Important information: The value of investments and the income from them, can go down as well as up, so you may get back less than you invest.
Sustainable investing means different things to different people. For some it is about avoiding certain activities or industries. Others see it as a more proactive thing - making a positive difference. Not just ‘do no evil’ but be a force for change.
A helpful way of looking at the range of different approaches is as a spectrum that runs from so-called traditional, value-focused investment at one extreme all the way through to values-based philanthropy at the other. The approaches that we usually think of as sustainable investing fall somewhere between these two.
Traditional investing falls out of the scope of this analysis, not just because it has no regard for environmental, social and governance (ESG) factors but also because to all intents and purposes no-one really invests this way anymore. Or at least no-one will admit to doing so. The evidence for taking ESG factors into consideration is now so compelling from a purely financial or risk-management perspective that it is hard to claim you are doing your job properly if they are not at least a part of your investment approach.
At the other end of the scale, philanthropy is out of scope because it is less about investing than giving. Like some of the investment approaches we will look at, it might target positive social and environmental impacts, but it does so with no requirement for financial return. It is about doing good, pure and simple.
In between these two are the five approaches you are most likely to consider as a sustainable investor:
1. ESG Integration. When professional investors claim that sustainability is a core part of their investment process (as they all do these days), what they are really saying is that their analysis includes some assessment of the financial risks of environmental, social and governance factors to the companies they are considering investing in.
For many investors who are looking to take a more sustainable approach this will feel too close to traditional, value-focused investing to really meet their needs. It is too light touch. And this is the category in which ‘greenwashing’ - pretending a fund is more sustainable than it actually is - will occur.
What’s at stake here is how aware a company is of the relevant risks to their business and how well they are managing them. All good stuff. But a company scoring highly in this regard may still be doing things that don’t feel ‘responsible’ or ‘ethical’.
2. Negative screening. This is traditional ‘ethical’ investing. It is about avoiding or excluding companies doing things that are considered beyond the pale - things like arms manufacture and trading, tobacco, the publication of pornography, the extraction of fossil fuels. Where you draw the line on this list is a matter of personal values.
Again, there is a risk management objective here. Changing values or regulatory shifts may mean that the oil & gas business is in long-term decline. Its cost of capital may rise over time. Many of the reserves booked by energy companies may never be exploited. These are all real financial risks. But essentially exclusion is a moral question.
3. Positive or best-in-class screening. This is the flip side of exclusion. It involves looking for companies that score well on environmental, social or governance factors. Again, this can have either a financial or an ethical focus. And increasingly, the evidence is mounting that the two concerns are inseparable. Analysis by Fidelity has demonstrated that companies that score highly on ESG factors have outperformed in both down and up markets in 2020. A good ESG score is a kind of proxy for quality. Companies that understand the forces shaping the world around them and respond appropriately are, by definition, better companies. And investors are increasingly rewarding them with a higher valuation and a lower cost of capital.
4. Thematic/sustainability themed. This category sits right in the middle of the sustainability spectrum. As such, a fund in this group might have more of a profit-focus or be more concerned with ethical values. You will need to look under the bonnet, read the objectives and be satisfied that the manager’s interests are aligned with your own.
Investing in a sustainability theme does not necessarily mean you are committed to changing the world for the better. It might just mean that you have seen which way the wind is blowing (literally in the case of renewable energy) and recognised the long-term investment opportunity a sector or theme represents.
5. Impact investing. The final category is arguably the most interesting to those investors who see their money as a mechanism for creating a better world. As the name suggests, it includes funds which invest in companies that are targeting social and environmental improvements. It might, for example, include investments in social housing or businesses that are trying to create jobs for ex-offenders.
And there is a spectrum within the spectrum here because funds may have differing demands of their investments with regard to the financial returns they deliver alongside their ethical impact. We call these ‘market rate’ and ‘concessionary rate’ funds. Again, it’s your decision as an investor how far towards philanthropy you want your impact investing to veer.
This is obviously a simplified view of a pretty complex picture and not all funds will fit neatly within one category. An impact fund may apply negative screening as well, for example. Hopefully, however, this provides a starting point for your exploration of the world of sustainable investing.
More on sustainable investing
Important information: Investors should note that the views expressed may no longer be current and may have already been acted upon. This information is not a personal recommendation for any particular investment. If you are unsure about the suitability of an investment you should speak to an authorised financial adviser.