Getting your head around ESG investing

Investors who want to take responsible factors into account when selecting funds face the tricky task of understanding what terms like sustainability, impact, and environmental, social and governance (ESG) mean, and how they are applied in practice by fund managers.

Given the volume of contradictory language and interpretations in the space, it is not a job for the faint of heart. But it can help to have an initial idea of the approaches one can encounter, before delving into the offerings available on the market.

Exclusions and ESG

Karen Ermel, director of responsible investing at Coutts, suggests looking at ESG as a spectrum that goes from purely focusing on returns to purely focusing on the responsible or ethical outcome, all the way up to philanthropy. Within this spectrum, there are different strategies fund managers can use in their portfolios.

These include exclusions, or 'negative screening', which remove any exposure to certain sectors or stocks on ethical grounds. This ranges from pretty basic exclusions such as controversial weapons or gambling, which from a global perspective usually have a limited effect on returns, to bigger and more impactful sectors such as fossil fuels. Excluding certain areas can dent returns by varying degrees.

Exclusions are typically applied based on levels of exposure to a given area. For example, a manager might not invest in a company that makes more than 5 per cent of its revenue from, say, thermal coal extraction. Even with exclusions in place a fund might still have exposure to that sector, although hopefully very small.

A common argument against exclusions is that they prevent engagement or 'stewardship', which involves investors using their influence as shareholders to steer a company in a more responsible direction. Many sustainable investment managers say that they engage with companies and this can be a valuable tool in their kit, but the extent of their actual efforts can be quite variable. Campaign group ShareAction publishes an annual report that scores asset managers based on their voting records on a range of environmental, social, and pay and politics resolutions. This found that in 2022 the four largest asset managers globally backed significantly fewer shareholder proposals than they did in 2021.

A second category comprises the strategies that fall under the specific umbrella of environmental, social and governance (ESG) investing. This is where things get complicated because interpretations of such terms can vary. Ermel argues that at their core, ESG strategies are about risk mitigation – not about making a wider positive social or environmental impact. This is where a lot of misunderstanding stems from. “Because there’s no standard definition, people start confusing the way a company is run with what a company actually does,” Ermel explains.

ESG scores typically look at things such as company policies, treatment of workers and company boards’ gender diversity. So, for example, oil companies such as Shell (SHEL) can have solid ESG scores despite their core businesses being harmful for the environment. And companies such as Tesla (US:TSLA), despite making electric vehicles, can be penalised because of the way they are run, how they source their materials or how they treat their workers.

Much depends on the data provider. Some focus on how companies score on ESG risks against their peers, which is not helpful when comparing different sectors. But, for example, Sustainalytics, which is part of Morningstar, groups companies into absolute risk categories that enable cross-sector comparisons. The use of ESG as a risk-control tool is also not universal and not always clear in how funds are marketed. 

Strategies under the ESG banner include ‘best in class’ or positive screening funds, which focus on companies that best meet ESG standards with an approach that can vary from selecting the best-performing companies to excluding the worst.

A popular fund that deploys negative and positive screening is Rathbone Ethical Bond (GB00B77DQT14). Anna Mercer, head of responsible investment research at Square Mile Investment Consulting and Research, explains: “The negative screening means the fund has a zero-tolerance policy to companies with a meaningful involvement in alcohol, gambling, nuclear power, pornography, predatory lending and tobacco, or are harmful to animal welfare, human rights or the environment.”

This company's positive screen looks for businesses that, for example, embrace workplace diversity, contribute to the community or offer products and services that benefit the environment or society. 

Sustainable and impact funds

When people look for a responsible or ESG investment, often what they actually want is a sustainable or impact fund. A sustainable solutions fund manager invests in companies that provide solutions to social and environmental challenges in the belief that this will result in long-term financial benefits, Mercer explains. Examples include Aegon Global Sustainable Equity (IE00BYZJ3771).

Meanwhile, an impact fund has an explicit intent to make a wider positive social or environmental impact, and should provide evidence of it. One example here is Ninety One Global Environment (GB00BKT89K74). Because impact funds are so focused on their responsible credentials, with these you often have to accept either a higher risk or a lower rate of return, Ermel says.

Assesing impact funds opens a whole new can of worms because managers have different interpretations of what "having an impact" is or how it is measured. But impact funds often publish annual impact reports which can help you determine what the approach and criteria of a specific fund are.

Sustainable and impact funds can vary by how broad or narrow a focus they take: Ninety One Global Environment, for one, concentrates on decarbonisation. Some funds provide an indication of their areas of focus via the United Nations Sustainable Development Goals, 17 themes that form the “blueprint for peace and prosperity for people and the planet”. These goals include clean water and sanitation, affordable and clean energy, and climate action.

There are also sustainable thematic funds, but if a fund invests in forestry or water that doesn’t guarantee that it does so in a sustainable or ethical way – particularly when it comes to exchange traded funds (ETFs). As Alice Ross has recently pointed out in the Financial Times, water funds tend to invest a lot in utilities companies whose environmental credentials can be far from obvious. 

Complications and regulations

Broad as they are, the classifications outlined above still present some problems. Firstly, these strategies are not mutually exclusive. “Most funds that we review as part of our research do embrace elements of exclusion, sustainability and impact,” says Mercer, with exclusions being used more often. “At the other end of the spectrum, fewer funds would qualify as pure impact strategies as this requires explicit metrics to demonstrate the positive change for people or the planet that each holding has.” 

John Ditchfield, chief executive officer of Impact Lens Financial Planning, a provider of responsible investment research and advice, adds that it is difficult for investors to navigate the space because of the confusion over the various ESG-related terms. “The problem is that there is relatively little consistency in the marketplace around the marketing and labelling of funds with terms such as sustainable,” he says.

Regulators are trying to step in. In the European Union, the Sustainable Finance Disclosure Regulation aims to set minimum disclosure standards for responsible funds to prevent so-called greenwashing. It classifies funds as Article 6 if they do not integrate any kind of sustainability into their investment processes, Article 8, or light green, if they promote environmental and social characteristics, and Article 9, or dark green, if they target sustainable investment. The Financial Conduct Authority, meanwhile, is working on a different system, which will classify funds according to whether they hold sustainable assets – labelled by the regulator as sustainable focus; aim to improve the sustainability of assets over time including through stewardship – sustainable improvers; or invest in solutions to environmental or social problems – sustainable impact. It is also looking to develop a code for ESG data and rating providers, and to better scrutinise ESG benchmarks.

All these regulations are something of a work in progress, and the object of much debate and misunderstanding. Once they are fully in place, things might become a bit clearer for investors. But for now, there is no alternative to thoroughly researching responsible funds before investing. 

Ditchfield concludes: “I think it’s very important that investors try to obtain as much detail as possible on the fund they are looking at and the underlying companies. This is often the best way to understand how the manager interprets sustainability, impact or ESG.”