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Exclusions-based investing vs traditional investing

We take a closer look at exclusions-based investing, where investors avoid certain sectors that could have a negative impact on the environment and society.

Important notes

This article isn’t personal advice. If you’re not sure whether an investment is right for you please seek advice. If you choose to invest the value of your investment will rise and fall, so you could get back less than you put in.

This article is more than 6 months old

It was correct at the time of publishing. Our views and any references to tax, investment and pension rules may have changed since then.

All information is correct as at 30 June 2021 unless otherwise stated.

We all invest to make money. But it’s also possible to reflect your values in the way you invest.

For example, more investors are choosing to avoid companies that have a significant negative impact on the environment and society, like tobacco, gambling and oil and gas companies. We call this exclusions-based investing.

Does exclusions-based investing lead to potentially better returns though?

It’s an age-old question, and one without a definitive answer. Logic tells us that reducing the number of investment opportunities should lead to worse outcomes. But several talented fund managers have carved out strong track records, despite excluding entire sectors from their investment universe although future performance is not guaranteed.

Here, we look at a traditional fund and an exclusions-based fund, managed by the same experienced team, drill down into the performance of exclusions-based funds and examine the lessons for investors.

Remember the case studies shown are provided for your interest and aren’t a recommendation to invest. Exclusions criteria will vary from fund to fund, so it’s important to check the detail carefully. All investments and any income they produce can fall as well as rise in value, so you could make a loss.

Troy Trojan Income vs Troy Trojan Ethical Income

Troy Trojan Income and Troy Trojan Ethical Income are two funds managed by Troy’s Equity Income team. The team have a relatively conservative investment philosophy. They aim to shelter investors’ money from the worst stock market falls, while increasing its value and paying a rising income over the long term. Please note the funds each currently hold shares in Hargreaves Lansdown plc.

Both funds invest in companies with advantages over the competition, like a unique product or service that rivals struggle to copy. This should allow them to generate strong cash flows over the long term and could support the company as it reinvests for future growth and pays dividends to shareholders. They avoid companies with lots of debt, and those that rely on taking over other businesses to grow.

The team behind both funds also carry out Environmental, Social and Governance (ESG) analysis on every company they invest in, to better understand the risks.

The main difference between the two is the Ethical Income fund won’t invest in companies deemed unethical. That includes those with significant involvement in armaments, tobacco, pornography, fossil fuels, alcohol, gambling and high interest lending. On the other hand, the Troy Trojan Income fund has the flexibility to do so. Despite this, there’s almost a 75% overlap in the funds’ underlying investments.

The chart below shows how both funds have performed since Troy Trojan Ethical Income launched in January 2016. Over that time, the Ethical Income fund’s outperformed its more traditionally-managed sister fund by 14.8%*. Of course, this is just one time period, and there will be times when the Troy Trojan Income fund does best.

The more traditionally managed fund also has more flexibility when it comes to generating income. It’s consistently paid out more in dividends than the Ethical Income fund. Past performance is not a guide to the future and dividends are variable and not guaranteed.

Troy Trojan Income vs Ethical Income Performance (with income reinvested)

Scroll across to see the full chart.

Past performance is not a guide to the future. Source: *Lipper IM, to 30/06/2021.

Annual percentage growth
Jun 16-
Jun 17
Jun 17 -
Jun 18
Jun 18 -
Jun 19
Jun 19 -
Jun 20
Jun 20 -
Jun 21
Troy Trojan Ethical Income 11.9% 3.6% 13.3% -3.2% 9.0%
Troy Trojan Income 11.4% 1.4% 4.2% -5.6% 8.2%
FTSE All-Share 18.1% 9.0% 0.6% -13.0% 21.5%

Past performance is not a guide to the future. Source: Lipper IM, to 30/06/2021.

Several exclusions-based funds have outperformed their more traditionally managed rivals in recent years. But to understand why, it’s important to recognise the impacts exclusions can have on performance, both positive and negative.

For instance, some avoid or limit how much they invest in companies involved in fossil fuels, like those that carry out exploration, drilling or refinery services. That meant they were less impacted by the poor performance of oil and gas companies in recent years.

Some also invest in alternative energy, like wind and solar power, or focus on energy businesses that are more advanced in their environmental practices. These companies have done much better than the broader global oil and gas sector over the period.

Exclusions-based funds also tend to invest more in the technology sector, which has done well in the last few years. Meanwhile, the tobacco industry, which most exclusions-based funds avoid, had a more difficult time.

Since the announcement of several coronavirus vaccines in November 2020 though, there’s been a stock market rotation. Technology companies, which had previously been among the top performers, have underperformed previously unloved areas like oil and gas.

Only time will tell whether this is a flash in the pan or the start of a longer period in the sun for traditionally invested funds versus their exclusions-based peers.

Investing in these funds isn’t right for everyone. Investors should only invest if the fund’s objectives are aligned with their own, and there’s a specific need for the type of investment being made.

Investors should understand the specific risks of a fund before they invest, and make sure any new investment forms part of a diversified portfolio.

What to think about when investing in exclusions-based funds

Exclusions-based funds have the potential to perform well over the long term. But, as shown above, their performance will be different to more conventional funds and the broader stock market at times. If areas they can’t invest in do poorly, they could outperform traditional funds. But exclusions-based funds could perform poorly if these areas do well. As with all investments, you could get back less than you invest.

Lots of the areas where exclusions-based funds can’t invest, like tobacco and some healthcare businesses, tend to be the ones that make money whatever shape the economy is in. It means some exclusions-based funds invest more in cyclical businesses, like those in the technology or financial sectors, whose performance has tended to mirror the health of the economy. Profits and dividends have risen during the good times but suffered during slumps.

Exclusions-based funds also tend to invest more in small and medium-sized companies. That’s because lots of large businesses operate in areas these funds can’t invest. Smaller companies have excellent long-term growth potential, but they can experience more ups and downs than larger ones, which makes them higher risk.

Some of the areas excluded by most exclusions-based funds, like tobacco and oil and gas, have historically paid the highest dividends. As of 5 July 2021 the average yield of the UK’s two largest tobacco companies, for example, was a whopping 8.1%. Remember though yields are variable, not guaranteed, and not a reliable indicator of future income.

Cutting out some of the highest-yielding companies and sectors means responsible income funds tend to pay lower dividends than traditional equity income funds.

It’s impossible to say whether exclusions-based funds will outperform traditional funds over the coming years, but they will perform differently from each other.

Whether you choose to invest in exclusions-based funds, traditional ones, or a combination of both, comes down to your personal preferences. You should carefully consider each fund’s objectives, and make sure they’re aligned to your own views and how much risk you’re happy taking.


Explore our Investment Times summer 2021 edition for more articles like this.

See all articles

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Important notes

This article isn’t personal advice. If you’re not sure whether an investment is right for you please seek advice. If you choose to invest the value of your investment will rise and fall, so you could get back less than you put in.

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