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May 30, 2016

Sustainable investing: How to do good and still make money

Many people are investing to make a positive impact in their country and around the world. This is often referred to as Socially Responsible Investing (SRI) – basically an investment strategy that seeks to consider both financial return and social good. What are the options for investors who are looking to promote concepts and ideals they feel strongly about?

SRI is no longer a niche – it has gone mainstream and we give here a brief overview over the investment landscape. We sort through the jargon and marketing pitches to help you find a sustainable strategy that is right for you.

Three main investment strategies

Even based on the same values, there are many different ways to invest. Some investors will want to exclude companies with questionable practices, otheres want to reward company’s behavior and a third group wants to actively push companies to do better.

1. Negative screens

Negative screening excludes certain investments based on ethical and/or environmental criteria. The key concept of this strategy is avoidance, rather than engagement. Examples of exclusion lists:

  • Sector: guns, tobacco, alcohol, gambling
  • Country: only democracies
  • Religion: Sharia conform investing

Advantage: With clear rules, investors know exactly what they get and can easily compare funds that follow the same exclusion lists.

Disadvantage: This approach may calm your conscience but does it change the world? If you think about it, companies that engage in questionable activities would like nothing better than if everyone who disapproved of their practices sold their shares.

2. Best-in-class

This approach considers certain criteria in investment analysis. It ranks the companies in their universe and only invests in the top rated comanpanies.

Advantage: This approach is suitable for low-cost indexfunds. Allows broad diversification.

Disadvantage: The rating system may not be similar from fund/index to another and thus an objective comparison is often difficult. You can also end up with questionable companies, simply because they are better than the worst in their sector.

3. Impact investing

The key strategy here is engagement. Selling a company’s stock on the Exchange due to negative screening has virtually no direct impact on the company. This is because on a Stock Exchange, the money does not go to-or-from the company; the Exchange facilitates the transfer of stock from one third-party owner to a subsequent owner — such that the company may not even know the transaction took place. If you directly want to change a company’s behavior, you need to use your shareholder rights and get actively involved.

Advantage: Potentially biggest impact

Disadvantage: You can end up owning those companies you find least agreeable (but where you have a chance to make a real change). Costs involved. Higher risk. Not suitable as a core investment.

What to look out for

Basically the same rules apply as for traditional investments:

  • Don’t overpay. No matter how well-intended an investment strategy may be, it can’t avoid mathematical reality. Every dollar investors pay in fees subtracts from returns. At Ipanema Capital we screen out funds that cost more than 1.0% p.a. We also do not accept performance fees. SRI shouldn’t be a wealth transfer to the fund management company. Too often we find investors who want to do good getting fleeced by the financial services industy.
  • Always reduce risk. The easiest way to reduce the inherent risk of investing is to diversify. Avoid thematic funds as much as possible. Invest globally and across different sectors.

What are the pros and cons? What about risk and return?

SRI carries a higher risk simply because they have a smaller investment universe. Less diversification always means more risk.

What about the returns? The conclusion we can draw from the available studies is that SRI investing has important negative consequences for returns. Morningstar estimates that social impact funds returned about 5 percent a year over the past 10 years, lagging behind large-cap funds by 1.1 percentage points a year. Another large study showed that there is strong evidence that an increase in the level of SRI comes at the expense of a reduction in performance. According to this study that covered nearly 2,200 funds, low-SRI funds underperformed by -0.7% p.a. and high-SRI funds by -1.5% p.a.

Summary – Don’t expect perfection

No company does only good in the world. A wind energy company might not treat its workers well. A LGBT-friendly company might still be a big polluter. Even the best fund managers can make mistakes – until Oct. 6th, Volkswagen was still included in the Dow Jones Sustainability Index.

There are many ways to combine investing and your ethical approach to life. One alternative to SRI is to actually avoid SRI funds and donate the higher expected returns to the charities that you are passionate about. This way you can make a direct impact on the causes you care deeply about and get a tax deduction at the same time.

It is therefore paramount for investors to decide what they feel strongly about. We can help you to find out what is important for you and then pick the investments that are most suitable.





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