- Companies ‘licence to operate’ is increasingly scrutinised
- Ethical investors should not only rely on data providers and asset managers
- Reporting frameworks are useful sources of information
Although financial preservation is likely to be a priority after a fraught year for the UK economy and stock market, the rapid growth of socially responsible investing suggests people are increasingly eager to align their investment portfolios with broader social values. Funds that describe themselves as sustainable or socially responsible generally analyse companies' environmental, social and governance (ESG) credentials and try to screen out companies that in their view are harmful to the environment or society, or badly run. But a problem is that funds' managers definitions of problem areas or companies might be different to yours, so it is important to do your own research to ensure that you are happy with where your money is invested.
When devising your own ethical investing strategy, there are two main approaches you can take. One is exclusion-based, whereby you avoid particular sectors. For example, many ethical investors avoid tobacco, gambling, arms manufacturing and pornography companies. But it is not always clear cut. For example, National Employment Savings Trust, the UK’s biggest pension fund, announced its divestment from fossil fuels earlier this year, making it one of a growing number of large investors to shun investment in oil companies. Other institutional investors, however, argue that by owning these companies and lobbying them to be more environmentally friendly, their net impact can be greater.
Another area that some investors may choose to avoid are large pharmaceutical companies as they conduct animal tests to develop drugs. But other ethical investors are happy to invest in big pharma, and might have a positive view on drug developers because of achievements such as producing coronavirus vaccines this year.
The other way to approach ethical investing is to search for companies that have a positive impact on society, rather than solely investing for financial returns. MSCI and Sustainalytics are two of the most widely used ESG data providers, so you could start by looking at some of the companies they rank most highly and take a ‘best in class’ approach.
Many funds classed as ethical are transitioning from having an exclusion-based approach to having a more positive and forward-looking outlook, aiming to focus on finding companies that have a net benefit to society, points out Adrian Lowcock, head of personal investing at Willis Owen. For example, Royal London Asset Management’s sustainable fund range is run by a team that uses positive screening to find the companies that they deem to have the best ESG qualities.
Understanding the societal impact of a company is a process that involves a lot of research. There are a number of asset managers who run so-called ethical funds, which can be a great way to build your strategy as they should have the resources to research the companies for you. You can read their sustainability reports and look at their investment ideas when constructing your own portfolio, or invest in their funds if you find a manager whose philosophy fits well with your own.
Elizabeth Stuart, analyst in sustainability research at Morningstar, suggests also thinking carefully about your risk profile. “An investor with a minimal risk appetite may wish to invest in a broadly diversified passive product which has been de-risked in terms of ESG,” she explains.
An investor with a greater risk appetite may want to add some smaller allocations to green bond, clean energy or social impact bond funds.
Review your portfolio
There has been a proliferation of industry bodies that aim to help investors assess the impact of companies they invest in. The Taskforce for Climate-Related Financial Disclosures (TCFD), Climate Action 100+ and Transition Pathway Initiative assess companies' preparedness for a low carbon economy. Many listed companies, including investment trusts, report TCFD in their annual reports so you can assess their environmental impact by reading those.
To assess a company's social impact you can look at which of the United Nations Sustainable Development Goals (SDGs) it aligns itself with and see if these values match yours.
Most large listed companies in the UK now produce sustainability reports explaining which of the United Nations’s 17 SDGs they contribute towards, and how they do it. If gender diversity is important to you, you can look at membership of the 30% Club which has a mission of achieving at least 30 per cent representation of women on all company boards globally.
For fund investors, the Morningstar Sustainability Rating, also known as its Globe rating, can be used to assess a portfolio's ESG risk. Ms Stuart says that “this can be drilled down to the company level as well, with analyst reports available for the ESG risks and controversies”.
Investors keen to reduce their exposure to ESG risk might want to invest in a fund with four or five Globes, as funds that have attained these are deemed to be the most sustainable in their sector by Morningstar.
If you are concerned about the environment, Morningstar awards a Low Carbon Designation to funds with a low carbon risk score and exposure to fossil fuels of lower than 7 per cent. The newly launched Morningstar ESG Commitment Level gives a qualitative analysis of funds and asset management companies with respect to their commitment to ESG, the resources at their disposal and the ESG experience of their management teams.
There are many other tools you can use to siphon through ESG criteria. Rowena Griffiths, chartered financial planner at Female Financial Management, says she uses the Synaptic research tool because it enables you to filter using negative criteria that you have selected, and positive criteria such as good labour relations and positive impact on the environment.
Ms Griffiths adds that while she tries to build portfolios with funds classed as ethical where possible, this can be harder for some regions. It is difficult to find high-performing ESG funds focused on Asia and emerging markets, where governance is often more opaque, and social and environmental practices are less developed. Rather than pick designated ESG funds in these regions, Ms Griffiths tends to invest her clients in funds run by companies such as Baillie Gifford "where I know they have an interest in being ethical”.
When you invest in a fund, also look at its 10 largest holdings. Many funds that describe themselves as ethical have a very wide investment universe and may hold companies that might not fit with your own ethics. Baillie Gifford Positive Change (GB00BYVGKV59), for example, has seen extraordinary growth this year, both in terms of performance and new money coming into the fund. Its objective is to invest in high-quality growth companies that can deliver positive change in one of four areas: social inclusion and education, environment and resource needs, healthcare and quality of life, and addressing the needs of the world's poorest populations.
However, its largest holding is Tesla (US:TSLA). which some ethical investors may wish to avoid. The carmaker has split opinions including among ESG data providers. MSCI ranks Tesla as one of the top car manufacturers on ESG grounds, whereas FTSE Russell ranks Tesla as one of the least ethical car brands. Despite the company selling eco-friendly vehicles it does not disclose the environmental impact of its manufacturing, which FTSE notes as a red flag.
UK-listed clothing retailer Boohoo (BOO), meanwhile, was rated double A by MSCI with regard to its ESG credentials, placing it among the top 15 per cent of its peers based on ESG metrics. But the company came under fire in July following allegations about poor working conditions and practices in factories making its clothes, showing why you should not rely on ESG ratings alone. You might also question the authenticity of any sustainable funds that hold or have held Boohoo – or at least look for their justification for doing this.
Watch out for greenwashing
So-called greenwashing has become rife across the asset management industry. Many fund managers highlight the importance of ESG in their investment processes, but far fewer have established ethical strategies. ESG investing has spiked in popularity, in part because ESG funds have outperformed conventional peers by a significant margin recently. This is largely because they tend to have a bias towards technology and healthcare companies, which have done well, and avoid fossil fuel companies, which have lagged.
When selecting an ethical fund it makes sense to opt for one run by a manager that has been in this business for a long time and has established processes, and is not just jumping onto the coattails of a trend. Royal London Asset Management, Liontrust (LIO) and Federated Hermes have good reputations with regard to running sustainable funds.
Look for an asset manager that votes at company annual meetings rather than outsourcing this, and perhaps collaborates with other shareholders to engage with companies on controversial issues and encourages change. Responsible owners focus on companies' plans to survive in the long run, through anticipation of change, reinvestment of profits and training staff.
It is important to regularly review your holdings to make sure you are happy with them – maybe once or twice a year – as things can change. For example, in Facebook's (US:FB) early days, it was praised for being an accessible social enterprise that connected people from all over the world. As it grew, questions arose about its use of data and the Cambridge Analytica scandal dramatically changed many people’s opinion of Facebook’s social value.