Sustainable and ESG investing explained

Sustainable investing and ESG (environmental, social and governance) investing describe investment strategies that pay close attention to environmental, social, governance and / or sustainability issues.

Fund strategies vary as they’re designed to do different things. Alongside looking to deliver long term returns, these funds use different strategies to encourage companies to improve their ESG behaviours. Some aim to help deliver positive impacts for people and the planet - while others focus more on reducing investment risk by excluding companies that they view as having poor ESG standards; many look at combining both of these.

ESG stands for environmental, social and governance. Broadly speaking, these headings provide the framework which allow investors to assess a company’s or fund’s sustainability credentials. They often overlap, and it can sometimes be hard to tell where an issue belongs as many environmental issues have social implications – and vice versa.

You might also find that ESG is often referred to as ‘sustainable investing’.

Find out more about Environmental investing.
Find out more about the S in ESG.
Find out more about corporate governance.

For many investors ethical issues are also important, such as avoiding armaments companies, tobacco manufacturers or companies with poor animal welfare standards. Many ESG and sustainability funds consider these issues although the funds we label as ‘ethical’ typically have the highest requirements.

For many investors ethical issues are important. Ethical investing generally favours companies with high ESG standards and avoids industries that may be considered harmful or misalign with personal values, like armaments companies, tobacco manufacturers or gambling. Many sustainability and ESG funds also consider these issues, however the funds we label as ‘ethical’ typically have the strictest requirements in these areas.

People often swap out terms like ‘sustainable’, ‘ethical’, ‘SRI (socially responsible / sustainable and responsible investing)’ and ‘ESG’ (environmental, social and governance) for each other. But while there is overlap, these terms were coined originally to lead to slightly different investment decisions.

Sustainable investment was originally concerned with helping to shape a greener, more sustainable future. ESG originated from investors wanting to reduce investment risk by researching how companies manage the environmental, social and governance issues that are relevant to their businesses. And ethical investment is an older term which strived to bring personal values into investment decision-making.

Fidelity’s sustainable and ESG spectrum incorporates both ethical and sustainable investing and you can find out more about this in our article on ‘Five ways to invest sustainably’.

Different institutions and funds have different ways of looking at environmental, social, governance and ethical issues.  These are explained to potential clients through criteria and policies (the main difference between the two being that policies are more detailed). Fund policies and criteria set out how a fund will deal with these issues, which in turn helps direct where a fund will and won’t invest.

Environmental issues (which should be explained in an investment fund's published ‘policies’ or ‘criteria’) consider a company’s impact on the planet, and may involve considering issues like climate change, biodiversity loss and plastics.

Social criteria consider how a company manages its relationships with employees, suppliers and the communities it operates in – or, in other words, people.

Governance relates to company management and leadership and may focus on issues like executive pay, audits, internal controls and shareholder rights and responsibilities.

Many funds also consider ethical issues which relate to personal values and concerns, which do not easily fit within the groups above. These include issues like armaments, tobacco, gambling and animal welfare.

The earliest documented examples of investment decision-making being made in line with a set of values dates back to faith groups in the 1800s, however these weren’t generally available to individual investors.

The first ethical funds (also referred to as socially responsible investing) emerged in the USA in the 1960s in opposition to the Vietnam War.  The first UK fund was launched in 1984. Its core focus was to exclude companies that didn’t align to its principles which at the time included armaments manufacturers, tobacco companies and businesses that were viewed as supporting the apartheid regime in South Africa.

It’s only in recent years that sustainable and ESG investing has really taken off largely as a result of growing concerns amongst both individuals and investment organisations about climate change.

Funds of this kind are important for two reasons. Firstly, because they allow people to invest in line with their personal preferences and lifestyle choice. Secondly, because they enable investors to group together to support companies (or investment strategies) that are building the kind of future they want to see.

And while no single fund strategy suits everyone, it’s becoming increasingly clear that investors have a major role to play in shaping our future and that the growth of this area is more relevant to business than ever.

Thanks to broader coverage in social media, TV and press, people are becoming increasingly aware of environmental issues and more socially aware on matters such as diversity and equal opportunities.

This increased understanding of real-life issues combined with shifting regulatory frameworks relating to topics like climate change (in line with the Paris Climate Agreement) mean that business and investment landscapes are changing.  As a result, strategies that focus on these areas are thriving.
   
This article goes into more detail about the relationship between sustainability and returns.

Before we had several decades of performance to look back on, there was a view that sustainable and ESG investing could lead to underperformance as fund managers’ options were more restricted.

It has become increasingly clear that companies that have higher environmental, social and governance standards are often better managed businesses and therefore more likely to succeed. In addition, funds which invest in companies that are ahead of regulatory change and helping to make progress possible are increasingly able to disrupt older business models. However, like any investment, the value of sustainable and ESG investments can go down as well as up, so you may get back less than you invest.

This article goes into more detail about the relationship between sustainability and returns.

Impact investment is relatively new and aims to help deliver social and / or environmental ‘real world’ benefits (which are continually measured to ensure their impact is enduring). Impact investing has evolved over time.

Originally, impact investment directly supported projects or organisations that might otherwise have failed to attract finance (a concept known as ‘additionality’), such as social housing or creating jobs for ex-offenders.
 
Impact investment has more recently expanded to include investment funds that hold often smaller, newer companies whose purpose is to provide solutions to environmental or social issues (which may include social housing and job creation).  These funds aim to help companies succeed and grow more rapidly through various forms of investment. Impact funds invest across a range of companies in order to help manage the risk for individual investors.

Fund strategies vary and the difference between a fund that labels itself as an impact fund and a sustainability, environmental or socially themed fund that also focuses on delivering positive impacts and ‘real world’ outcomes is often very limited and therefore hard to spot. Both may aim to measure positive impacts, so it’s important to be guided by where a fund aims to invest.

Fidelity’s sustainable and ESG spectrum incorporates a range of options and you can find out more about this in our article on ‘Five ways to invest sustainably’.

‘Greenwashing’ is where fund managers (or others) mislead potential clients by making false or exaggerated claims about a company’s or fund’s environmental standards.

The best way to guard against most aspects of greenwashing is to look closely at what a fund is designed to do. Funds that say they exclude a particular area, such as tobacco or oil companies, can be expected to do exactly that.  Funds that say they will invest in line with named themes, such as renewable energy or healthcare, are more complex to monitor but can be expected to hold companies that align to those themes. Funds that say nothing on these topics, or are unclear in their communications, cannot be expected to invest in any particular way and their views about particular issues may differ from your own.

Funds also have different positions on stewardship – or engaging with companies to encourage them to adopt higher standards – which can lead to different investment decisions. Funds that rely substantially on stewardship activity may hold more controversial companies with the aim of encouraging them to change. So, if you are keen to avoid potentially controversial companies you may prefer to consider funds with stricter exclusions or a stronger focus on positive themes - such as sustainability themed or ethical funds.

It’s also important to remember that many listed companies are very large and complex.  Most have both positive and negative features - so where one fund manager may see problems another may see a useful service or valued employment opportunities.

Ultimately, guarding against unwelcome surprises comes down to carrying out your own due diligence as strategies vary. You should start by looking online and even visit the fund manager’s own website, to understand what an individual fund sets out to do, its purpose and where it will and won’t invest.

Find out more about greenwashing and how to protect against it.

The design of investment funds is always a combination of what a fund manager (or fund management company) believes makes sense and what they think their customers will want to invest in.

For funds that specifically focus on environmental, social, governance and ethical issues there is an additional layer of planning required.  Designing their strategies often involves weighing up lots of different issues, considering what people want today and where the investment risks and opportunities lie.

Some fund managers take the decision to focus on a specific industry, like water, or issue, such as climate change. Whereas others choose to have far broader remits, like sustainability funds and ethical funds.

There are also many different approaches that investment funds can take - from avoiding companies with poor standards (exclusions), to investing in companies that are providing useful services (positive stock selection) and encouraging companies to change (stewardship activity).

Climate change is a good example of this. Some people – and therefore some funds - will simply want to avoid coal, oil and gas companies. Others will want to focus on investing in renewable energy companies. And some will want to encourage oil companies to change their ways and become renewable energy companies.  Some will also care about supply chains, employee relations and management practices. Others may not. Different fund strategies reflect each of these variations – and much more.

And when unforeseen challenges arise - such as when a company behaves in a way the fund manager did not expect or an accident occurs - some fund managers may continue to invest in a company so that they can encourage senior management to change their ways, whereas others will make a swift exit. There is no magic formula… but the good news is that fund managers are increasingly focusing on such things.

ESG reports disclose data which explains the influence a company has on environmental, social and governance (ESG) issues.

Also known as a ‘sustainability report’, shareholders can see a performance analysis across the three key ESG areas. Through quantitative and qualitative data, the report will look at what the business has achieved and the impact it has on all ESG factors. And any future goals the business is working towards.

Although ESG reports are not compulsory, the rise of regulations in corporate ESG data means it’s often in the best interests of the business to communicate their strategy and consider transparency with shareholders.