generalize.

In general, depending on the time frame you examine, "ethical" investing seems to result in performance that is roughly the same or better than general stock indices. Meir Statman of UC Santa Clara has done some academic research on this question.

Now, part of that under-/over-performance is tied to the performance of tech stocks which usually pass through ethical screens -- so performance was excellent during the boom but took a beating after the market burned off that fad.

Check for an example of an index (located in Canada) that has consistently overperformed.

Also, Innovest (also Canadian) has done backtesting on actual portfolios and currently manages "ethical" portfolios for some large institutional investors. Their website is:

In general, however, North American investors and academics lag far behind Europe and the UK in examining the issue of ethical investment. What others are finding is that ethical behaviour by companies may or may not add value, but it does serve as a usefull and financially relevant proxy for a higher standard of management in general. The United Nations just released a report on this subject but I do not have the link.

11:57 AM, February 02, 2006  
Anonymous Megan MacDonald said...

Is it the responsibility of NGOs, nonprofit organization and green companies only to think about the ethical investment and not us?

Unethical investing is actually a series of individual unethical decisions. I think coolest way to fight with it is that every individual should at their level make ethical choices (See: This will for sure bring a sustainable development and a strong economy.

8:44 AM, August 28, 2009  
Blogger Nick Barrowman said...

Thanks, Megan, for your comment and the link. I agree that all of us need to think about the ethical aspects of our investment decisions. But sometimes we're insulated from those ethical considerations, and it's too easy to ignore them. Many of us are invested in mutual funds and pension funds without knowing much at all about the companies that are involved. I think it's important to make it a priority to know what we're supporting both directly and indirectly.

9:28 AM, August 30, 2009  
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2:15 AM, October 13, 2018  

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