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All you need to know about ESG and sustainable investing

Daniel Lane

Daniel Lane - Fidelity Personal Investing

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.

In this article:
What is ESG investing?

There have always been investors keen to match their money with their morals. This train of thought has taken on a few labels - responsible, ethical, green, and most recently sustainable and ESG. There’s a difference now though. Whereas previous iterations of the idea of doing good with your investments were mostly subjective and quite niche, ESG and sustainable models can be used more widely by bringing in more than morality.

Environmental, social and governance (ESG) standards measure not just a firm’s impact on the environment but also on its employees and the society within which it operates. Renewed focus on companies’ responsibility to their surroundings, staff and customers has allowed the conversation to evolve around what it means to do good with your money. And it’s not just a select group of firms expected to do their bit.

Rather than delivering profits by all means necessary without being questioned, more firms than ever are being held to account on how they make their money and are encouraged to be transparent on areas like their carbon footprint, gender balance and ethnic diversity in management positions.

Increased transparency allows investors to decide for themselves whether a company matches their moral aims, in what they’re trying to achieve and how they’re doing it, as well as their financial ones. Far from being a ‘nice to have’ or material for a marketing campaign, strong ESG standards are now front and centre of the corporate landscape, with companies scrutinised closer than ever.

 

What is ESG investing?

Our investment director Tom Stevenson sheds some light on what ESG investing is all about and the different ways investors can tap into the theme.

How does ESG investing work?

Fund management groups across the board quiz company management teams on their ESG credentials regularly and look for signs that firms are doing the right thing by their employees, the industry regulator, the environment and their surrounding communities. This could mean making sure staff are paid a good wage, corporate risk management is sensible and not likely to attract fines for bad practice, or asking what firms are doing to reduce pollution and support local initiatives.

But fund analysts also do their own research behind the scenes by talking to suppliers and competitors and delving into the financials to see if there is anything to add to their overall view of the company.

Fund groups do this on behalf of the everyday investor and often carry enough weight to demand change where necessary, increase exposure to firms exhibiting good ESG practices (provided the rest of the analysis stacks up), or walk away from firms on shaky ground with no plans to increase ESG focus.

It’s important that these stewards of investors’ capital use their influence and banks of resource to call out malpractice where they see it, reward good practice where it’s evident, and guide our savings towards the opportunities deemed sustainable and in line with what we can reasonably expect from a company, as a member of the public.

That said, there are always differences in what we all deem acceptable, as our opinions on ESG-related topics can be political and subjective.

While fund groups across the globe are increasingly making ESG analysis a priority, quite often what they want to know, at the very least, is that a company is not falling foul of these standards. This creates a more focused opportunity for certain funds looking for companies who not only meet the standards but actively try to champion them. In its simplest sense, this is what makes ESG-dedicated funds different from the rest.

While the former strategy allows investors to feel more comfortable that the funds they invest in have performed the due diligence necessary to satisfy a certain standard, the latter makes sure that those investors keen to see their money allocated to positive causes have options too.

Listen to our podcast on ESG investing

Can your investments do well for the world, as well as doing well for your bank balance?

ESG investing - where environmental, social and governance concerns are given priority - is increasingly in demand but that term covers a multitude of different approaches and outcomes.

What do you need to know to ensure your money matches your morals?

Ethical, sustainable & socially responsible (SRI) funds - the ESG spectrum

While ESG is often used as an all-encompassing term and we can split it into the two crudes groups above, it represents a spectrum of the different attitudes towards what investors want from the companies they invest in, and how they plan to use their own money.

Ingrained connotations of investors factoring in ethical and socially-conscious concerns in the past conjured up images of green activism, philanthropy and endless pictures of windfarms and solar panels. But, importantly for investors, the spectrum begins away from ideas of funding projects which eat capital just because ‘it’s the right thing to do.’

It’s common for investors to brand the whole ESG spectrum an ‘ethical’ pursuit but, while there are still ethical funds out there, what’s ethical to me might not be to you. Objective measures of defined ESG features tend to satisfy a lot of what ethical investors are trying to include, and weed out, when they invest and give key indicators they can use to benchmark companies over the long term.

This is where it makes sense to talk about sustainability instead. From an investment standpoint, it’s simply not sustainable to keep channelling money towards projects that don’t provide a return whether they have a short-term positive influence or not.

Close attention to sustainability lets investors see how repeatable and reliable a firm’s long-term corporate plan is, how resilient its revenue streams are and how likely it is to survive, given its environmental impact and changing consumer habits.

Is all ESG investing the same?

The reason many of us are drawn to ESG funds is because we feel there’s something the mainstream funds are missing out. Even with their increased adoption of ESG mindsets, they still might not give us exactly what we need sometimes due to our religious concerns, personal aversion to certain industries or their lack of distinctly positive investments we’d like to be involved in.

This opens us up to a wealth of niche (and increasingly not so niche) strategies designed to meet our needs, offering multiple sub-themes under the ESG umbrella.

As mentioned, some ethical funds might blacklist whole industries like tobacco, or companies like media groups publishing pornography, purely on moral grounds. The advantage for likeminded investors here is that they know their money will not conflict with their morals even if companies in these sectors become more attractive on more generic ESG measures. The basis of this approach can often be used by investment groups and individuals, for whom violating religious or cultural rules is simply not acceptable.

Other funds carrying the ‘responsible’ tag can use this type of negative screening process, focusing on avoiding anything that clashes with the fund’s values, laid out in the prospectus. Then there are the positive screeners, targeting companies with particularly good ESG credentials.

Funds focused on social responsibility typify this process; identifying net contributors to positive projects like social housing is their aim, rather than simply ignoring firms who aren’t involved. Furthermore, instead of finding companies doing good, funds themselves can support initiatives - this way they have a clear route to guarantee the ESG standards of the project and can represent their investor base in parallel with their values.

Bryn Jones, manager of the Rathbone Ethical Bond Fund describes his approach: "We have a negative screening process which avoids companies with certain negative practices. These can range from environmental damage, mineral extraction, animal testing and pornography to gambling, tobacco and alcohol production. Then our positive screen looks for evidence of social or environmental change, gender equality in employment and work with charities, among other criteria. So, we're not only looking at negative things, we’re also looking for something that's nice and solid that gives a business a strong ethical bias.”

The environment still plays a big part on this side of the investment industry and the thematic and sustainable funds on offer tend to best reflect this. These portfolios specifically target sustainability-driven themes like green energy and water to satisfy environment-conscious investors.

Does ESG investing mean giving up returns?

In short, no. While screening processes do whittle down the number of companies open to ESG funds, it’s no different to the screens used in the likes of value or smaller company strategies to sort the wheat from the chaff.

Up to now, a hurdle to ESG funds has been the relative strong performance of sectors like tobacco and oil which often don’t quality for inclusion in sustainable portfolios.

However, as some of these narratives unravel and the world grows increasingly concerned with public health crises, along with efforts to grow our use of renewable energy, this opinion is carrying less and less weight.

As Fidelity’s Jeremy Podger says, the exact opposite could be true: “Adopting ESG principles in investment is compatible with - and will likely enhance - the investors’ traditional risk and return objectives.”

Those companies exhibiting the most stable and sustainable characteristics could be the most attractive over the long term. These companies could be less likely to get caught up in corporate governance scandals, additional so-called vice taxes or environmental disasters, which all eventually affect the bottom line.

Rathbone’s Jones reiterates that factoring ESG concerns into the stock selection process can only benefit long-term investors: “We do a lot of the things you’d expect from a mainstream manager in looking at the fundamentals of a business, so that’s not in any way sacrificed. In fact it’s augmented by additional levels of due diligence.”

Is ESG investing all about morals?

A fund manager once told me: “Investors don’t pay me to take a moral stance, just to make them money” - a statement I have watched make less and less sense over the years. What it reflects is how polemic the ideas of profit and ESG used to be, and perhaps how inseparable they are now. You don’t have to be an activist to want to know the companies in your portfolio are being run like they should, with attention to risk and obedience to their regulator.

In fact, this added level of assurance is one of the reasons why ESG strategies have garnered support in recent years even within the mainstream.

Long-term investing is about compounding growth steadily over the years, creating a snowball effect as interest builds on interest. As a result, for fund managers focused on the long term, the quality and integrity of a business model and the team employing it are paramount. This means avoiding companies with subpar checks and balances on their accounts, or those risking the reliability of quality growth for vanity projects or short-term profits.

In this sense, sustainability has nothing to do with ethics and everything to do with identifying trustworthy, dependable management with a good track record of delivering business progress and consistent growth.

More on ESG investing

Important information: Investors should note that the views expressed may no longer be current and may have already been acted upon. An Investment Manager’s focus on securities of companies which maintain strong environmental, social and governance (“ESG”) credentials may result in a return that at times compares unfavourably to similar products without such focus. No representation nor warranty is made with respect to the fairness, accuracy or completeness of such credentials. The status of a security’s ESG credentials can change over time. Overseas investments will be affected by movements in currency exchange rates. Investments in emerging markets can be more volatile than other more developed markets. Reference to specific securities should not be construed as a recommendation to buy or sell these securities and is included for the purposes of illustration only. 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.

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