What is ethical investing? Your complete guide

Investing solely to maximize returns is no longer the only priority for many investors. Increasingly, individuals are focusing on assets that not only offer strong financial returns but also contribute positively to environmental and social issues. 

A 2022 study conducted by Stanford University revealed that 70% of investors aged 18 to 41 are deeply concerned about environmental challenges. In contrast, only 35% of older investors expressed the same level of concern. This shift in priorities is particularly evident among younger investors who are not just looking for profit; they are willing to sacrifice some financial returns to invest in companies that align with their ethical and social values. This approach is at the heart of what is known as ethical investing.

Understanding Ethical investing

Ethical investing refers to the practice of choosing investments that align with one's personal values and beliefs, particularly in terms of social and environmental responsibility. While the concept of ethical investing lacks a universal definition, it generally involves selecting companies whose products, services, and business practices reflect the investor's principles.

Historically, ethical investing was a niche activity, often practiced by religious groups who sought to avoid investing in industries like gambling, alcohol, or tobacco. However, the landscape of ethical investing has evolved significantly. Today, it has gained widespread popularity, especially among younger investors who are keen to ensure that their investments support ethical and socially responsible business practices.

Ethical investing has transformed from a strategy of exclusion—where investors avoided companies that conflicted with their values—into a proactive approach. Investors now actively seek out companies that are making a positive impact, such as those focused on clean energy, sustainable practices, or fair labor conditions. By doing so, they are not only aiming for financial returns but also contributing to a better world.

Types of Ethical investment funds

Ethical investing encompasses various approaches that cater to different values and priorities. These can be broadly categorized into four main types:

1. Socially Responsible Investing (SRI)

• Definition: Socially Responsible Investing focuses on excluding companies that operate in controversial or unethical industries. This often includes industries like gambling, firearms, tobacco, alcohol, and oil.
• Approach: Investors practicing SRI typically avoid businesses that engage in activities they consider harmful to society or the environment, aiming to support companies that align with their ethical values.

2. Environmental, Social, and Governance (ESG) investing

• Definition: ESG investing involves evaluating companies based on their environmental impact, social responsibilities, and governance practices. 
• Approach: Investors consider factors such as sustainability, ethical labor practices, and transparent governance. The focus is on supporting companies that prioritize long-term, sustainable business practices and have a positive societal impact.

3. Impact investing

• Definition: Impact investing seeks to generate measurable social or environmental benefits alongside financial returns. This approach is ideal for investors who want to make a tangible difference while still achieving growth.
• Approach: Impact investors typically look for companies that address global challenges, such as clean energy or affordable healthcare, and offer solutions that also drive profitability. For instance, they may invest in companies developing solar energy systems to support renewable energy.

4. Faith-based investing

• Definition: Faith-based investing aligns investment choices with religious beliefs and values. Investors exclude companies whose operations conflict with their faith.
• Approach: Faith-based investors prioritize companies that uphold principles consistent with their religious teachings, avoiding those that engage in activities or produce products that contradict their belief system.

Comparing SRI and ESG investing

While ethical investing categories share a commitment to aligning investments with ethical standards over purely financial gains, there are distinct differences between them.

To begin with, Socially Responsible Investing (SRI) typically focuses on excluding certain companies from an investment portfolio. SRI involves avoiding industries or business practices that the investor finds objectionable. In contrast, Environmental, Social, and Governance (ESG) investing involves actively selecting companies based on how well they align with the investor's ethical values. ESG investing is about making deliberate choices to invest in companies that meet certain environmental, social, and governance criteria.

ESG investing is a more proactive approach, as it involves the active selection of companies that align with the investor’s values, rather than simply avoiding those that don't.

Impact investing, on the other hand, can incorporate elements of both SRI and ESG. This approach involves building a portfolio that not only aligns with ethical standards but also has the potential to deliver significant financial returns.

Faith-based investing does not necessarily follow the principles of SRI or ESG, though it can consider those factors. This form of investing may also overlap with impact investing. However, faith-based portfolios are primarily guided by the religious values of the investor or organization, rather than by secular ethical considerations.

How do Ethical investment portfolios perform?

Does ethical investing require you to give up potential gains? Interestingly, investing in companies that align with your values may not lead to lower returns.

We analyzed the performance of two index funds over the past three years—one focused on socially responsible investments and the other tracking the broader market:

iShares ESG Screened S&P 500 ETF (XVV): This ETF, which follows socially responsible investing principles, was launched in September 2020. It invests in companies within the S&P 500 but excludes those that might be considered controversial. Starting at a price of $25.58 in September 2020, it rose to $31.76 by the end of May 2023. This represents a 24.16% increase over 2.5 years. If you had invested $1,000 at the fund's inception, your investment would have grown to $1,241.60 by May 2023.

iShares S&P 500 Index Fund (WFSPX): This fund tracks the performance of the entire S&P 500, without any ethical screening. Its price increased from $396.14 in September 2020 to $491.24 in May 2023. A $1,000 investment in this fund during the same period would have grown by 24.00%, reaching a value of $1,240.00.

From September 2020 to May 2023, the iShares ESG-focused S&P 500 fund slightly outperformed the broader S&P 500 by approximately 0.16%.