Let's use an aeronautical analogy. We can think of investing as being subject to headwinds and tailwinds: headwinds come into your face and retard your progress, while tailwinds come from behind and speed you on your way. Part of the skill of investing is to find the tailwinds and avoid the headwinds. For example, the old saws,'don't fight the Fed' and 'cut your losses' tell us to steer clear of the headwinds of monetary policy and momentum.
The problem for ethical investors is that there are three headwinds acting against them:
■ Ethical criteria exclude tobacco and alcohol stocks. This means they might be light on low-risk stocks and so fail to benefit from the tendency for these to do well on average.
■ As Adam Smith pointed out, there are compensating advantages to different stocks. If some of your returns come in the form of feeling that you've done good, there'll be less to come from financial returns. To put it an equivalent way, ethical stocks might be over-priced relative to unethical, because there's a demand for good investments. This should lead to lower returns on ethical stocks and higher returns on unethical ones. Sure enough, the Vice Fund, a US fund investing in naughty shares, has beaten the S&P 500 over the past 10 years.
■ Positive ethical screening might attract investors to smaller, fashionable speculative stocks, such as green technology plays. This runs into the headwind that glamorous, 'exciting' stocks tend to have poor long-run performance around the world.
Given these headwinds, how can ethical investors do well? It's because there are also some tailwinds in their favour.
To see one, consider what happened when Paul O'Neill became CEO of Alcoa in 1987. He set the company the target of minimizing employee injuries. And in the following 10 years, Alcoa's profits and share price soared. This is no isolated instance. Successful firms such as Merck, Sony and Johnson and Johnson were founded upon trying to make great products rather than crude profit maximisation. And many of our most familiar food products - Bird's custard, Cadbury's chocolate, Colman's mustard - built their brands in the 19th century by rejecting the prevalent short-term profit maximizing strategy of adulterating their products.
These are examples of what John Kay calls "obliquity" - the fact that we can often achieve one objective by focusing upon something else. Alcoa's profits rose because, when workers and managers thought more about safety, they also found ways of increasing efficiency generally. And companies that get a reputation for behaving well to suppliers, employees and customers can benefit from that goodwill. As Robert Cialdini of Arizona State University has shown, investments in reciprocity - doing people small favours - can earn big returns.
Mr Kay quotes approvingly Jack Welch, former boss of General Electric: "shareholder value is the dumbest idea in the world."
You don't have to look far to vindicate Mr Welch. It’s become a cliché that, in the 'noughties', banks lost their focus upon customers and became short-term money grubbers. They did not thrive for long.
All this tells us that investing in companies that behave well - truly well rather than merely having intelligence-insulting mission statements - can work, because good ethics makes for good business. Research by Elroy Dimson of the London Business School and colleagues have found that when firms are spurred by shareholders to improve their social responsibility, their shares subsequently do well.
Obliquity, though, is not the only tailwind ethical investors have. Another is the phenomenon of limited attention. It is impossible for any fund manager or investor to monitor properly all the stocks in the market. This means a supposed disadvantage of ethical investing - that it confines us to a smaller universe of shares - isn’t necessarily a drawback, because conventional investors are also confined to a smaller universe by virtue of their limited cognition.
In fact, it might even be an advantage as it could allow them to profit more from momentum effects. One reason why shares are often prone to momentum is that good news on earnings, or a price rise for other reasons, attracts investors' attention to a share’s merits, and their buying causes prices to rise further. But if ethical investors' limited universe allows them to pay attention all along to some good stocks, they will have bought before the attention-limited investor, and so they'll profit from his buying.
Ethical investors, then, have three headwinds and two tailwinds. Sadly, history shows that the balance of these has been unfavourable. During the past 10 years the FTSE4Good UK index has underperformed the All-Share index over the last 10 years, rising by 36.8 per cent compared with 56.7 per cent. And in the past five years, many UK ethical funds have under-performed the average all companies fund.
But this isn't the end of the story. Perhaps ethical investors have another tailwind - evolutionary finance. The idea here is that investment strategies wax and wane rather like populations of species do in biology. Imagine a new source of profits is spotted - say, that ethical stocks are cheap. The strategy 'buy ethical companies' then multiplies, as animals do if they find a new food source. This spread of the strategy bids up share prices, to levels from which subsequent profits are low or negative - just as the increase of a species depletes the food source. This causes some of the strategies - some members of the species - to die out. But as they shrink in number, so the food/profit source replenishes itself. And the cycle can then begin again.
Herein lies the hope for ethical investors. It could be that past losses have killed off some ethical investors, which would mean that ethical stocks are cheap for those members of the species still alive. If so, the upward part of the population cycle will begin again.
I confess that I don't know if this will happen. But I do know that if you are an ethical investor hoping to beat the market, you have to believe that the tailwinds of evolutionary finance, obliquity and limited attention are with you. To believe this, however, requires you to believe a lot of things that fund managers generally don't, for example:
■ You can't believe in the virtues of shareholder value, because profits are better maximised obliquely.
■ You can't believe conventional fund managers are good at spotting underpriced stocks because the ubiquity of limited attention means many such stocks - even if they exist - will escape their attention.
■ You can't consistently be a value or growth investor because evolutionary finance predicts that there'll be longish periods when either strategy fails to pay off.
Personally, I'm sympathetic to this rejection of conventional wisdom. But let's be clear. To be an ethical investor requires you to hold some out-of-consensus attitudes.
