Environmental, social and governance investing has grown strongly over the last few years, in terms of both assets flowing into funds and investment vehicles available.

According to data from Morningstar, annual European sustainable fund flows increased from €50bn (£45bn) in 2018 to a record-breaking €120bn in 2019, bringing the total assets under management to €668bn.

This increase was mirrored in the number of sustainable funds, which increased by 360 in 2019, to total 2,405.

This interest has, if anything, increased since the start of the Covid-19 crisis.

For example, people have noticed and appreciated the lower levels of pollution (due to much lower economic activity), while companies that treated their employees badly were punished by the consumer and those that behaved well rewarded.

Ethical investing

The original form of this type of investing, often known as ethical investing, was just negative/exclusionary screening – the screening out of companies or even industries based on specific criteria, such as a significant portion of the firm’s profit coming from: alcohol, gambling, tobacco or weapons; or the company using animal testing or child labour.

ESG investing involves searching out and including companies based on desired ESG characteristics rather than just excluding firms

Such funds, however, usually had lower returns and higher risk compared to equivalent funds which had not been screened.

This is to be expected from a theoretical point of view – when investors limit their universe they risk underperformance and greater risk because they are not selecting the most ‘efficient’ set of investments – and is probably the main reason why this type of investing never really took off.

ESG investing involves searching out and including companies based on desired ESG characteristics rather than just excluding firms with undesirable business activities.

The approach involves a systematic consideration of specified ESG issues throughout the entire investment process in order to increase returns and reduce risk.

IA responsible investment framework

Using the Investment Association responsible investment framework, there are three different levels to ESG investing.

Exclusions, similar to the ethical investing described above, involves the exclusion of investments in certain companies and sectors from the fund or portfolio based on pre-defined criteria.

Sustainability focus is where investment is made in companies on the basis of their fulfilling certain sustainability criteria and/or delivering on specific sustainability outcomes.

This can take the form of positive screening, where the investment manager looks for businesses that are ‘best-in-class’ based on ESG ratings; or sustainability-themed investing, where investment is made in companies that target specific sustainability themes such as climate change mitigation, pollution prevention sustainability solutions and approaches that relate to one or more of the UN Sustainable Development Goals (SDGs).

Impact investing is when investment is made with the intention of generating a positive and measurable social or environmental impact.

Examples include: a social bond fund which invests in bonds whose funding is ring-fenced for projects or initiatives that have the intention of generating positive and measurable social or environmental impacts; investing in private equity where it can be demonstrated that the money invested will go towards having a positive social or environmental impact; and SDG impact funds where impact is measured against the UN SDGs.

It can be easy for a fund manager to justify that their investment has a sustainability focus but the key words here are being able to demonstrate that the impact is ‘positive’ and ‘measurable.’

Taking the example of a fossil fuel company that invests heavily into researching forms of renewable energy, it may be argued that the company targets the theme of climate change mitigation; however, it is unlikely that the company’s overall impact towards this goal will currently be a positive one.

It should be noted that a fund may not necessarily fall into just one of the above levels of ESG investing. In fact, it is likely that there will be elements of at least the first two in the fund.

Unlike the original ethical investing described above, much research has shown evidence of a positive performance effect with ESG investing, or at least no performance penalty.

Several studies have shown that a majority of ESG funds outperform their non-ESG equivalents.

Most recently, research by Morningstar analysed the impact of the market downturn in Q1 2020 caused by COVID-19 and found that 51 out of 57 (89 per cent) of their sustainable indices outperformed their broad market counterparts.

The reason for this can be attributed to the fact that companies that score higher in terms of ESG tend to have better corporate governance policies, care more about the treatment of their employees, produce more sustainable products and are less prone to events such as environmental disasters, with their subsequent clean-up costs and expensive PR damage.

During times of market distress there is a flight to quality, which benefits these higher ESG-rated firms.

As well as numbers showing better performance by ESG funds compared to their non-ESG equivalents, another reason for the growing interest in ESG investing is the fact that new MiFID II rules will next year require advisers to ask clients about their ESG preferences and take these into account when assessing the range of financial products to be recommended to them – fund and portfolio recommendations will need to match each client’s individual ESG preferences

As a result, advisers will need access to ESG data and fund research in order to fulfil their requirements and some reasonably detailed research will be needed before the adviser can recommend any ESG funds to their clients.

Several firms now provide research and ratings for funds based on their ESG characteristics and integration of ESG factors.

At Defaqto we recently launched our own ESG Reviews for funds which cover, among other things:

  • The fund’s ESG policy and how well the fund aligns to it
  • Product involvement, if any, in certain controversial areas
  • ESG integration as per the three levels described above
  • Any adherence to the UN SDGs
  • The fund management firm’s voting and engagement policies with corporates on ESG issues
  • The company resources in terms of ESG behind the fund

The information for all of this is obtained through a detailed meeting with the fund manager and other key individuals.

Challenges to ESG investing

What are some of the challenges with ESG investing?

One of the biggest challenges has been the lack of uniformity in definitions.

Terms such as ‘responsible’, ‘sustainable’ and ‘green’ can mean different things to different people.

This made it difficult for investors to know exactly what a fund was offering and, possibly as a result of this ambiguity and the growing popularity of ESG funds, there was an abundance of funds launched with a buzz word such as one of the ones above.

In some cases, however, there seemed to be little to do with ESG in the fund’s process upon closer inspection.

This is referred to as ‘greenwashing’ that is, providing misleading ESG claims to investors in order to capture ESG inflows.

People in the industry have, though, been aware of this issue for some time and investment bodies have moved to address it. In a report published in November 2019, the IA launched a responsible investment framework that aimed to standardise some of these terms.

Within this report, the IA set out definitions for some of the key phrases used in ESG investing, such as ‘ESG integration’, ‘exclusions’, ‘sustainability focus’, ‘impact investing’ and ‘stewardship’. This has provided a much needed first-step to a homogeneous approach to ESG investing, although we expect to see more progress in the future.

Another challenge with ESG investing has been the lack of consistency between ESG rating providers, both in terms of fund and company ESG ratings.

Given the vast amount of ESG data points and the fact that each rating provider has their own criteria and weightings as well as other differences in methodology, the correlation between the outputs of the various ratings agencies is generally low.

One study, Krosinsky C (2018), The Failure of Fund Sustainability Ratings, calculates a correlation of approximately 0.3. Such low correlations make it difficult for advisers and their clients when selecting funds this way.

These low correlations can also cause problems for investment managers relying on company ESG ratings, with the results of their screening changing drastically depending on which data provider is used.

As a result, many funds now disaggregate the ESG data and apply their own weightings. As such, it is important for investors to be aware of what methodology the fund uses and what the criteria are.

Perhaps as a result of the above challenges as well as the misconception around performance being worse for ESG funds, some advisers were slow to warm to the idea of ESG investing.

According to research conducted by Boring Money in September 2019, only 30 per cent of advisers thought their clients would value a conversation about ESG. In reality, however, 72 per cent of the fund investors surveyed said they would value this.

Not surprisingly, this has continued to be the case since the start of the COVID-19 market volatility.

At the end of April 2020, Federated Hermes, an asset manager known for responsible investment, polled 200 advisers and found that 82 per cent had seen a rise in client requests to allocate capital to ESG focused funds.

Despite the above challenges, we expect to see the popularity of ESG investing continuing to increase. This, undoubtedly, means the launch of new ESG funds and a greater range of options, making it especially important for investors to be able to assess whether the fund meets their ESG criteria.

 

Patrick Norwood is Insight Analyst (Funds) at Defaqto

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