Is it fair to say that if “ethical companies” are good investments they will end up in vanilla ETFs anyway because they will be in the top 300 or 500?
June 15, 2021
We explore the growing trend towards ethical investing.
We break down exactly what it is, how it works, the pros and cons and how you should decide whether it’s right for you. We cut through the noise and share the important things to consider before diving in to ethical investing.
You’ll also hear how we are approaching ethical and moral issues and whether we plan to change our investments going forward.
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Dave: [00:00:00] Hi everyone. And welcome to a new episode of fire and chill. Glad you could join us today. We’ve got a special episode for you, and it’s a pretty juicy topic. We’re going to be talking about ethical investing. So I will explain what it is, how it works, the pros and cons and how you should think about ethical investing.
If you do decide that it’s something you want to do with your investments. And we’ll also come with some of the things that we think that. Tend to get overlooked when it comes to ethical investments. And, we may even squeeze in a rant. So stay tuned for that. Okay.
Pat: [00:00:50] or two or three or we’ll get, I think Dave and I are going to have a lot of fun with this episode. I think the first thing I just want to say is this episode was spurred on by the recent changes of the IWLD ETF, which was originally an all world share equity fund offered by BlackRock. And they recently changed it to an ethical fund, like right from under the feet of its existing investors, which I think.
Was a pretty crappy move for their existing customers in that fund only because whatever you think about ethical investing, once you’ve invested in a fund and you’ve been in it for a few years, you’ve got embedded capital gains. So if the investment fund manager comes along and changes the mandate of that fund, now you’ve been forced into a fund that you might not necessarily want to have invested in, but you’ve got these embedded capital gains.
You’re stuck with this hard decision of realizing those capital gains or sticking with a fund that you might not be happy with.
Dave: [00:01:53] Yeah. And that’s that’s almost a slap in the face to the investment base that they have because the customers that are in these funds have invested. In that fund because it was a, that’s one of the benefits of index fund is that it’s a rules-based investment. That’s not gonna change from under you, just because someone makes a different investment decision.
Like a, an active manager might. To have the fund change while you’re invested in it. And it being a big, broad, relatively boring index fund where you think it’s going to stay the same. That’s, that’d be really annoying. So I can imagine people are pretty frustrated with that.
Pat: [00:02:28] yeah, I’m not even invested in this fund. And I was pretty frustrated with it. And only because I W L D I felt was the only real competitor to VGS in the Australian market. And it was a pretty con like compelling competitor as well, because they actually offered a lower management fee. But the structuring was just a bit, not ideal.
Like it was a fund of funds and it was a fund of overseas funds to as well. So I think that’s why they weren’t as popular in the first place. Whereas VGS is total replication in Australia, not a fund to funds, even though it had a slightly higher fee, it was more popular for that reason.
Dave: [00:03:08] Yeah.
Pat: [00:03:08] And so now, VGS sits alone in the Australian market, as far as I can tell as the only like developed world ex Australia index fund
Dave: [00:03:18] um, and I suppose, some people might just wonder why didn’t they just create, if they wanted to make an ethical global index fund, why didn’t they just make a new fund rather than change the existing one? Which people were quite happy investing in to begin with.
Pat: [00:03:32] Yeah, so I think. I W L D must just not have been as popular as they were hoping for it to make it maybe as profitable or as economically viable as they needed it to be. And again, they, I think they could have just tweaked a few structuring things and it would have been a massive elite popular fund, but it was just these small little structure, things that needed to change for them to get there.
And not this wholesale change of mandate, but I digress. Obviously, if they just change the mandate of this fund, then they’ve already got an installed user base providing fees for this ethical fund. Whereas if they started at an ethical fund from scratch, they wouldn’t have had an installed user base and they wouldn’t have had those fees coming in straight away.
Okay. So I think it’s a pretty sad day for Australian investors to lose total world ex Australia index fund.
Dave: [00:04:22] At least they, they’ve got those capital gains perhaps to pay, or they can stay in the fund if they want to. And they don’t really mind the changes, but they do have other options
Pat: [00:04:30] But the thing is like if someone wanted to invest in an ethical fund, they would have done that. Like they wouldn’t have invested in IWLD to begin with,
Dave: [00:04:38] That’s what I was thinking. You know, this isn’t what I signed up for.
Pat: [00:04:41] Yeah, no one in IWLD would have invested in IWLD. If what they wanted was an ethical fund, because there was already competitors on the market offering ethical funds.
Dave: [00:04:51] Yeah.
Pat: [00:04:52] So I don’t think this helps any of their installed user base. Unfortunately,
Dave: [00:04:56] Okay. So let’s move on and let’s get into today’s topic. And first we’ll just, let’s run through a little bit about what is ethical investing and we’ll explain the ins and outs a little bit of it.
Pat: [00:05:07] Yeah, ethical investing, which for our purposes just means investing in assets that meet certain ethical or moral standards. And Dave and I are just going to shrink this right down to what most people mean. Which is just like an index fund or a fund. We can invest in companies that people deem to be more ethically run companies for whatever criteria reasons we’ll get into soon.
Dave: [00:05:31] and you might’ve seen this also mentioned as ESG investing and the ESG stands for environmental, social and governance. So these are the things that basically the companies are measured on and I’m judged by. And whether of whether they meet certain ethical or moral standards. And a common way to do this is really just by starting with an individual index fund, which already has all of the companies available in it.
And then essentially filtering out the companies or the stocks that don’t meet the ethical criteria that the fund has set. So the most popular type of way to do this, which you’ve probably heard about is some ethical funds or exclude things like tobacco companies, or maybe gambling stocks, or alcohol producers, or maybe firearms producers as well.
Pat: [00:06:20] So there are so many different types of ethical funds that it’s actually hard to keep up. There’s lots of different filtering, lots of different criteria. It all really starts to get a bit confusing. So some funds will avoid stocks like oil, gas, mining, some avoid, even big banks. They’ll avoid food companies, payday lending, certain chemical manufacturers.
The list is endless as to what someone may consider ethical or unethical. And what would be included in this sort of fund.
Dave: [00:06:51] And so I guess the idea behind this is to construct a portfolio where none of your money gets invested in companies that are deemed to be maybe less ethical or unethical, or even in questionable industries. Which on the surface sounds pretty reasonable. Wouldn’t you say?
Pat: [00:07:10] It does sound reasonable. That’s why they’re so popular. Right?
Dave: [00:07:13] yeah. So let’s get into some of the pros and cons of ethical investing. Then
Pat: [00:07:17] When you invest ethically, you get to invest in a way that you feel better about. You can avoid having your money in companies that you think are causing damage or harm to the planet or people or animals or whatever ethical standard that you hold dear to yourself.
Dave: [00:07:31] ESG companies, they can even attract more customers because people will choose to buy from certain companies whose ethics aligned with their own. And you might see, have seen. People making different purchasing decisions over recent years because of things like this. And so if that’s the case, certain ethical companies might survive longer or they may become more profitable as a result of the way they’re run and the way they’re managed like that with certain standards.
Pat: [00:07:57] So when you invest ethically, you can have a small effect on how hard it is for that company to raise money in the future or how expensive it is for that company to raise money in the future. So the more money that flows into ethical companies that reduces their cost of capital. If they do want to do fundraising in the future and the less money that flows into non ethical companies say tobacco companies, when they need a raise money in the future, it’s more expensive for them to do so
Dave: [00:08:27] And so I suppose the last benefit of ethical investing that we’ve got here is that you’re still likely to achieve pretty decent returns over time. Assuming you’re still investing in a reasonably big sized basket of different companies. Well, what’s the downside, pat? Those things all sound pretty decent
Pat: [00:08:43] yes, they do. So one of the big downsides is higher investment fees. Some funds are only a bit more expensive than a typical index fund, but others are way more expensive than a typical index
Dave: [00:08:54] and it probably depends how much filtering they’re doing and how much, I don’t know. I don’t know about thought and effort and care, but how much. How much criteria and different things that they’re trying to follow for that particular fund. So you can imagine a fund that has a huge list of criteria that where the manager has to do a lot of digging and a lot of research into that company’s procedures and how it’s run.
That would be a lot more time consuming. And so you can imagine that fund might charge a higher fee as a result of that extra work involved.
Pat: [00:09:27] Yeah, definitely. And because you’re excluding a bunch of companies. What’s it going to end up happening is you’re going to deviate from the market return in some way, you’re going to get like tracking error. And so the less likely the index that this ethical fund is for more different to the index returns you’re going to get.
And I would say, and I think Dave would agree you would probably actually get slightly worse returns over the long-term than you would out of just a plain vanilla index fund.
Dave: [00:09:54] That’s, that’s what the average is, would say, because we’ve, as we spoke about in our episode on index funds, which was episode number 12, a lot of the market’s returns over time, end up being driven by a…say the market returns 8% per annum. That’s not what every stock returns.
Definitely not. So there’s a big, big skew in returns and what performance different companies achieve over time. And so you end up finding that the market is heavily led or the market’s return is driven by a small group of very very big long-term winners. And so if you’re excluding companies, for whatever reason, you are increasing your chances that you may miss some of these big long-term winners and end up achieving a lower performance as a result.
But the thing is, I suppose we don’t know in advance, which ones those are going to be.
Pat: [00:10:52] no, definitely not. This is like getting a bit into active fund investment. I think something else that like really needs to be said is. Choosing a company that is ethical or unethical is actually a lot harder than it sounds who’s actually making these decisions. Do those decisions align with your beliefs?
Like where exactly do you stop? Do you consider apple an ethical company?
Dave: [00:11:16] Yeah, okay. The marketing tells us that we can do better, while doing good. So I’ve actually seen this multiple times, whether it’s on TV or on the internet in various places, they’ll say that you can achieve better performance and you can essentially save the planet or do, or these help these causes that you might care about.
They basically are saying that ethical investments are better anyway, and you can achieve better returns as a result. So they’ll often say look at the last five years performance or something like that to prove that, Hey here’s a good example of how you can do better while making a difference in a positive way at the same time.
Pat: [00:11:52] Yeah. And let’s just clarify here in this same podcast, like a little earlier, we said some of those companies may do better over the term that does not mean that you as an investor in one of those companies will do better over the long term. At all. So let’s get into this. Some people will look at like the past three, five or 10 years of ESG performance, and they’ll see that it’s actually done really good over the last three, whatever 10 years, compared to a plain vanilla index fund.
And that will conclude, oh, look. We thought ethical funds would do better. They have done better over the last 10 years. Therefore ethical funds really can give you better returns and you can invest in an ethical way as well. But this is actually just a really this is actually just a trick, right? Because. What I suspect is happening, and this is a bit of speculation. So a bit of speculation ahead, just warning, the funds because they have this ethical flavour to them. People have been buying them up over the last five to 10 years, and this has nothing to do with the expected returns of the ethical fund.
This is just about the food flavour preference that some people have for ethical investing. So this sort of piling in of people who want to invest ethically into ethical funds is driving the funds to increase in price and driving the companies in those funds to go up in price, which is giving the appearance of improved returns over the long term versus a plain vanilla index fund.
But you have to remember that. Yeah. The people who are buying these ethical funds, they’re doing it for, regardless of whether they’ll get better performance over the long-term or not. There has nothing to do with the company’s earnings yield, their expected growth. Any of that, like there’s no price discovery or, sorry, I shouldn’t say there’s no price discovery, but there’s a certain element of the investing population, which is buying these without taking those things into consideration.
Let’s say. And so that is driving those prices up.
Dave: [00:13:54] But let’s just say someone has the argument that well, if those companies do better in the future as well, and the other companies, or the less ethical companies decline as a result of their fundamentals, not popularity, then that that difference in performance will come to pass anyway.
And the ethical companies were out performing. The other ones will lag just based on fundamentals rather than where the funds are going into them or out of them.
Pat: [00:14:20] Yeah. So we’re getting into the murky territory here of active fund management, right? What you’re making there is and active argument for investing in one company over another. This is no different to saying I think China’s is going to perform really well over the next decade. So I’m going to invest in China or it’s no different than saying tech is the future, or I don’t know, space travel is the future or cannabis is the future.
So I’m going to invest in index funds that covered those specific areas. You can have, I have those arguments, but you must recognize that is an active argument when you’re saying, oh, Companies that perform ethically and run themselves ethically by my set of ethical criteria, which is different to everyone else’s set of ethical criteria are going to do better in the future.
Therefore, I’m going to get a better return out of investing in those companies. This is nonsense, right? We would never like, no one here would be listening to Dave and I like you and me, Dave, if we were sitting here like some of these more active investing podcasts telling you about why companies or why industries are going to do better in the future.
If Dave and, we sat here and talked about how healthcare and vaccine production is going to ramp up over the next three to five years. And you should invest in health care. We’d lose half our audience, but somehow.
Dave: [00:15:40] stay tuned for the next episode where we talk about the two best plays for the electric car revolution.
Pat: [00:15:46] Yeah, exactly. But somehow in the fi community ethical ESG investing gets like this pass from being scrutinized by the same criteria we scrutinize other invest active investment decisions and it’s intellectually inconsistent. I’ll say. To give it this pass.
Dave: [00:16:07] Yeah, so, so you can’t exactly say, okay. I think these companies are going to outperform because of X, Y, and Z, but then also be critical of active management at the same time.
Pat: [00:16:18] No, you can’t precisely. And so some people might try what I’ll call the meta argument. And the meta argument is I believe that more people are going to want to invest in ESG companies, which will drive the price higher over at least the short to medium term. And I’m going to try and catch that wave of investing in ESG companies while money’s piling into them.
Dave: [00:16:42] Speculative rubbish at best.
Pat: [00:16:43] yeah, so it’s still like an active argument for investing in ESG companies. And just to drive this point home. This is no different to like a substantial set of the population saying I want to invest in companies that start with the letter B The letter B. It really has nothing to do with the fund’s performance, but because a substantial set of the population is investing in those companies say, BHP, it’s going to drive the price of those companies up and that’s going to drive.
The short term return to look higher than what the long-term return is going to end up being. And because the price has been driven up in the short term, for reasons that are outside of the, I’ll say the fundamentals.
Dave: [00:17:28] The company performance.
Pat: [00:17:29] Yeah. Then you will necessarily get a long-term lower expected return.
Dave: [00:17:36] yeah, That’s fair. That’s fair. I suppose the thing is that the kind of the weird part is that can continue for a very long time. So if the funds that’s moving into ESG or ethical investing continues for the next 10, 20 years, technically those companies can keep outperforming for that long because more money is flowing into them and out of other companies that are deemed to be less ethical.
And then by then you get to the point where those ethical companies have very, very high valuations because of how popular they’ve become and other companies that are deemed less ethical become very, very cheap in comparison. So that can continue for a very long time. But then you get to this weird kind of situation where you might have just some hypothetical ethical company trading on like 100 times earnings or something like that.
And you’ve got some dirty tobacco stock that’s trading on like two times earnings and paying a 30% dividend yield or something ridiculous like that. And so then you have active investors that would essentially come in to reap the benefits of those cheap prices. And at some point prices become too high on one end and too low on the other end. And then,
Pat: [00:18:51] the market will arbitrage away the difference because there’s always going to be people in the market who are there to make the highest investment returns.
Dave: [00:18:59] so essentially what we’re saying at that point, is that while the money that’s flowing into ethical investing can actually boost the performance in the short-term in the long-term. It may be a drag on performance because those companies become overvalued because they’re more popular and become overpriced at that point.
And the other companies that are deemed less ethical become underpriced because there people are trying to void them for certain reasons.
Pat: [00:19:27] Yeah. And honestly, that’s what I suspect is happening. So the discount rate is being driven lower for ethical investment companies or companies that are traditionally considered ethical. And that’s driving that increase in price is driven completely by a crushing of the, what we call the discount rate, which is.
The expected return that an investor expects on a certain investment and it’s not being driven by an increase in the actual the expected profits coming from those companies.
Dave: [00:19:58] and I suppose what what we touched on earlier is what is ethical is not exactly as straight forward as it seems, you could be critical of banks that are pushing people into products that they don’t need, which we’ve certainly heard cases of that. And then there are things like supermarkets who take advantage of their size and can bully farmers into low prices to get so that they can have undercut their competitors.
And then we’ve also heard of tech companies which are essentially mining our data and know absolutely everything about us. So you can question that, things like that aren’t ethical. And then you’ve got maybe real estate developers are unethical because they’re clearing land. So they pulling down like forests and stuff to, to build houses.
And then you’ve got drug and cosmetics companies, which are testing on animals or using questionable ingredients. And you could also argue that basically every company is pushing us to buy things we don’t really need. That’s the ultimate ethical argument.
Pat: [00:20:58] Yeah. Where does where does the buck stop? Like you could say apple is unethical because there’s some of their practices in low socioeconomic countries. And how do you judge a company in totality based on some certain specific criteria? It’s not straightforward at all.
Dave: [00:21:16] it’s so hard. I’ve seen ethical investment funds who won’t invest in banks or people who won’t invest in banks because they lend money to mining companies. But then, so that kind of helps them facilitate their business, but then do avoid real estate trust to rent buildings, to mining companies, because that helps them facilitate their business as well?
They’re still doing business together.
Pat: [00:21:37] Do you avoid like heavy machinery manufacturers who sell their machinery to the mining companies? How about the people who do the catering at the camps? Do you avoid them too? Like Sedexo? Wait, where does it end? Like we’re so integrated. How about the, like, how about Dell who sells the mining company laptops to do their work.
Dave: [00:21:57] They’re all, everyone’s playing a part in that you could argue that for sure.
Pat: [00:22:00] Yeah.
Dave: [00:22:01] funds avoid like junk food manufacturers, which sounds, it sounds reasonable, but do you avoid the supermarkets which sell it, which that’s where most people are buying their junk food from. So do you avoid those as well? And if you avoid like power companies due to like coal and gas use, what if those, what if certain companies are also investing heavily in renewable technology over the next five years and even now. Couldn’t you argue that’s at, that’s actually helping green technology because of heavy investment into it?
So starts to get pretty murky pretty quickly. And it’s not quite as black and white as it seems.
Pat: [00:22:39] If a company is making like a lot of existing profit from their coal sale power, but they’re investing hugely into renewable energy in the future, would they still be able to invest in renewable energy if they didn’t have the back catalogue of coal customers? That they were able to sell power.
Dave: [00:23:00] And I suppose that’s the thing that really gets me. If we knew everything that was happening at every company, you’d probably only invest in a handful of them. There’s just too many things and too many people and the world is, it’s just not as clean cut as we’d like it to be.
So this stuff tends to get pretty nuanced in a short space of time.
Pat: [00:23:20] yeah, forget 50 shades of gray. This is like 3 million shades of gray, it’s, it’s impossible to pass this out properly and let’s get into this even deeper.
How do we think out these investment boards are making these decisions? Do your decisions line up with their, like your ethical components line up with their ethical compass?
Like you have a group of people sitting at a boardroom table, like ticking boxes about power consumption or, work in third world countries. And it’s just it’s so arbitrary. It’s so completely arbitrary. If you’ve ever sat in a company meeting about something, you know how arbitrary these things can be.
There can be like drags from one into the other.
Dave: [00:24:04] and you would probably find that. Companies who figure out that they’re being screened on certain criteria will start gaming the system and working for those criteria or to superficially meet those criteria while maybe sacrificing in other areas of the business, which will probably just be just as important.
Pat: [00:24:24] Yeah. Do you remember the Volkswagen diesel emission
Dave: [00:24:27] Yeah, I do. Yup. Yup.
Pat: [00:24:29] Oh, goodness. Clean diesel Volkswagen gamed, the emissions testing that the EU did for over a decade to sell more diesel cars. And they were they’ll found out like a decade later and they’d already sold millions of these dirty diesel cars onto the market.
And it was like this huge scandal, but would have been considered an ethical company maybe for those 10 years.
Dave: [00:24:55] Yeah.
Pat: [00:24:55] But anyway, that aside I suppose that’s a pretty new, like niche case.
Dave: [00:24:59] That’s the thing. If you’re against fossil fuel companies and you avoid those, do you also avoid car companies? Which are making petrol cars, it’s just so hard man to where do you draw the line? There’s just so many, there’s just so many different things that you could point to.
It’s just very hard. But then I suppose we have to bring it back to, we have to bring it back to this investment lens. So if we’re doing this and investing in an ethical way, are we actually hurting that company?
Because a lot of it comes back to, okay, I don’t want to support that company.
And in fact, I want to hurt that company. So if everyone gets together and avoids the shares of those companies, can we actually hurt them in that way?
Pat: [00:25:41] in a roundabout indirect way, which we covered a bit earlier, but directly when you buy a share in a company, you’re just buying it off someone else who already owns that share, you’re buying it on the secondary market.
Dave: [00:25:57] I think that’s something that a lot of people don’t quite realize is when you’re investing in shares, you’re not actually giving the company your money. You’re investing, you’re buying shares from somebody else who’s selling shares. So you can think of it like a property
Pat: [00:26:11] Yeah, exactly. Like your shares are being sold amongst people. It’s only in very rare cases where you’re actually giving the company money. And that’s when the company does an IPO like an initial public offering, or when a company is doing a capital raising, but those are much rarer than companies trading in shares trading between people.
Dave: [00:26:34] so just to point something out that may be obvious, but it might not be obvious. The company’s profit will stay the same, whether we buy their shares or not are buying shares from somebody else doesn’t really help the company. So us not buying the shares doesn’t really hurt the company very much either their profits don’t disappear because we’re not investing in a certain company.
And so you could argue, but if everybody does it, if everybody avoids them, then they’ll go bankrupt. Because the share price will go to zero. I’ve seen that argument before, but this like that is such wishful thinking because on what planet do they think that’s going to happen?
Because as we said before, there’s so many people watching the market every day, looking for opportunities. So if a company becomes cheap, it’ll either get bought out by another company. who has a lot of money to buy a competitor out, or it could be taken private or active investors will come in and buy those shares at the low price.
It’s not just going to disappear. It’s still selling the same amount of stuff as before, before we stopped or before we avoided buying their shares. And the, so they’re still making the same amount of profits and the value of a company’s ultimately determined by its profits at the end of the day. That’s the reason these companies don’t disappear is because people are buying their product, not buying their shares.
Pat: [00:27:54] Yeah. Correct. So unless this changes the company isn’t going anywhere.
Dave: [00:27:59] Okay.
Pat: [00:27:59] As long as the company’s able to sell products or service, and they’re able to make a profit on that. The share price apart from trying to raise capital in the future has no difference to the
Dave: [00:28:10] So, if you want to actually hurt a company you do that by cutting off its profits. So you avoid the product, you don’t avoid the shares that doesn’t, if one makes much more difference than the other.
Pat: [00:28:21] Yeah. Correct. And this is through society, changing its own behavior has nothing to do with the investment dollars going into those
Dave: [00:28:29] but I think it’s something we feel like we can control, like we’re doing something to hurt that company. We don’t like, don’t you think it’s a bit of the illusion of control. We think we’re having a bigger impact than we really are.
Pat: [00:28:41] Yeah. I also think that. The idea that you can have your cake and eat it too, like the whole oh yeah. You can still get, you can get better returns by investing in ethical companies and you’re investing ethically. Uh, that just, that gets people so excited. It’s oh, I can, I get to feel good. And I get to make more money.
Dave: [00:29:00] so nice, like high returns and save tax at the same time.
Pat: [00:29:05] Yeah. But at scale stuff, yeah. It’s just not true.
Dave: [00:29:10] There’s not a lot of point that hating on, fossil fuel companies. If you’re still driving around a Petrol car and using normal electricity every single day. You’re making no difference on the other hand while you’re fuelling their profits on the other side. Yeah, you gotta look at the entire picture, not just one tiny little increment of it.
And so that’s like a friend you have who might be blowing all their money, but then complains about the cost of living, like they’re creating the results, but then complaining about it, hoping that it’ll change even though they’re what’s driving it. So that’s, I’ve got a little, I’ve got a little example.
Pat: [00:29:54] but wait, wait. I just want to say as well, we have these investment boards with these pretty like basic, like tick-box nonsense, like are, is this, do they invest in like mining or whatever it’s you don’t even think most people would agree that electric cars are good for the environment.
Like they’re the future to make electric cars, you need a mind for lithium and steel. You can’t have electric cars without my, without mining. And so what do you do? W what decision are these investment boards making and do they, do you really think they know all the details and all the nodes of how the system comes together to be able to make sound decisions about what’s ethical and what isn’t.
It’s bloody impossible. It’s impossible. And only that it’s like it’s so naïve to think that you can make those decisions and it’ll actually be ethical. Let’s just stop mining for steel. Well, okay. We have no trucks to deliver food to people anymore. It’s ridiculous. We need. We need to work towards a better future in some way, but we can’t just make these broad brush like statements about what’s ethical and what
Dave: [00:31:11] Yeah, so many of these things is like taking one step back before you take two steps forward. The current things that we have in place that might not be ideal or might not be classed as ethical are still necessary until we. Create the new technologies to wean us off the old ones, the new technology doesn’t just fall from the sky.
Pat: [00:31:33] no, we’re a society that is like climbing a ladder and agent wrong of the ladder is built upon. All the rungs below it, like we would never be where we are today without our fossil fuel use. Let’s let’s just get that out there.
Dave: [00:31:48] Puts people off to say something like that would, you can understand why, but you can’t ignore that at the same time.
Pat: [00:31:54] No, and I’m not saying that I want fossil fuel use to continue forever. I’m with most people, let’s get rid of this shit, but like punishing companies that are keeping the world alive at the moment. Is just not a very anyway, we’re getting into our own ethical compass
Dave: [00:32:11] I’ve got one, like I’ve pretty much stopped eating meat for ethical reasons, because of animals and how they’re raised and treated and all the rest of it. So I could spend all my spare time trying to hurt Maccas and maybe some cattle farming companies or something like that by telling people to avoid their shares at all costs.
But wouldn’t, it be more effective if I was to try and convince people to actually stop buying their products. Which of those two things do you think would be more effective if I really wanted to hurt those practices and those companies? It’s not the first one. It’s not avoiding their shares.
Pat: [00:32:45] No, certainly
Dave: [00:32:46] Like as much as we wish we could. We really can’t banish companies from society. If they still have customers, because if they still have customers, they’re still. Needed for some reason, it just doesn’t work like that.
Pat: [00:32:56] Yeah, correct.
So, Dave, with all this ethical investing happening, couldn’t we say. Even without it, the world is steadily becoming more ethical over time. In any case, like long before ethical investing was ever a thing, wasn’t society marching to a more ethical place. And it has been for hundreds or thousands of years. Let’s be real here.
Our, if we look at what our, even some of our grandparents, let’s be honest, Some of the times their ethical compass is something that a young person would feel is oh, what were they thinking back then? Like 50, 60, 70 years ago, like the treatment of women in our society was like abhorrent, but now where we’ve moved in a much better place and this had nothing to do with.
Punishing companies by not buying their shares because they didn’t treat the women will. Yeah. That’s just one specific example about how is just we’re continually improving. And our attitudes are continually changing toward a better place. And it has nothing to do with how we choose to invest our money, but it does have a lot to do with the pressure that companies and society puts on companies to pay in a better
Dave: [00:34:09] Yeah, I think that’s a good way to put it because the fact that we’re even talking about it and the fact that people are so mindful really of what’s happening and the different problems that are in society, that means that a lot of people are focusing on it, which means a lot of. Attention is called to to companies to be held accountable for their actions.
Really. So if you look at, I don’t know if anyone’s really looked at company reports, but they all have a section for ESG and how they’re tracking themselves on different environmental factors maybe, or like a social responsibility. Point of view. They’re developing all of these different metrics to track themselves because they’re receiving pressure from shareholders, from analysts, from from society.
And it’s such a focus now for, even for everyday people and for companies themselves. And I think we are moving in a more ethical direction, regardless of who’s buying what shares.
Pat: [00:35:06] yeah. It’s hard to believe, but it’s the customers that put the pressure on the companies, not necessarily the shareholders, the shareholders only imperative is to make the most profits. And the way that a company does that is by pleasing their customers, giving the customers what they want, and that will make the shareholders the most profit in the long term.
Dave: [00:35:28] So, if you stopped buying a product, the company will stop making the product. All that sounds a little bit negative pat. So it might sound like we don’t at all care about the environment or about ethical things, which is definitely not the case.
Pat: [00:35:49] No, it’s not the case at all. And Sorry. I just want to point out like another example about like stuff that I do personally in my own life and how you could really look at it from both lenses. So for anyone who doesn’t know, I’m a project manager in infrastructure construction, and one of my main roles for the last few years.
Has been to improve the accessibility of train stations around Sydney. So this means for people who are less mobile, who may be vision impaired, maybe who may be elderly, like we’re putting in lifts, we’re making ramps that are very level we’re putting in disabled car parking spots. Is this practice ethical or unethical?
Like I’m doing something that is improving the lives of many people. Who perhaps used to find it more difficult to get around the public transportation network in Sydney in the exact same moment, I’m using untold amounts of energy and concrete and steel, and like hundreds of thousands of hours of like worker time and driving diesel trucks and machinery back and forth to get this all done.
Where does that sit on the ethical scale?
Dave: [00:36:57] it’s tricky. Isn’t it?
Pat: [00:36:58] It’s so tricky. It’s impossibly tricky and yeah.
Dave: [00:37:02] that’s a good little example because there’s, there would be a lot of cases like that where there’s something happening, but then it has a double, it has an effect on both sides. So there’s some good to it, but there’s also some not so good to it. The way so many things are.
Pat: [00:37:19] yeah.
Dave: [00:37:20] so how can we actually be more ethical and have more of an impact then if we’re saying, it’s not going to make a world changing difference by avoiding certain company’s shares, what can we do?
Pat: [00:37:30] I think mostly we have to use our power as consumers and as people who buy products and services, because that is when you buy a product or a service, you went directly providing the profit for companies. So as a society, we can direct our behaviours to make purchases and to buy services that actually make a huge, tangible, and immediate difference.
The company profits, and that’s what actually matters.
Dave: [00:37:56] Without that profit of that company dies. So if you want to support certain companies because they are ethical and hurt other ones, because you deemed them to be less ethical, you do that with your purchasing choices first and foremost. So let’s say that our top priority is the environment. We can do a few things about that.
We can drive less or get an electric car. I suppose we can use solar power.
Pat: [00:38:20] as long as you’re okay with the steel mining and the lithium
Dave: [00:38:23] That’s the thing, I didn’t do that. So it’s already been created, isn’t it? That’s the thing. You can use solar power. You can eat less meat, use less plastic plants on trees and buy products, which are from companies that you deemed to have been kinder to the environment when they made their products.
And so I suppose one way you can use money and your investments in a certain way is to invest in, normal, low cost funds, like you would normally, and then take whatever money you like from your personal account and donate that directly to causes that you care about. And again, that will make immediate direct and tangible impact on what that organization or that charity is doing.
Pat: [00:39:10] that’s right. And another way is to just buy less stuff overall, upgrade your electronics double the time it takes for you to upgrade your electronics. Say from two years to four years, You’re making a huge, actual difference to the amount of like stuff that ends up in landfill and the amount of new stuff that has to get manufactured on your behalf.
Dave: [00:39:33] I think the There’s a bit of a misnomer in the, green product space. A lot of it’s, there’s a lot of marketing in it. Most of the time, the greenest choice of all is to not buy any product. So it’s to use what you currently have because whatever product there is, there’s a lot of materials and resources and water and energy and transport that’s gone into that product to making it to the shop for you to purchase it. So usually the kindest choice is to not buy anything.
Pat: [00:40:01] Definitely. Definitely.
So one idea, if you are into ethical investing is to say, instead of making ethical investments, just invest in normal low-cost index funds and take a bit of your profit each year and donate it to charities that you think are worthwhile, that you perhaps do something for the environment or do something for other people, which is a way that I think would be a much better way to do
Dave: [00:40:27] Yeah. And just as a side note, you know that because if we have that big basket of companies, that’s not had any filters applied. So just take a normal index fund, for example, there’ll be some companies in there that you don’t like and that you wish would go away or hope go away over time. For me, that’s completely fine.
I’m happy if some of the companies in my fund disappear and go broke over the long term because their profits aren’t sustained because maybe green energy takes over and all the rest of it.
I’m happy about that, but it’s still makes sense to me to own the whole basket in the first place. So that’s what I’ll be doing, investing in normal funds and then taking my spare cash or whatever, and donating directly to stuff that I care about.
Pat: [00:41:10] yeah. Good stuff. So how about our takeaways and final thoughts for the episode, Dave?
Dave: [00:41:15] if we had to boil it down, really, we’re not against the idea of ethical investing, it’s just really easier said than done. There’s a lot of nuance to it and it’s a few flaws and honestly, some of the marketing is a little bit silly and that making promises that aren’t really fair.
Pat: [00:41:35] Yeah. I this whole better returns plus change the world, it’s noble and all that sort of thing. But I think you, I have to say this again. You will necessarily get worse returns if you’re making decisions based on something other than investment returns. And that’s just the mathematical reality.
Dave: [00:41:58] That’s the likelihood. Anyway.
Pat: [00:42:00] look without getting into active investment decisions, which I think we have covered in previous episodes, let’s accept just off the cuff. Cause we’ve said in other episodes that we’ve proven, not proven, but we’ve shown the evidence that active decision-making doesn’t improve returns. So on the balance of probabilities, We accept that active investment.
Decision-making doesn’t improve returns. Now, if you’re going to make decisions for a reason, other to deviate from the index that has nothing to do with returns, you will necessarily have to get on the balance of probabilities, worse returns than otherwise, because the decisions you’re making have nothing to do with returns.
Like we can’t even get better our returns by making decisions with a focus on improving returns. And we’ve proven that active managers can’t do that. Now. We’re not even looking at returns and we’re making different decisions about our investments and with where somebody people are getting lulled into the belief that this is going to improve returns.
And then they’re using active arguments such as oh, ethical companies are going to be the leaders of the future. That’s now you’ve just injected an active reason for making that
Dave: [00:43:12] Yeah.
So if you are going to invest in ethical funds, do it because it’s what you feel good about, and it’s how you want to approach your investments. Don’t do it for the reason of hoping, expecting that you get higher returns.
Pat: [00:43:26] Yeah, I think that is a very important point. It’s you have to make this decision with your eyes open, that it will most likely not lead to a better return. There is a possibility that will, but that’s a random possibility. I’ll say.
Dave: [00:43:41] and ethical investing does come from a really good place, but it’s not quite as simple as it seems. And there is a few downsides that are glossed over, which we’ve discussed today and it can help us make make us feel like we are making a difference. But when you think about it properly and you consider like the big picture, there are a lot of other things that we can do personally, that will have a much bigger impact than avoiding certain companies shares.
But at the end of the day, ultimately, it’s up to you. We can’t really give any recommendations here on ethical funds, which ones are better than other ones, because like we said, it’s very nuanced and you have to decide, if you want to apply an ethical filter and what kind of funds you want to invest in depending on your own ethical goals, I will say.
So we just say that hopefully that fund is relatively low costs and that it’s as diversified as it can be. And you’ll find that some of the big ETF providers do provide ethical funds, like Vanguard or betashares and others like that. So if you are keen, have a browse around and see if some of them make sense to you.
Pat: [00:44:45] no recommendations, but maybe consider the, using some of your own money to invest in the ethical causes you believe in. And let that reduce your return rather than investing in an ethical fund, which will also reduce your return. And I’m going to say it, necessary mathematically, if a price of an investment is bid up for a reason other than its expected return, then mathematically, it must give you a lower expected return over the longterm.
So you can have a more direct impact on the things you believe in by taking some of your money and putting it there, then accepting a lower return for no apparent
Dave: [00:45:26] that what you’ll be doing Pat?
Pat: [00:45:28] Eventually. Yeah, for sure. Maybe I should start that sooner.
Dave: [00:45:32] Get onto it.
Pat: [00:45:33] Yeah. Watch this space.
Dave: [00:45:38] All right. So that’s it for today’s episode. We just want to say thank you for listening. We appreciate you taking the time out of your day to listen to our show as always, we hope we’ve given you some food for thought, and don’t forget, you can find us and more from us at our blogs. You can find pat and his blog, lifelongshuffle.com.
And you can find me at my blog, strongmoneyaustralia.com. Also, if you have feedback or you have topics, suggestions, or maybe some questions for us, you can send those through to email@example.com. Thanks again, and we will talk to you next time.
Is it fair to say that if “ethical companies” are good investments they will end up in vanilla ETFs anyway because they will be in the top 300 or 500?
I bought MEC at its IPO a few years ago, and have added over time. Pays a steady dividend and price doing well – I sometimes forget it’s ethical.
The common sense you guys speak is so refreshing!
I did have a look at some offered ‘Ethical’ ETF’s a while ago, and came to the same conclusion that essentially all companies in all offered ETF’s can be marked as unethical in some way, shape or form.
Just own the main index funds and let society take out the companies doing the most harm, no point in essentially creating your own ethical portfolio which would more than likely underperform most index funds.
I did find it interesting however that Woolworths has demerged its Liquor and gambling arm ‘Endeavor drinks’ with one of the (reported) main reasons of being more attractive to ethical institutional investors. Anyone thinking Woolworths won’t continue to utilise is vast logistics network for the Endeavour business is kidding themselves, especially as Woolies will continue to hold an almost 15% stake in the business. Again just of an example of a company advertising itself as ‘ethical’ on the surface to fool the ‘masses’.
I’m not an ESG investor and never will be. However the below rant some ups why I give people a free pass:
One way to look at it would be that ESG investing is a way of some people saying. I’m no saint and definitely in it for the money, but I don’t need to be a complete dick about it. I can still make a good profit from my investments, whilst only supporting ethical companies. This way I’m only investing in the future, infrastructure and services I want to be available in the future. A lot of people are content with sacrificing a small amount of returns to this, even if this is completely in vain. Basically fight the good fight for the hell of it, even if you’re going to achieve shit all. Some people will try to go as ethical as possible, and invest in a way that encourages Australia and the world to achieve this. The ideal end result is a compromise, nobody wants to live in the stone age. Without people investing this way, things will never change, however in saying that I doubt ESG investing will actually make enough of a difference.
I would also add that ESG needs to be done by picking individual stocks which will lead to sub optimal results, not necessarily bad but sub optimal. Pretty much every ESG fund holder, will find unethical investments in the fund. ESG is too personal and subjective.
To practices ESG investing, you’d need to probably do at least the following to come to a reasonable compromise:
1. Stock pick, choose only companies that are ethical to you.
2. Be an ethical consumer, if a company is not ethical enough to invest in, don’t be their customer.
3. Choose and ethical super fund and bank.
4. You are now a very active investor, deal with the probably still good, but below index results.
ESG investing is excepting a lower return, to fight the good fight for the sake of it, and you won’t achieve much. Hey I’m cynical, but I can understand why people would go for ESG investing, and respect that choice. Even within the FIRE community.
I love the podcast Dav and Pat, but I feel like you guys got so caught up in the advertising copy that it tainted the rest of your thoughts on this issue. Granted it was a bit OTT, but maybe your response was too…?
I think there are a few of pro-ethical investing points that you missed, I’ll put the most compelling first.
1. CEOs and other high-level managers get a lot of their compensation in the form of stock. Generalising wildly, they are also often quite $-focused, so hitting them in the wallet can be quite an effective way to bring their attention to the issue.
2. I feel like you’re letting the perfect be the enemy of the good. Ethical investing, especially ethical indices, are imperfect tools. Incomplete alignment with your own morals and greenwashing are problems, as you pointed out, but they don’t completely invalidate the idea, and half a step forwards is better than no step. Likewise, you mentioned other methods are more effective at making change in the world – no doubt, but that doesn’t mean you can’t do both.
3. Finally, when we invest we own a tiny portion of that company. It’s indirect with index investing, and hard to do much with, but we do still own it and are getting income from it (assuming it pays dividends). Does that give us some portion of moral responsibility for what the company does? I’d say yes, so it does stick in the throat when a company I own uses slave labour, or destroys our environment. Perhaps you and Pat think differently here, I do think index investing makes us feel isolated from the destination of our money.
I’ve got about 1/3 of my investments in ethical funds, so I guess I’m not all in on it, but I did want to see what you thought about these points. If you did cover them and I missed that part, apologies! One of the things I love about the podcast is that it’s basically you two having a great chat. I won’t agree with you all the time, but that’s inevitable, and I promise not to write in every time like a grumpy newspaper reader!
That’s a mind blowing point Pat! Food for thought.
I invest in VESG, and it filters out fossil fuels, alcohol, tobacco, gambling, weapons, nuclear power, and adult entertainment. Personally I don’t mind alcohol, nuclear power, and adult entertainment, but it does mean a lot to me to exclude those other industries. Then I basically cross my fingers that the tracking error is minimal! 😉
Thanks for the responses both!
At the risk of going around in circles even more so than I’ve spurred on, all you can do is come to an imperfect compromise, and that’s better than nothing. My reason for not bothering with ethical investing is somewhat based on Pats point. Picking ethical stocks is extremely hard, subjective, different people have different views, and where do you draw the line when compromising? I’m fine with the concept of stock picking and making my own compromises, then just excepting a lower returns.
As a person who basically likes to pick funds, then just stick to allocations, I don’t mind research but hate ongoing effort. I can’t be bothered putting in the effort required to do this effectively. ESG funds aren’t enticing enough for me, I probably just hate the concept of someone else deciding what’s ethical for me to invest in. Which isn’t the best argument, considering most ESG funds are probably a better compromise than a plain vanilla index fund, if you’re willing to except lower returns.
Also I didn’t really mean to give Dave credit for any extreme view points. Going almost vegan is more than I’ve ever done. I could easily go flexitarian as a compromise, from a moral standpoint I agree with consuming less animal products and meat. Yet I’m a heavy meat consumer, I don’t even have any excuses for this, it just is what is. I’m probably just lazy.
Hi Dave and Pat,
Great podcast and certainly a topic that sparks lots of debate. I could not help to give my own 2 cents.
You did not mention in your podcast some other points, I have heard elsewhere about this topic, which I thought I would add.
Sin Funds – In the USA, you can purchase EFTs and managed funds which are called Sin Funds. These are the reverse of ethical investing. These are funds that just hold Tobacco, Fire Arms, Alcohol, adult entertainment and gambling. Depending on what you read and the period measured some claim these funds have had better returns than ethical investing. An example fund is VICEX on the Nasdaq. This makes it easy to invest in this area if you believe that these industries will outperform.
External groups – I remember reading sometime back about a US-based ethical fund that suffered extreme withdrawals and problems with activists. I tried to google this but could not find the story, others may know more details. From what I remember the fund removed some companies which it claimed were helping Israel harm Palestinian settlements in Gaza, as this was not ethical.
A large number of Jewish investors and lobby groups claimed the fund was Antisemitic and launched a campaign to take down the fund. It was successful and the fund had to reinstate these companies. Despite the fact, they were not ethical. In the US many special interest groups lobby large investment firms to have their own agenda embedded into the Active Investment Managers investment decisions. This issue is also avoided if you stick with passive investments.
Moral Funds – Some managed funds have been set up as moral funds. These are typically linked to religious beliefs. They will use e.g the Christain faith and check that investments are made following biblical principles. There is some cross over with Ethical investing and I expect that we will see more of this in the future. In Australia, you could invest with Christain Super that uses a Christian faith-based investment philosophy. However I have see this more with US based stuff that I have read.
Great podcast guys, really refreshing to hear your opinions in this space and I liked your reasoning. There is a lot of hypocrisy in this area. I work on green energy projects with a lot of people who consider themselves ethical individuals. The thing is, many of them drive near new SUVs everyday but the bike rack at work is almost empty.
IMO with more corporations and institutional investors diversifying their boards and upper management, one thinks that those with more ethical investing practices will get more of the predicted 68 trillion in generational wealth transfer over the next 25 years.
“ the transfer of wealth from baby boomers to heirs over the next two decades is a bit like climate change: The consequences may eventually be huge, but it’s easy to ignore the issue in the short-term”
Perfect is the enemy of good.
I would argue that you are trying to say “Ethical ESG aren’t perfect, they don’t match your so why bother”.
For me, this comes to how when I take a distribution that has undergone checks to eliminate the worst of companies (according to my preferences and this is check via the PDS) – I am after all taking a position in a company indirectly via an ETF.
The argument of paying out a percentage of you returns seems odd and I suspect most people wouldn’t do it to the level required to make up for the profits that have come from what is typically considered non-ethical – it’s not like you get a breakdown of where all your distributions come from.
The argument around lower returns is fair, the rational reminder has a really good episode around this and it’s something that people should be aware of i.e. investment tastes.