Can you make money from investment markets while maintaining a principled stance on ethical issues?
Proponents of ESG investing – where ethical, social and (corporate) governance concerns are to the fore in decision-making – certainly believe it is possible.
Once dismissed as a virtuous concept that potentially compromised portfolio returns, ESG investing has moved centre-stage within the global investment arena in recent years.
ESG is one of several approaches to investing which is as concerned with its impact on people and the environment as it is with potential financial returns (see below for other versions of ‘principled investing’).
For younger investors in particular, investing with a conscience is becoming an important consideration often driven by major issues of the day, from concerns about climate change to calls for Western businesses to sever their ties with Russia in light of the latter’s invasion of Ukraine.
Here’s a closer look at ESG investing, including what it is, how it’s moved into the mainstream and the best way for investors with principles to get involved.
What are the roots of ESG?
So-called ‘ethical’, ‘socially responsible’ or ‘green’ investing strategies aren’t new.
Their roots date back to the 1960s, when stock market investors began to exclude from their portfolios both individual companies, as well as entire industrial sectors, because of specific business activities.
Examples included avoiding companies with an involvement in South Africa’s then apartheid regime, as well as the shunning of businesses concerned with practices such as armament manufacture or tobacco production.
The term ‘ESG’ was first coined in a 2004 report called Who Cares Wins, Connecting Financial Markets to a Changing World.
Produced jointly by the United Nations and Swiss Federal Department of Foreign Affairs, the report recommended ways for the finance industry to better integrate environmental, social and governance factors into its practices, including asset management.
Since then, ESG investment has grown at a phenomenal rate. According to the Global Sustainability Investment Alliance (GSIA), in 2020 approximately $35 trillion in assets were being managed in accordance with ESG principles across five major markets: Australia & New Zealand, Canada, Europe, Japan and the United States.
GSIA says this equated to about a third (36%) of all professionally managed assets across the regions in question.
According to data providers Refinitiv Lipper, 2021 was a bumper year for ESG-focused funds, with the sector attracting an inflow of $649 billion over the year to 30 November. This compared with $542 billion and $285 billion for the same period to 2020 and 2019 respectively.
Why invest ethically?
In 2020, the ESG movement was given extra momentum when Larry Fink, the boss of BlackRock, the world’s largest investment firm, argued that a fundamental shift in capitalism was under way to which companies and investors needed to respond if they wished to prosper.
Fink suggested that principled investing was neither ideological, nor ‘woke’, but the best route to obtaining long-term rewards from businesses.
What is ESG investing?
Professional fund managers typically put together equity investment portfolios – ones with exposure to stocks and shares – according to strict criteria and themes.
For example, investment funds tend to be categorised by the country, region or industrial sector in which they invest.
A UK equity fund, therefore, invests in companies that trade on the London stock market. A technology fund, meanwhile, typically restricts itself to companies in the tech sector.
ESG investing adds another filter to the potential stock choices made by a fund manager to take into account a company’s environmental, social and corporate governance practices.
In theory, companies that actively support positive change across a number of measures – as determined by independent ESG research – will find themselves nearer to the top of a fund manager’s ‘buy’ list than their rivals.
Key ESG measures
For the purposes of ESG, the three key measures are:
- Environmental How a company acts towards the welfare of the planet. What kind of impact does it have on the environment?
- Social. How an organisation treats its employees, customers, suppliers and local communities. Includes factors such as racial diversity, inclusiveness and recruitment practices.
- Governance. How a company is run, including the way it is audited and the way it administers shareholder rights. Also covers attitudes to executive pay as well as how a business communicates and generally interacts with its shareholders.
How is ESG performance worked out?
The key measures above read as noble sentiments, but in practice their application can be challenging. For example, the metrics used to work out whether a business can be described as ESG-worthy can often be subjective.
More than a dozen different frameworks are used to assess the credentials of a business. Because
ESG measures are calculated using varying methodologies, there is no single authority when it comes to evaluating absolute scores, often making it difficult to know how ‘green’ a company is.
The City watchdog, the Financial Conduct Authority, requires ESG assertions to be ‘reasonable and substantiated’.
Data providers help inform fund managers with their decisions. For example, MSCI provides a grading system ranking businesses from AAA (best) to CCC. Data is collected from company disclosures, as well as government, academic and other independent databases.
ESG investing – decision time
Would-be ESG investors need to make long, hard decisions before they start allocating cash to perceived feel-good stocks and funds.
Investors, for example, each have their own idea about what constitutes appropriate corporate behaviour and whether a particular company or investment fund matches the values an individual holds most dear.
Take arms manufacturing, for example, a timely consideration given the events unfolding in Ukraine. Companies making arms and military hardware have long been on the ‘to avoid at all costs’ list for many ESG funds.
But what if, say, an arms manufacturer supplies missiles to a nation perceived as the underdog in a conflict? Earlier this year, the Latvian deputy prime minister asked: “Is national defence not ethical?”
An industry that seems repellant to one person might seem like a necessary evil to others.
Take the pharmaceutical sector. Investors may choose to shun the industry because of moral objections surrounding animal testing. Others, however, might embrace pharmaceutical companies for the life-saving roles their vaccines played during the Covid-19 pandemic.
ESG investing – DIY or take advice?
As well as having clear demarcation lines about suitable types of investment, would-be investors also need to decide whether they are going to pursue a DIY approach – and select their holdings themselves – or rely on (and pay for) professional advice.
If you’re looking to be ‘hands on’ and are keen to ensure that your investments align with your morals, you’ll probably want to build your own DIY portfolio.
To do this you’ll need to open an investment account with an online trading platform. To shield your investments from tax, up to a maximum of £20,000 a year, you could consider making them via a stocks and shares ISA.
As a DIY investor, when weighing up potential funds, it’s important to check where your money is going to be invested.
You can find out more by reading the fund factsheets supplied directly by investment management firms, or from the research tools offered by your investment platform. Alternatively, consult data providers such as Morningstar and Trustnet, which also supply information in relation to a fund’s holdings.
Building a portfolio from scratch takes time, effort and regular monitoring and review. If that’s not for you, an alternative way to create an ESG investment portfolio is to seek help either from a so-called ‘robo-adviser’, or by employing the services of an independent financial adviser (IFA).
Robo-advisers are digital advice services that build and manage investment portfolios based on your risk appetite and investing aims. They tend to cost less than the in-person advice offered by IFAs.
IFAs, however, are able to research the entire funds market and make investment recommendations according to both your financial goals as well as your principled investing requirements.
Does ESG have its detractors?
Yes. Tariq Fancy, BlackRock’s former chief investment officer for sustainable investing, has poured scorn on ESG investments saying they overstate their impact and that market-led solutions were a distraction from government-led ones.
The subjective nature of measuring ESG also means that, while a company may fulfill certain criteria, it falls short on others. This can leave fund managers with the tricky choice of deciding which stocks to include within a portfolio and which ones to omit.
Aside from the issue of whether a particular company or fund passes the ESG test, there are other considerations for investors to bear in mind.
Screening out individual companies and entire industrial sectors can increase the risk that your investment will miss out on growth and opportunities. On the flip side, the extra analysis associated with ESG measures means investors may end up with exposure to better-managed companies.
Does ESG affect performance?
Some commentators believe incorporating an ESG strategy involves accepting a trade-off, in other words, accepting lower returns as a trade-off for doing good. Others believe the opposite.
Last year, a group of academic researchers from the universities of Pennsylvania and Chicago predicted that green assets are likely to underperform in the future. They explained that, while returns from green assets had been buoyed by money flooding into the space due to climate change shocks in the previous decade, this alone would not be enough to sustain future expected returns.
In contrast, fund manager abdrn says it strongly believes that ESG can have a positive effect on both corporate financial performance and on portfolios. It adds that companies that are well managed and which consider risks and opportunities around ESG issues should outperform over the long-term.
Whichever side of the debate you take, it’s worth remembering that ESG investing remains susceptible to the same human factors we see elsewhere, namely, fear and greed. Individual stocks or industrial sectors that are popular with ESG investors will end up overvalued if they are hyped up too much.
In such a scenario, the issue of ‘mispriced’ assets could pave the way for a period of underperformance. This would not, however, be an invalidation of ESG investing, just evidence of human nature in action.
Other forms of ‘principled’ investing
There are various forms of principled investment, often with overlap between one version and another.
Ethical investing involves selecting investments that avoid dealing with products and services that may be considered harmful or fall short of upholding personal values, such as tobacco, adult entertainment and gambling. Many ethical funds also screen for environmental issues such as deforestation or negative social issues such as low employment standards.
Faith-based investments align with the principles of certain religious groups. To build these funds, a negative screening process is used to exclude practices that could be deemed unsuitable by religious standards, for example, alcohol and gambling.
This involves investing in companies that either directly focus on improving the environment or avoid investing in those that damage it (eg, oil and mining companies).
Impact investors aim to generate positive, measurable influences on society and/or the environment, alongside a financial return. Typical areas that impact investing might aim to challenge include traditional (ie non-renewable) power generation and gender inequality. Impact investing can be associated with lower financial returns, though this is not always the case.
This is an alternative term for a range of investment approaches including responsible, sustainable or ethical investing. It usually means that ESG factors and values have been integrated into the investment process. Some examples may include human rights and environmental sustainability.
An investment approach that considers ESG factors, with a focus on companies seeking to improve wellbeing and which have a positive impact on society and the physical environment.
Fund managers practising good stewardship not only regard themselves as part-owners of the businesses in which they invest, but they look to make sure they’re run in a way that benefits all shareholders. They vote at company annual general meetings (AGMs) and engage with management holding it to account, while using their bargaining power to promote positive change.