How to invest ethically without harming your returns

For years, ethical investing and environmental, social and governance (ESG) was touted as the future of finance and the solution to a world on fire – promising to align profit with purpose.  

The idea was simple: by directing investment toward companies that make a positive real-world impact and away from fossil fuel firms, investors could both grow their wealth while helping combat climate breakdown.

ESG-focused strategies once enjoyed rapid growth and enthusiasm. However, after a period of underperformance, an increasingly volatile global economy and mounting scepticism fuelled by accusations of ‘greenwashing', ethical investing has quickly fallen out of favour.

Maximising returns appears to have reclaimed pole position in investors’ minds, but does doing good really have to come at the expense of performance? Here, we examine whether ethical investing is truly in decline and whether you need to compromise your values to achieve a strong return on your investment.

Please note: the content contained in this article is for information purposes only and does not constitute financial or investment advice.

What is ethical investing?

Ethical investing is an umbrella term for all approaches to investing that consider ethical values as well as financial returns. 

Traditionally, ethical investing meant not investing in certain companies that contravened your beliefs. This often included fossil fuel firms, arms manufacturers, tobacco companies and gambling firms.

More recently, however, it has expanded to include focusing on companies that make a positive real-world impact, or investing in firms to help them reduce their negative impacts. 

Several funds also sprang up, which marketed themselves as ESG funds, supposedly offering a basket of ethically minded and sustainable firms.

• Find out more: ethical investing explained.

Has ethical investing lost its appeal?

Investors have been pulling money out of ESG funds at record levels. In the first quarter of 2025 alone, there were $8.6bn (£6.5bn) of net outflows, according to data from Morningstar. The retreat was very pronounced in Europe – and even more so in the US, where it marked the 10th consecutive quarter of withdrawals from ethical funds. 

So what’s behind the cooling enthusiasm? 

Dzmitry Lipski, head of funds research at Interactive Investor, says several factors have contributed to the shift. 

Greenwashing is the practice of exaggerating or falsely advertising a company’s environmental friendliness. A Which? investigation earlier this year found examples of hundreds of products on sale in the UK using vague and unsubstantiated environmental claims.

Lipski added: ‘Regulators in Europe are increasing scrutiny on companies exaggerating sustainability claims and misleading investors, which have added further compliance challenges for fund managers and potential confusion for investors.'

Last year, as part of this crackdown, the Financial Conduct Authority (FCA) launched ‘sustainability disclosure labels’ for UK investment funds, while the EU has implemented a similar programme for European funds.

These labels are designed to provide investors with clear and simple information on a product’s sustainability goal.

While some have taken up the labels, 383 funds across Europe and the UK instead opted to drop their ESG-related terms altogether in the second quarter of 2025. 

For many funds, branding themselves as ESG had simply meant 'considering' the effects of climate change and how it might impact their portfolio, rather than doing anything to mitigate it.

• Find out more: how to spot a green investment fund.

Funds dump ESG terms

Investors flock to safe havens

Political and economic shifts have also contributed to ESG’s downturn. In the US, President Donald Trump’s renewed opposition to ESG investing and climate goals has led some firms to deprioritise sustainability altogether.

Add to that the wider backdrop of geopolitical instability and a volatile global economy, and it’s little surprise that investors have been seeking out safer territory – favouring defensive stocks, established sectors and traditional safe havens such as gold.

Still, the question remains: have investors truly turned their backs on ethical investing in pursuit of higher returns?

• Find out more: are you bankrolling the climate crisis?

Are investors willing to sacrifice principle for profit?

Despite recent outflows from ESG funds, many investors still care about aligning their investments with their values. A Which? survey of 1,260 members in August 2025 found that 75% of those who invest were familiar with ESG and ethical investing.

While 97% said that financial return was an important factor in their decisions, 52% said it was equally important that their investments reflect their personal values and 47% said that they prioritised a positive environmental impact.

Our members told us that there are certain sectors they deliberately avoid. Some 52% said they shun tobacco firms, 51% avoid gambling companies and 48% stay away from businesses with poor labour practices.

Avoidance was lower in other areas: 17% said they exclude fossil fuel companies and 17% avoid arms manufacturers. A number of investors also said that they steer clear of firms with connections to countries such as Russia, citing ethical or political concerns.

When asked about balancing principles with profit, 52% said they would accept lower returns to ensure their investments align with their morals, while 29% said maximising returns was their main priority.

Which brings us to the burning question – do you really need to sacrifice returns for principle?

• Find out more: how to balance your investment portfolio.

Are ethical funds really underperforming?

Sustainable funds have had mixed results in recent years, but so has the wider market. Some have struggled, while others have matched or even beaten traditional funds.

A study by Morgan Stanley, which analysed 99,000 funds with sustainability characteristics, found that sustainable funds outperformed traditional funds in the first half of 2025, delivering median returns of 12.5% compared with 9.2% for conventional funds. This followed a weaker spell in the second half of 2024.

Morningstar also tracks the performance of companies that meet specific ESG criteria through its sustainability indices. The table compares how three of these indices have performed against their non-sustainable counterparts over the past five years.

Annual returns for select Morningstar indices

Years where a sustainability index outperformed its non-sustainable counterpart are highlighted in green, while under-performing years are in red.

The data shows a mixed picture. In some years, ESG-focused indices have beaten traditional benchmarks, while in others they’ve lagged behind. Much depends on which sectors are driving growth at the time. 

Climate and net-zero aligned indices had a very strong 2024, according to Morningstar, while rapidly increasing electricity demand linked to AI data centres is driving fresh investment in clean energy stocks.

The second quarter of 2025 also saw ESG funds rebound in terms of cash inflows, with European investors pouring $8.6bn of net new money into ESG funds.

As Lipski points out: ‘While sustainability and ESG has shifted from the investment agenda, the fundamental trends and risks that initially drove its rise – such as climate change, social inequality, and corporate governance issues – remain real risks that investors can't ignore.

‘Regardless of ESG labelling, sectors such as renewable energy, electric vehicles, and sustainable infrastructure continue to attract substantial investment.’

• Find out more: how to invest for income.

How to spot a green investment fund

A good starting point when researching ethical funds is to look for the sustainability disclosure labels.

According to Which? research, there are currently around 145 funds using or planning to use these labels in the UK.

The FCA’s criteria for adopting a label include a requirement that usually at least 70% of the product’s assets must be invested in accordance with the chosen sustainability objective.

So far, 93 of the 145 funds have made a public disclosure, according to Morningstar, a list of which can be found in the table.* 

However, an ESG label alone isn’t proof of impact. Lipski says investors need to dig deeper.

Some fund managers also have much better records than others when it comes to supporting environmental measures. 

ShareAction, a UK charity that campaigns for responsible investment, recently found that BlackRock, Fidelity Investments, State Street Global Advisors and Vanguard often vote against ethically minded shareholder resolutions at company AGMs. 

It’s worth taking the time to check a fund’s stated aim, portfolio holdings and past performance, as well as its net asset value (NAV) – the total value of its assets minus liabilities. 

When checking a fund's fees, consider comparing it with a non-ethical fund targeting a similar area (such as tracking the FTSE 100). Are the fees similar, or are you paying an unreasonable premium?

You can also use Morningstar to check a company's or fund's sustainability rating. Morningstar assigns a rating based on ESG risk from environmental, social, and governance factors. 

Chris Beauchamp, chief market analyst at IG, highlights two ethical funds that have performed broadly in line with the FTSE 100 and S&P 500 over the past five years.

iShares ESG Aware MSCI USA ETF seeks to track the investment results of an index composed of US companies that have positive environmental, social and governance characteristics, while screening out certain sectors such as tobacco and civilian firearms. The fund has annualised returns of 15.3% over the past five years and an ongoing charge of 0.15%.

Vanguard ESG US Stock ETF also has screening for certain industries, such as tobacco, adult entertainment and some types of weapons manufacturing. It has annualised returns of 15.2% over the past five years, and an ongoing charge of 0.09%.

As an alternative to funds, investors could also consider so-called 'green bonds', which are available for more risk-averse investors. The UK government now issues green gilts, where proceeds are directed towards a range of environmental projects.

Dzmitry says: ‘Sustainable investing may not be experiencing the explosive growth of previous years, but for many it remains a vital strategy. Investors should align decisions with their values and long-term priorities rather than reacting to market fluctuations or headlines.’

• Find out more: investing in green bonds explained.