Ethical Investing: ESG Investments Deliver Strong Returns

Ethical Investing: Environmental, social and governance (ESG) criteria are a set of standards for a company’s operations that socially conscious investors use to screen potential investments.

Environmental criteria consider how a company performs as a steward of nature; Social criteria examine relationships with employees, suppliers, customers, and the communities where it operates; Governance deals with issues such as a company’s leadership, executive pay, and shareholder rights.

ESG investing is sometimes referred to as sustainable investing, responsible investing, impact investing, or socially responsible investing; in recent years younger investors in particular, have shown an interest in putting their money where their values are and brokers and fund managers have begun to offer a number of actively managed or exchange-traded funds (ETFs) and other financial products that follow ESG criteria.

A widely held belief in the past was that those that chose to invest with the view of making a positive impact would have to sacrifice growth or income when compared with less ethical investments.

However, recent performance data from Morningstar dispels that belief by highlighting the stellar performance of a number of ESG funds.

The data, as at the end of July 2019, showed that the top three performing ESG funds each achieved returns of more than 16% over a 12-month period, and all of those in the top ten recorded double-digit growth.

Top10 ESG performers over one year to July 2019

_{Source: Morningstar}

Not all funds fared quite so well of course, in fact the bottom four performers all fell in value over the twelve month period, but that was not unique to the ESG sector.

Investment strategies

In a sector that is still settling on strict definitions, managers broadly have three types of strategy to choose from to ensure that they deliver on their ethical mandate – Environmental, Social and Governance (ESG), Socially Responsible Investing (SRI) and Impact Investing.

Despite the fact that these terms are often used interchangeably, and indeed the edges can certainly blur, there are some key differences.

‘Positive screening, as it sees funds focusing on what they want to invest in, rather than what they want to cut out’

Peter Michaelis, head of the Liontrust Sustainable Investment team, told FT Adviser about the sustainable methods fund managers use.

The first is negative screening – avoiding certain industries because of the negative or damaging effects of their products, such as weapons and tobacco.

Mr Michaelis explained: ‘Another approach is to invest in sustainable themes. This is known as positive screening, as it sees funds focusing on what they want to invest in, rather than what they want to cut out.

‘Such funds may concentrate on a single theme such as renewable energy while others have multiple sustainability themes that can include healthcare, resource efficiency, and education.

‘Many cling to the perception that ethical investment is about what you can’t do, whereas we think it’s about what you can do.’

The third method involves engaging with the companies that managers invest in. This is called ‘impact-investing’ and is about influencing the management of firms into making positive changes to their strategy or operational management.

Which strategy is most appropriate will very much boil down to where an individual investor’s values lie.

Kate Elliot, senior ethical researcher, Rathbone Greenbank Investments, told FT Adviser the starting point for any discussion around ESG always comes back to terminology:

‘How inclusive is the use of the term ESG in this instance?

‘Does it include funds with a sustainability, thematic or impact bias, or just those integrating ESG analysis into the broader investment process?’ she says.

Ms Elliot added that, generally, the aim for most ethical investors is the desire to avoid harm and promote positive change, believing an active approach to the ongoing management of investments promotes positive change through more robust voting and engagement.

Among ethical funds, approaches vary and positive and negative screens, engagement policies and underlying holdings will differ; the challenge for the manager is to understand what is being offered, how it’s being delivered, and if it meets the needs of a client.

A great challenge for managers when researching companies, is that not all that claim to be taking a socially responsible approach actually meet the requirements – commonly known as ‘greenwashing’.

Greenwashing

This is a term coined in the ’80s to identify those firms claiming to be producing products or services that are environmentally friendly, but on closer inspection found to be misleading; this is a problem that persists today.

Ms Elliot notes: ‘With so many new products and services coming to market, it can be a challenge to see through the greenwashing and separate the providers with genuine commitment and the right expertise from those who are simply capitalising on a marketing opportunity.’

To highlight the problem, Global Investment Alliance research  found that assets in European sustainable funds fell from 53% in 2016 to 49% in 2018 with greenwashing flagged as the main culprit – the suggestion being that some funds’ ethical strategies were being overstated.

However, some commentators were more positive, suggesting the trend supported the fact that managers were prepared to ditch funds that are not meeting the necessary sustainability requirements.

Examples of ‘greenwash challenges’ investors may face when selecting managers include when a manager misrepresents their fund as sustainable, purchasing ESG data which is then never, or only rarely, used as part of investment decision-making.

‘an example of greenwashing is a thematic fund which suggests it is ‘green’, includes issuers which the objective observer would not class as sustainable’

Sometimes, a thematic fund which suggests it is ‘green’ may include issuers which the objective observer would not class as sustainable; another example is where engagement work carried out by an investment management firm is done by ‘corporate governance’ staff members who do not interact with the fund managers.

However, the speed of developments within the sector means that those looking for specific sustainability objectives should be catered for; and its a fluid and personal situation – for some, excluding sin stocks such as oil and gas is all important, while for others, investing in fossil fuels is acceptable if a company is taking positive steps in developing renewable energy capabilities.

One thing is for sure, if there is client demand, the industry will ensure there are products to match, and if investment returns remain high, the ESG sector seems set fair for dramatic growth