Ethical investing has become incredibly popular in recent years.
The promise of being able to put your money towards businesses that don’t harm the environment,
exploit vulnerable workers, or engage in bad business practices is obviously very attractive.
The idea of this practice is that by denying these bad companies access to investment,
they won’t have the opportunity to grow and continue their harmful practices.
Some big names in the investment space have also backed up an ethical investing strategy
by saying that not only will it do good for the world, but it will also do good for your
wallet, because it can offer higher returns than a traditional investment strategy.
The problem is that… it almost certainly CAN’T.
Ethical investing may feel good but under the surface it effectively rebrands one of
the biggest mistakes that people are make when getting into investing, not being diversified…
What’s more is that ethical investing might not actually have the positive effect on the
world that you might initially expect from listening to the thought leaders in this space.
So it’s time to Learn How Money Works and find out why ethical investing is bad investing.
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people what they want to hear, this was made possible by the generous support of my channel
members and patrons on patreon.
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Alright, so before I start ripping into ethical investing it’s important to understand how
it actually works.
When investors talk about ethical investing they are most often talking about ethical
investment management funds or ethical index funds.
Popular examples of which include Chamath Palipatiya’s Social Capital, as well as
large selection of publicly traded indexes from companies like BlackRock and Vanguard.
Now actively managed funds have their own problems, multiple studies have shown that
after management fee’s only a teeny tiny percent of them consistently outperform the
market so already they are not off to a great start.
But to keep things fair I want to park those types of investment companies to the side
for this video and focus just on the ethical index funds.
These are far more likely to be used by regular investors and they also make up a far larger
share of the market.
We are also going to ignore the associated fee’s on these funds, which are normally
substantially higher for the ethically branded variants, so trust me I really am trying to
give them a fair go her.
But with that out of the way the first thing you need to know is how are these indexes
made?
Well like all index funds ethical indexes are made up of tiny slices of lot’s of different
securities.
These thin slices will then be bundled up into an index and sold off to regular investors
as a totally new security with inbuilt diversification.
This is amazing for most investors because diversification is just SOOO important when
building out a portfolio, but it can also be prohibitively expensive.
To buy a capitalisation weighted share of every stock in the S&P 500 would cost hundreds
of thousands of dollars.
Some individual shares themselves can be worth more than an average person’s entire portfolio
so index funds like the SPY are a much more suitable alternative.
Ethical index funds work basically the same way, but they only let ethical slices into
their index pie.
There are two ways they can do this, the omission method or the inclusion method.
The omission method is the most common and it involves investment companies starting
with a base index of lots of companies and then kicking out companies that operate in
certain industries, perhaps fossil fuels and tobacco companies.
This works well but there are inevitably some bad players that will fall through the cracks.
Nestle is a snack company so it wouldn’t be omitted from this index despite not exactly
being what you might call a shining beacon of moral virtue.
This is where the inclusion method is preferable.
This is where investment companies will individually pick and choose companies that adheres to
their ethical framework.
Generally speaking inclusion funds will be filled with companies that really are trying
to make the world a better place and omission funds will be mostly filled with companies
that aren’t completely terrible.
So now that you know what goes into creating these funds, you might think this still sounds
pretty good, and that’s why it’s time to learn about the two big reasons why they
are not…
…
The savvy investors amongst you may have already picked up on the first major problem when
looking at how these funds were made which is that by one means or another there is some
system actively selecting stocks.
The more you pick and choose your stocks the less diversification you will naturally have
which is a really bad thing.
To demonstrate why, consider a casino filled with lots of tables all offering various games.
For the sake of this example lets say on average that these games have a house edge of 10%,
which means for every 1 dollar you put into a game you are expected to make just 90 cent’s
back.
To keep it even more simple imagine one of these games is the simple flip of a coin.
If you lose the flip you give up any money you bet on that hand, if you win the flip
then you win one dollar and eighty cents maintaining the 10% house edge.
Obviously this is unfair, but it’s effectively how all gambling works, it’s normally just
a little bit less obvious.
Ok, so as a player, how many flips of a coin would you bet on to maximise your expected
return?
The correct answer is none, or if you are forced to you want to be on a little as possible.
If you bet on one flip sure you might lose it all then and there, but you have at least
a 50% chance of making some money.
Statistically speaking it only goes downhill from there.
If you don’t believe me I have linked a Monte Carlo simulator in the video description
so feel free to play around with it.
Alright now let’s flip this example on it’s head.
What if you were the casino manager?
How many games would you want people to play to maximise your potential return?
You would want them to play as many as possible.
A player that comes in and drops a bucket of money on a single hand is actually very
scary to a casino because that player has an almost 50/50 chance of walking away with
double their money.
If a player instead decides to split their money up and play over 50 hands they are almost
guaranteed to loose money.
This is why if you ever go to Vegas you will notice that most card games have table limit’s
to spread out people’s gameplay and give the odds time to do their thing.
Now replace casino with stock market.
The American stock market has historically returned around 10% per year so that means
if you are an investor, you are in the fortunate position of having the house edge.
Of course, you could put all your money on a single hand or a single stock and generate
massive returns in a very short period of time, but with the house edge you are (statistically
speaking) better off spreading out your money as much as possible to let the odds do their
thing.
Now this makes a few assumptions, you could have insider knowledge or be a card counter,
but both of those strategies are going to get you kicked out of the respective example
very quickly.
What this means for our ethical ETF’s is that they are intentionally forgoing the inherent
benefit that comes from playing as many hands as possible, and what’s worse is that they
are often omitting entire games all together.
Let’s say that tomorrow large lithium ion batteries were shown to give people cancer.
This would be devastating for electric vehicle companies, but it would probably be great
for the fossil fuel industry.
In theory a well-diversified portfolio would have exposure to both of these industries
and the losses in the former would be mitigated by the gains in the latter.
If you were only exposed to the more ethical industry, you would feel all of this pain
directly.
You may personally believe that ethical businesses are the future, and I hope your right, but
that is a belief, it’s a speculation… good investors don’t speculate…
…
Alright, now what if you have taken all of this on board and are still happy to deal
with a slightly lower return in order to do your part for the good of humanity?
Well there is still a better way, because beyond everything else, ethical investing
probably doesn’t do that much good at all.
Almost every stock that is purchased to make up these ethical funds will be purchased from
the secondary market.
That is shareholders that already owned the stock and are now selling it, rather than
the company itself.
That means that money invested into tesla, isn’t going to fund new electric cars, more
than money invested into BP is going towards setting the world on fire.
The money is just going to the random investor that owned the shares before you.
Now these is one counter argument that ethical proponents will use to dismiss this critique
which is that company managers have an obligation to maximise shareholder value, if their morally
tainted shares become so unpopular that the value tanks then the management will be forced
to change up operations or risk being thrown out by the board.
This idea is nice in theory, but here is what will actually happen, let’s say an investment
fund decides to go ethical and dumps all of their oil and natural gas holdings.
The price of these shares take a beating after the selloff but now they represent a better
value to morally indifferent investors.
If this happens enough then sure the share value of a company might plummet but that
only makes it more popular amongst buy and hold investors who might start getting a 5,
10 or even 15% dividend on their newly discounted stock purchase.
This increased earning per share will drive demand and counteract the effect of the ethical
selloff in the first place.
For better, or for worse, people engage in the stock market to make PROFITS.
Going in there with an ulterior motive (however noble) is going to put you at a big disadvantage.
If you really do feel passionately about these issues that’s fantastic.
honestly, I am right there with you.
But ethical investing is just not the right way of going about pushing change.
You would be far better off investing wisely and using your extra profits to donate towards
the causes you believe in, or even purchasing products from companies that you believe are
doing good.
Ethical investing might give you the warm fuzzies, and I am sure there are going to
be a million comments in the comments section talking about how XYZ index returned 20% last
year, but that’s all missing the point…
If you want to invest wisely, you need to respect the statistics, one index generating
great returns over a year or two is no different from a gambler on a lucky wining streak.
If you want to invest your money, invest well, if you want your money to do good for the
world, spend it in ways that do good for the world, don’t become an ethical investor
and expect to be the saint of wall street, because it’s just not the way it works.
Now if you want to learn about another type of scheme promising to mix financial gain
with moral virtue, go and watch my video on the dark secret behind those Omaze giveaways
you have likely seen sponsored all over YouTube.
A big thank you again to all of my amazing patrons and channel members for making it
possible for everybody to keep on learning…
How Money Works.