Ethical investing on the basis of “sin screens” or fossil fuel exclusion can increase or reduce returns, and makes the ability to find suitable substitutes for excluded areas an important consideration when selecting investment managers, according to a study.

The research, carried out by Chendi Zhang and Lucius Li of Warwick Business School (WBS), analyses the impact of ethical investing on returns, volatility and income.

It was commissioned by Newton Investment Management, which wanted to address a lack of studies on the impact of imposing ethical constraints on an investment portfolio.

Rob Stewart, portfolio manager at Newton IM, said: “We hope Dr Zhang and Dr Li’s independent work is a useful starting point for investors.

“The report highlights a number of points, but, importantly, it clearly demonstrates the impact of ethical exclusions varies considerably over time, by region and by restriction.

“Investors need to be aware of these variables and factor them into their decision-making when debating how to implement an ethical investment strategy.”

The report also notes that, when it comes to selecting managers, investors should take into account their ability to find suitable substitutes to mitigate impacts of excluded areas.

The study covers more than 10,000 stocks in 28 developed and emerging markets and 1,283 bond issues in the US, and looks at returns, volatility and income from January 2004 to July 2015.

It considers five “sin screens”, of adult entertainment, alcohol, gambling, tobacco and weapons. 

Fossil fuel screens involved coal and oil and gas.

The report notes that the use of “sin screens” reduces returns over the period of the study – for example, by 0.47% per annum for developed market equity returns – but that there are significant variations across countries/regions and individual screens.

For example, excluding tobacco has had a negative impact of 0.02% p.a, while in the UK it has reduced performance by 0.43%.

Excluding the five key areas in Europe (except the UK) has historically delivered a 0.01% p.a. historical impact, however.

The impact of sin screens also varied over time, while defining how screens are implemented – materiality or threshold-based versus sector screens, for example – can also have a significant impact, according to the study.

The researchers also look at the impact of some form of climate change-related restriction to their investment portfolio, given that “the increasing social awareness of climate change has sharpened the focus on fossil fuels”.

Nordic pension funds have been particularly active when it comes to fossil fuel divestments. (See related articles below.)

The researchers find that a fossil fuel exclusion policy would have significantly benefited emerging market portfolios, increasing returns by 1.1-1.2% per annum from 2004-15, although there was no significant impact of fossil fuel screens on developed market portfolio returns, volatility and income over the course of the study.

“The de minimus impact on yield is perhaps surprising given that oil and gas has historically been heralded as one of the best yielding sectors,” according to the report.

Interestingly, say the researchers, emerging market portfolios benefit significantly from a fossil fuel exclusion policy over all rolling three-year periods used in the study.

This is surprising, they say, because it is the case even in periods when oil prices are rising rapidly.

“It could perhaps be argued,” the report says, “that this positive effect is attributable to the fact many emerging market oil companies are under state control and, as a result, are not necessarily managed with shareholders’ best interests in mind.”