What Is Ethical Investing and How Do You Do It?

Ethical investing doesn't need to be intimidating, especially with the rise of robo-advisors and socially responsible mutual funds.

Alana BensonOctober 15, 2020
What Is Ethical Investing and How Do You Do It?

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If you’d like to invest but are concerned about your investment dollars supporting industries you don’t agree with, ethical investing may be just what you’re looking for.

Ethical investing is all about aligning your personal moral compass with your investment portfolio. Thanks to impact portfolios offered by robo-advisors and a plethora of sustainable mutual funds, ethical investing is more lucrative and easier than ever.

Ethical investing definition

Ethical investing is a strategy where one chooses investments based on a personal ethical code. Ethical investing supports industries making a positive change, such as sustainable energy.

Of course, what is “ethical” depends on the person. What is ethical to you may not be to someone else. That’s why it’s important to look behind the curtain of ethical investments and make sure they align with the impact you’d like to have.

Ethical, sustainable and socially responsible investing: What’s the difference?

Not much. Ethical investing has lots of variations, including sustainable investing, socially responsible investing, green investing, impact investing and ESG investing. Most of these trend toward the same idea: creating positive change by thoughtfully and intentionally investing your money.

But how they achieve that idea varies. Some only include positive-impact investments, while others simply exclude negative-impact investments. Still others use both inclusionary and exclusionary methods. The above names for ethical investment strategies are often used interchangeably, without much consensus on which are exclusive, which are inclusive and which are both.

That’s why it’s important to understand a fund or advisor’s methodology for choosing particular investments: Some may simply exclude investments in tobacco and firearm companies and call that portfolio “sustainable” or “socially responsible”  — without actually including any “sustainable” assets.

One important thing to note is that many types of ethical investing, regardless of what they’re called, use ESG investing factors — environmental, social and corporate governance — to grade specific investments along an ethical curve. For example, if you’re creating an impact portfolio with a social justice focus, you may look for investments that receive a high ESG score in the social category.

Can I make money by investing ethically?

While no investment is guaranteed, the performance of ethical funds has been shown to be similar to the performance of traditional funds — in fact, some research shows that ethical fund performance may be superior. According to Morningstar data, sustainable funds outperformed their traditional peers in 2019, with 66% finishing the year with returns in the top half of their Morningstar categories. (Morningstar is a NerdWallet advertising partner.)

The general idea is that companies that treat their employees well and are thoughtful about their environmental impact may also be better run and less prone to scandal — which can result in a material benefit. For example, companies that adhere to ESG concerns may avoid fines and lawsuits for issues such as mismanagement of toxic waste disposal, sexual assault and harrassment charges and fraudulent transactions, since they may have policies to help avoid those issues in the first place.

There is also some evidence that suggests that ethical funds may offer lower levels of market risk than traditional funds, even in volatile markets such as the downturn during the first few months of the COVID-19 pandemic. According to Morningstar data, 24 out of 26 ESG index funds outperformed comparable conventional funds during the first quarter of 2020.

How to build an ethical investment portfolio

Creating an ethical portfolio doesn’t have to become a second job. Here’s how to start investing ethically:

1. Decide how involved you want to be

When it comes to building an ethical portfolio, you can choose to build it yourself by picking and choosing specific investments and monitoring them over time, or you can get some help.

I want to build my own portfolio. If you want to be sure the investments in your portfolio align with what’s ethical to you, it may be a good idea to build your own portfolio. Some brokerages are better equipped to help you find ethical investments than others. For example, some have screener tools to help you find the right funds for your portfolio. If you don't already have a brokerage account, here's how to open one. Then you can head to step 2.

This is a lot of work. I want help! Most individuals probably prefer to make socially responsible investments when possible, but “when possible” means different things to different people. It takes a lot of time and effort to figure out how committed a company really is or which ethical practices they prioritize — time that you may not want to dedicate to researching stocks. This is where robo-advisors can be helpful: Robo-advisors use algorithms to build and manage investment portfolios based on your risk tolerance and goals — and in some cases, your ethical preferences.

Robo-advisors are often cheaper than traditional advisors, and a handful offer socially responsible portfolios. Unfortunately, since most robo-advisors don’t allow you to add specific investments to your portfolio, if you wanted to invest in a particular company, you wouldn’t be able to. You'll need to investigate a potential robo-advisor’s methodology to make sure they use both inclusionary and exclusionary filters if that’s important to you.

2. Know what’s ethical to you

Take some time to outline what an ethical investment looks like to you. Does an oil company still count as “ethical” to you if it has robust environmental initiatives, or would you rule investments in oil out entirely? Knowing what industries you want to support and which you want to avoid will make it easier to include or exclude certain investments.

3. Find ethical investments

Once you have a brokerage account and you know your priorities, you can start building a portfolio that aligns with your moral compass. Reading reviews from independent research firms such as Morningstar can help give you an idea of how well a company scores in terms of ESG investing factors, and whether you’d like to invest in them.

Two types of investments you may consider for a sustainable portfolio are stocks and funds. Here’s what you need to know about them:

Individual stocks. It’s generally a good idea to limit the portion of your portfolio that’s in individual stocks, but if there is a company you expect will perform well over time, you may want to include it. Some companies offer a sustainability report, which will give you a sense of any green energy or cultural initiatives they’ve taken on, and what kind of environmental impact the company has. It’s also a good idea to see how a company’s employees rate the work culture through an independent site such as Glassdoor. Learn more about how to research stocks.

Mutual funds are a quick and easy way to diversify your portfolio, and there is a growing field of ethical funds to choose from. Mutual funds invest according to criteria laid out by the fund manager, which may include ESG factors. If your broker offers a screening tool, you can explore different funds and stocks to find the ones that will best fill out your ethical portfolio.

To learn about the details of a particular fund, you’ll want to look through its prospectus, which should be linked on your online broker’s website. You’ll want to look for two things in particular: a fund’s holdings (a list of all the companies a fund invests in) and its expense ratio. Expense ratios are annual fees taken as a percentage of an investment. For example, if you invest $5,000 in a mutual fund with a 1% annual expense ratio, you’ll pay $50 a year. While some funds with “ESG” or “sustainable” in their name have higher expense ratios than traditional funds, there are also ethical funds that are cheaper than their traditional counterparts.

» How do you manage your portfolio? Learn about investment management

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