It wasn't long ago that the idea of ethical investment was anathema to most investors – a worthy exercise that delivered dull investment returns at best that only the wealthiest do-gooders could afford to absorb. But for most companies, corporate and social responsibility is no longer just a box-ticking exercise. A wave of regulation and growing customer awareness of social and environmental issues means ethics now have a genuine effect on the bottom line – and that means investors can no longer ignore how clean (or dirty) a company's profits are.
That very real trend is manifesting itself in a major shift into socially responsible investment vehicles. According to the latest biennial trends report from the Global Sustainable Investment Alliance (GSIA), sustainable investment around the world grew by a quarter between 2014 and 2016 to $22.9 trillion (£17.4 trillion). Institutional investors are, unsurprisingly, leading the way, with many having proclaimed their commitment to responsible money management by becoming signatories to the United Nations Principles of Responsible Investment (UN PRI), and by incorporating the UN Sustainable Development Goals (SDGs) into their investment practices, which loosely speaking refer to the assimilation of environmental, social and governance (ESG) considerations into investment decisions.
Over the years, investing with a conscience has shifted from being a niche concept to becoming fully integrated into financial markets. As we shall explore in this feature, various approaches and products have emerged to allow investors to pursue their convictions and generate healthy returns at the same time. Indeed, ‘The Good Investment Review’ – an April 2018 report by Good With Money and 3D Investing – identified 216 ethical and sustainable funds available to UK investors, collectively comprising assets under management of £105bn. And sustainable investment isn’t just confined to pension funds and charities. In the US, Canada and Europe, the proportion of sustainable retail investments relative to institutional investments doubled from 13 per cent to 26 per cent over the GSIA’s two-year time frame, as investors have become demonstrably more aware of how their money is being put to work and whether this chimes with their beliefs – our annual Top 100 Funds list now contains four ethical funds to reflect this growing demand.
Do principles breed profits?
Investing ethically has in the past been thought of as requiring a trade-off between moral concerns and generating returns. But a growing body of evidence – including the performance of our ethical Top 100 Fund picks – suggests that following a moral code needn't hamper portfolio growth – in fact, data suggests, it can enhance it. In 2015, even before the recent ethical boom, Morgan Stanley reviewed various studies on sustainable investment performance, and the performance data of 10,228 open-ended mutual funds and 2,874 separately managed accounts based in the US, denominated in US dollars. It found that – on an absolute and a risk-adjusted basis, across asset classes and over time – “investing in sustainability has usually met, and often exceeded, the performance of comparable traditional investments”.
Even if you're not interested in funds and prefer to buy company shares directly, it's still worth considering an ethical approach to stock selection. That's because there is a growing body of evidence that companies that are on top of ethical issues may demonstrate stronger all-round management, or are simply well-aligned with the ethical concerns of their customers and taking advantage of the ethical and social market opportunity. For example, shifting from traditional energy sources to environmentally friendly alternatives can not only cut carbon emissions, but also save costs – which should in theory benefit a business’s bottom line. At the larger end of the corporate scale, Alphabet’s (US:GOOGL) Google said in April that it now buys enough renewable energy to match the electricity that its operations consume. Meanwhile, Apple (US:APPL) is now globally powered by renewable energy. And here in the UK private Suffolk-based brewery and distillery Adnams has achieved the same goal, only using wind, solar and hydropower.
Conversely, companies that have flouted environmental or social concerns – whether that’s climate-change awareness, safety or corporate governance – have frequently proved bad investments, as numerous major scandals testify, the BP (BP.) Deepwater Horizon oil spill or the Volkswagen emissions violation being just two examples. At the very least, investors should make themselves aware of the risks they face when companies operate in such morally hazardous territory – BP and VW have had to cough up $65bn and €26bn, respectively.
The screening process
To understand their stock-specific exposures to ethical opportunities and risks, investors use a process called environmental, social and governance (ESG) screening. This approach is now part of the wider stock selection process in the same way as cash flow analysis or assessing management’s track record might be. Proponents of ESG investing believe it helps to weed out companies that face environmental or social risks, while identifying those that stand to benefit from emerging sustainability trends such as the rise of renewable energy.
Lisa Beauvilain, head of sustainability and ESG at Impax Asset Management (IPX), said: “It is key to integrate financial and ESG analysis together, they complement each other.”
ESG investing is still in its infancy and there is not an agreed upon best practice investors can look to, but ESG investors typically have a list of potential risks that each company must be assessed against (see boxout). However, as Gerrit Smit, head of equity management at family office adviser Stonehage Fleming, points out, this can be "very difficult and time-consuming” for private investors looking to 'green' their portfolios – there's a lot of information to wade through on the internet, and no clear standards as to how it should be interpreted.
And while many major index providers now offer ESG indices that identify and rank companies for their green credentials, their selection criteria have faced some criticism. Ms Beauvilain said often indexes based their rankings on a company’s level of disclosure and transparency, which often simply comes down to the country in which the company operates. What’s more, often screening criteria do not take account of a company’s sector, so a fund investing purely in oil and gas companies in Europe – where regulations demand typically higher levels of disclosure – would probably have a higher rating than a fund focusing on renewable energy companies in the US, where less disclosure is needed.
This confusion around what qualifies as a sustainable or socially responsible investment strategy has meant that some investments labelled as such would, in the eyes of most investors, be nothing of the sort. Investors keen to make their money a force for good should be very wary of this so called 'greenwashing', where companies or funds exaggerate their actions and commitment to sustainability issues for marketing purposes. Is an oil producer really green if it makes a small investment in solar power, or a tobacco company healthy because it offers vaping products? Ultimately, it is for individual investors to decide what qualifies as a sustainable investment in their eyes, but if you are attempting to incorporate ESG into your investment process bear in mind that green credentials are just as vulnerable to window dressing as balance sheets are, and it is always worth looking for further evidence to support or disprove companies’ claims.
According to the GSIA, by far the most common strategy for portfolio greening is so-called negative screening, accounting for $15 trillion in assets under management in 2016. This process works by simply excluding certain sectors or companies that are incompatible with pre-determined ESG criteria, rather than looking for companies acting in a socially or environmentally positive way. Typical examples include ‘sin stocks’ such as tobacco, alcohol, gambling and pornography businesses, but weapons manufacturers or major polluters such as oil and gas companies often face the chop.
But here lies a potential problem: where to draw the line? Beyond the obvious candidates for negative screening, the approach can be very personal and the list of so-called sin stocks endless. Portfolios with a Catholic tilt might embargo companies involved in stem-cell research or contraceptives. Animal lovers might eschew pharmaceuticals companies that conduct animal testing, but produce lifesaving medicines. What about companies using complicated financial structures to minimise their tax bills? Or food producers using ingredients such as palm oil, whose production can threaten fragile rainforests? Or shipping their food in the plastic packaging that's disturbing marine ecosystems (the BBC's recent documentary Blue Planet has had a huge impact on driving consumer awareness of ESG issues).
ESG screening tools, like that offered by index and data provider MSCI, can aid the selection process – monitoring, among other indicators, the percentage of revenue deriving from certain activities – so investors can identify that companies are operating within thresholds that they're comfortable with. One common response to finding that investments fail negative screening is to dispose of them altogether – a process known as divestment.
Positive screening and impact investing
Alternatively – or additionally – investors can take a proactive approach, buying into businesses and sectors that demonstrate exemplary ethical conduct. A central genre here is ‘impact investing’, whereby funds and companies help investors make a tangible environmental or social impact, while also hypothetically seeing good financial returns.
Instead of avoiding companies one believes are harmful, sustainable investors invest in companies or projects that stand to benefit from long-term growth trends, such as the proliferation of renewable energy or recycling. “The thesis for us is that these sectors will be growing faster than the rest of the economy,” Ms Beauvilain says.
This process is arguably more complicated than negative screening because there’s no standardised method of defining good and bad ESG practices, and no set rules for measuring positive change. Still, disparities may taper as the idea gains increasing recognition.
In any case, investors seeking ethical plus points could take a thematic approach. Different strategies have emerged over the years to reflect people’s numerous priorities and concerns – be these carbon emissions, gender diversity or employee happiness at work.
Here, we explore trends and opportunities within the environmental ‘E’ and social ‘S’ spheres. Each, in our view, contributes to better governance ‘G’ when implemented successfully.
E for Environmental
Environmental impact investing encompasses everything from waste management to energy efficiency, with climate change and population growth as the two major themes expected to drive growth in the sector. Most companies in the sector are focused around one of four major themes, and most projects tie into one or both of the driving forces:
- Energy: Both renewable energy generation and improving efficiency.
- Water: Improving and expanding water infrastructure, improving water treatment and recycling water used in industrial processes.
- Waste management: Recycling, reducing plastic usage and processing waste.
- Sustainable food: Dealing with the growing food demands of an expanding global population, and reducing the use of plastic packaging.
Environmental themes are more prevalent from an impact investing standpoint, and as a result are far easier to access than social impact projects. UK-based investors will already be aware of a wide array of companies dealing with these issues. Smart Metering Systems (SMS) installs and manages smart meters used to improve energy efficiency, while Biffa (BIFF) and Renewi (RWI) are working on improving waste management using anaerobic digestion and recycling. In early September the water utilities unveiled their spending plans for improving water quality and infrastructure over the next asset management period.
However, changes in regulations are making it easier for investors to access companies and projects in new ways. The introduction of the innovative finance individual savings account (Isa) – which allows individuals to lend money through peer-to-peer lending platforms – and social investment tax relief, which allows people investing in social enterprises to deduct 30 per cent of the cost of their investment from their income tax liability, have created new ways for retail investors to access impact-based investments.
One such platform is Abundance, which allows people to invest in impact projects. Bruce Davis, founder and managing director of the platform, said when the platform launched in 2012 the majority of the projects available were small-scale one-to-two-year investments in wind or solar projects. Now, it is hosting less prevalent technologies such as tidal or biomass projects, with longer time horizons.
“We’re seeing fewer but larger projects,” he said. “That reflects the maturing nature of the industry.” Most of the projects available for investment are either in the higher-risk construction phase, lasting one to two years and offering a return around 10-15 per cent, or lower-risk operational projects offering 4-7 per cent.
The trend towards larger projects is expected to continue, as the European Parliament recently overhauled its crowdfunding rules, allowing companies to raise up to €8m (£7.1m) without publishing a prospectus. The previous limit was €5m.
Lisa Ashford, chief executive of rival platform Ethex, expects changing demographics to drive growth in impact investing, as the millennial generation begins to engage more with financial services and investment. Indeed, research conducted by Ethex shows that while those aged 18-40 account for just 40 per cent of the total eligible population, they make up 51 per cent of those who already have ‘positive investments’, while the 41-50 and 51+ age brackets account for 16 per cent and 33 per cent of the market, respectively.
However, Mr Davis said the average Abundance user is part of the ‘boomer’ generation, with around £10,000-£12,000 invested. They are also financially savvy and expect to make a return. “It’s a myth that these businesses make a low return,” he said. “You should expect to make inflation-beating returns on wind and solar.”
Both agree the challenge for impact investing is in creating appealing investible projects, and in making sure people are aware of them. “It isn’t a problem of capital, it’s a problem of finding the right projects,” Mr Davis says.
S for Social
According to the UN PRI, examples of social factors include working conditions, local communities, conflict, health and safety, employee relations and diversity.
It follows that good working conditions and employee engagement should breed fewer departures, more productive work and possibly better financial returns.
France-based Sycomore Asset Management launched its equity fund, Happy@Work, in 2015. A quick caveat: the fund is open to UK institutional investors, but not UK retail investors. Still, it exemplifies an emerging trend that might materialise in other portfolios.
Happy@Work focuses on European companies, looking at how they value human capital. Sycomore meets with different management teams, gauging businesses’ culture and values. It considers employees’ sense of purpose, autonomy, their competence – looking at corporate investment in training and career management – the working environment and fairness, looking at diversity and wage differentials, among other areas.
Meanwhile, London-listed asset manager Standard Life Aberdeen (SLA) launched its UK Equity Impact Employment Opportunities fund in February 2018, in collaboration with Big Issue Invest (BII). The strategy is open to retail investors. And its objectives sound promising. It favours companies with more than half of the workforce in the UK, and which have the potential to “grow and sustain strong long-term financial returns” while also promoting and implementing good employment opportunities. Moreover, a percentage of the fund’s management fee goes to BII, for investment in its social missions.
The fund can hold a range of 40-80 stocks, and currently holds around 53. Investors should note that a more concentrated fund can bring greater risk. Among the top 10 holdings at present are Fevertree Drinks (FEVR), held for its ‘wage’ impact case; FDM (FDM), held for its workforce development impact case and RPC (RPC) for job creation.
Social and financial inclusion
Social and financial inclusion are two major focuses for impact investing. In January 2017, investment house Baillie Gifford launched its Positive Change Impact Fund (GB00BYVGKV59), which also has a retail share class. As at 31 August 2018, its performance was up 76.2 per cent since inception against the index (MSCI ACWI) performance of 20.2 per cent. But the fund’s time horizon spans five years, and future returns could differ from those seen so far.
Baillie Gifford’s fund invests in 25-50 global high-quality growth companies. It comprises four key themes: social inclusion and education; environment and resources; healthcare and quality of life, and base of the pyramid.
‘Base of the pyramid’ relates to companies whose products or services address the needs of the 4bn people globally who earn less than $3,000 per year. One company sitting under this thematic umbrella is Safaricom – Kenya’s largest telco, which runs mobile payments platform MPesa, helping to support financial inclusion. Safaricom has contributed 6.5 per cent on average to Kenya’s GDP every year over the past decade.
Another ‘base of the pyramid’ stock is Indonesian micro-finance provider Bank Rakyat. Two-thirds of adults in Indonesia are currently ‘unbanked’, underlining the opportunity here.
That said, those seeking to invest in micro-finance providers can also do so directly, rather than via funds. ASA International (ASA) became the first publicly quoted microfinance provider in Europe when it floated on the premium segment of London’s main market in July 2018. ASA provides guarantor-backed loans to low-income, female small business owners in Asia and Africa. The group says it has an addressable market of around 365m potential clients in existing countries.
And the half-year numbers to June were broadly positive. ASA’s clients grew by 29.6 per cent to over 2m. Loans to customers were up almost a third to $314m. Client deposits soared from $46.6m to $56.4m. This performance came despite the adverse currency effects in certain regions.
The shares have also risen considerably against their IPO price of 313p. That said, as we noted at the time, a lack of listed peers can make it challenging to value ASA. And in a recent ‘Taking Stock’ column, Mark Robinson raised the question of whether such lenders could be feeding “feeding an unsustainable cycle of debt”.
Various funds and companies now identify diversity as a positive ESG criterion. And included within this category is female representation and equal remuneration – issues that have been propelled since 2017 by the requirement for many UK companies to publish data on their gender pay gaps.
Beyond fairness, tackling this problem makes economic sense; PwC found that increasing female full-time employment rates to 61 per cent, from 43 per cent, could boost the UK’s GDP by £180bn. And women are also becoming more conspicuous on the investment scene. Management consultancy The Boston Consulting Group estimates that global private wealth held by women investors could reach $72.1 trillion by 2020, up from $33.9 trillion in 2010.
How to capitalise on this trend? In May, Legal & General (LGEN) launched the first gender-focused fund to focus only on UK-listed companies: the Future World Gender in Leadership UK Index Fund (GB00BF2LS457) – or the ‘GIRL’ fund. The asset manager ranks companies by four gender diversity standards: women on the board of directors, women executives, women in management and women in the workforce. Selected companies must achieve at least 30 per cent on these measures.
This is another fund without a performance track record because it has existed for less than one calendar year. And a more general lack of long-term data is something investors must contend with when considering any ethical strategy. But buying into the ESG universe could ultimately be worth the risk – if implemented via judicious portfolio management.