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The Evolution and Potential Future of ESG Investing

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The Evolution and Potential Future of ESG Investing

Written by: Jennifer Hill | Baillie Gifford

Ethical investing has been around for over three decades but has recently captured the public consciousness and been thrust up the political agenda. The BBC documentary War on Plastic and David Attenborough’s Blue Planet II have helped to bring the scourge of plastic and effects of climate change into sharp focus.

“Ethical, or responsible investing, has become a hot topic in 2019,” said Darius McDermott, managing director of Chelsea Financial Services. “Recent television programmes have highlighted what a huge global problem plastic has become, and climate change – although denied by President Trump – is becoming more apparent to all, so there is more public pressure to address the problems and more interest in what action can be taken.

“Away from things we can see, people are also becoming more aware of less visible issues like human rights and animal welfare both abroad and at home – things like treatment of employees and how companies work with local communities. In some ways it reflects what we are seeing at a political level – a rejection of the rich getting richer, poor getting poorer and profit being the only consideration.”

Investing with reference to ethical or environmental, social and governance (ESG) principles perfectly captures the zeitgeist of modern investors. Indeed, investors are uniquely well placed to help solve many environmental and social challenges, according to Julia Dreblow, a director of SRI Services.

“Without the support of investors, it is hard to see how existential threats like climate change and biodiversity loss might be addressed,” she said.

MYTH BUSTING

The argument against ethical funds has usually been that going green comes at a cost – that they are likely to underperform mainstream peers. A recent poll of Interactive Investor customers found that 15 per cent believe returns must be sacrificed in order to invest ethically.

It can be difficult to compare returns on ethical or ESG funds because they cover such a broad church of investments, but research into this area shows that companies with high ESG scores are less volatile, higher quality and better able to hold up during downturns.

Morningstar’s analysis of academic studies on the subject and its own analysis of performance data point to a positive link between material ESG considerations and a company’s financial performance.

Rebecca O’Keeffe, head of investment at Interactive Investor, a direct-to-consumer investment platform, said: “Ethical investing is, by its very nature, hugely subjective. However, far from compromising investment performance, there is a growing body of evidence that suggests companies with good ESG practices should be expected to outperform their less ethical counterparts, especially as interest in sustainability and environmental issues grows.

“Investors need to stop thinking that ethical options limit their investment potential and consider ways in which they could help improve both the planet and their financial futures.”

ETHICAL INFLOWS

A growing number of them are doing so.

“Lots of research has shown younger people are more concerned with their investments being ethical and having an environmental slant to them than previous generations,” said Laura Suter, personal finance analyst at AJ Bell, another platform.

“Our own customer research shows that millennials are more likely to rank ethical investing as ‘fairly important’ or ‘important’ than baby boomers. It’s also likely that as people increasingly become more environmentally conscious in their lives this will filter through to their investments.”

“However, this belies the change that is going on, as much of it is being driven in the institutional side of the market,” said Adrian Lowcock, head of personal investing at Willis Owen.

In the institutional market, sustainable investing is increasingly a licence to operate, according to Chris Greenwald, head of sustainable investment research and stewardship at UBS Asset Management, with questions about the integration of sustainability becoming standard in procurement processes.

“Asset managers without a convincing approach to sustainability integration are simply no longer competitive,” he said.

Retail investments are likely to follow suit. “What starts out institutionally will feed through to the retail space, especially those areas which have proven to boost performance,” said Lowcock. “This is why the broader ESG principles are getting wide adoption even in funds which are not ethical.”

ESG INTEGRATION

ESG factors are fast becoming a key consideration for asset managers, who are integrating them into their investment processes regardless of whether or not a fund is billed as ‘ethical’.

“Virtually every fund manager is talking about this, but within five years no-one will be talking about it – it will just be accepted that fund managers have incorporated ESG into their investment process,” said Ben Yearsley, a director of Shore Financial Planning.

While the term ‘ESG’ might appear homogenous, he points to fund managers putting different values on the ‘E’, ‘S’ and ‘G’.

‘Good governance should be a given – why would you want to invest in a company with bad governance practices? Where funds will differ going forwards is the emphasis they place on the E and S.

“This is where the darker green and ethical elements might come into the equation. All funds will claim ESG in the future, yet most will be very light green instead of the dark green ethical versions that will exclude many companies.

“So really in the future it’s only dark green ethical investors who want to exclude certain industries such as fossil fuels who will have to seek specific funds, as virtually all others will have an element of ESG.”

DEFINING ETHICAL

While ethical investing used to focus primarily on negative screening – simply excluding ‘sin’ stocks like tobacco and weapons manufacturers – it has evolved to look through a more positive lens.

Some fund managers actively look for companies that are doing good things and are having a positive impact on the world around them, often referred to as ‘impact’ investing.

“Baillie Gifford Positive Change and Montanaro Better World have a thematic impact approach,” said Patrick Thomas, head of ESG investments at Canaccord Genuity Wealth Management. “Funds like these are the future of this space – clear exclusions, defined performance targets, identifiable themes and focused reporting around impact.”

Others favour sustainability aware ‘best in sector’ companies or put companies under pressure to improve their operations through responsible ownership strategies.

“Defining an ethical stock is not that straightforward,” said Christian Holland, chief investment officer of Facet Investment Management. “William Hill is viewed as an ethical investment because it has done more than any other quoted bookmaker to help addicts and problem gamblers.”

Amazon could equally screen positively on certain metrics. While the technology giant has been criticised for tax avoidance and the amount and types of packaging it uses, it plans to join the ‘zeronauts’ by going carbon neutral by 2040.

“Amazon is sending a strong signal to other companies that they all need to engage with the challenge of climate change and announce similar ambitions,” said Frederik Dahlmann, associate professor of strategy and sustainability at Warwick Business School.

“At the same time, Amazon would do well to consider its wider role in our daily lives. With its market dominance and ubiquity, the company should also engage with concerns about packaging and the circular economy, for example by making delivery vans take back wrapping paper and cartons.”

INVESTOR CHOICE

The variety of strategies and terminology used in the space can be confusing – 40 per cent of Interactive Investor customers find it complex, which is likely to be a significant factor in the fact that only 23 per cent invest in ethical funds.

In response, the platform has worked with SRI Services to produce a list of more than 140 socially responsible and environmental funds, investment trusts and exchange-traded funds (ETF), which it has broken down into three style definitions summed up by the acronym ‘ACE’: ‘avoids’ (funds that focus on simply excluding companies, sectors or specific business practices); ‘considers’ (funds that consider a range of ethical and/or ESG issues when balancing positive and negative factors); and ‘embraces’ (funds that focus on companies delivering positive social and/or environmental outcomes).

“Investors now have enough suitable sustainable fund options from which to choose, enabling them to build broadly diversified portfolios,” said Hortense Bioy, director of sustainability research at Morningstar.

“For years, that was not the case. Investor choice will only become more robust over the next several years as asset managers continue to roll out new and differentiated strategies, and the many recently launched ones establish longer track records.

When it comes to fitting these funds into a portfolio, “some could be used as direct substitutes for broad core funds, while narrower investment propositions such as those focusing on specific sectors such as renewable energy or water could only be used as satellite investments”, he said.

Jennifer Hill is an award-winning British financial journalist. She left The Sunday Times, where she was deputy Money editor, to set up her own company, mediahill Ltd.

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