Socially responsible funds are becoming increasingly popular, and around half the money flowing into the area is invested passively in ETFs and tracker funds. These aim to replicate the performance of an index rather than trying to beat it. While they generally offer a cheaper route to investing than actively managed funds, investors need to look under the bonnet to see exactly what they are buying.
Check the index followed carefully
Some passive funds may not be stringent enough for more socially responsible investors. For instance, UBS MSCI United Kingdom IMI Socially Responsible UCITS ETF, sometimes held in portfolios branded ‘socially responsible’, invests in fossil fuel giant BP and miner Rio Tinto. L&G Ethical Trust also includes mining companies, a stance that may be questionable to some investors wishing to invest in line with their values.
Royal London UK FTSE4Good Tracker Trust is perhaps also controversial given that Shell is a large position. Shell has been calculated to be the fourth-largest greenhouse gas producer of all time and has been the focus of climate change protests.
Fossil fuel companies can of course be as much part of the solution as part of the problem, and investors have a role to play in helping shape their policies. Of the major energy companies Shell may be leading the way compared to many others in terms of cutting greenhouse gas emissions through the transition to renewable energy. However, for many people the whole sector isn’t doing enough, and they might wish to avoid it. Shell is sanctioning several new fossil fuel extraction projects that, according to Carbon Tracker, are not aligned with the UN Paris Agreement on climate change.
Blanket activity exclusions in the FTSE4Good Index, which the fund aims to track, are tobacco, weapons and coal. Given the inclusion of major oil and mining companies we would suggest this index represents a ‘tilt’ towards sustainable investing at a portfolio level – fewer stocks get excluded compared with many stricter funds that invest in a more focussed socially responsible manner. It underlines the need to look under the bonnet of what you are buying.
Index providers argue that ruling out whole areas would mean forfeiting the ability to engage with and bring pressure on companies, with the threat of them being thrown off if they do not improve. Allowing ‘best-in-class’ companies (that are assessed as being better corporate citizens than their immediate peers) into these indices also potentially creates a competitive force for good, plus it should be appreciated that engaging with the ‘bad’ to improve can potentially be more impactful than just backing the ‘good’.
There are a range of views on these issues, and investors should closely scrutinise whether rules-based methodologies of passive funds meet their own values. Active funds offering more focused portfolios of companies that are genuine ‘sustainability leaders’ may be more appealing to investors wanting a more stringent approach. Alternatively, passive funds that track a more focussed or thematic index might be a consideration, albeit they might come with a higher cost and less diversification than the more simplistic trackers.
One reason why more mainstream passive funds tend to be ‘lighter green’ is that they often use these best-in-class methodologies in their portfolio construction. While they may exclude companies whose products have obviously negative social or environmental impacts – for instance Nuclear Power, Tobacco, Alcohol, Gambling, Weapons, Thermal Coal and Adult Entertainment – the bar may be set too low for investors wishing to invest according to stricter ethical criteria or a greater focus on sustainability.
They often include companies with above-average environmental, social or governance (ESG) scores in their sector peer group, but when compared to a wider universe of stocks they could fall short of what an investor might expect in terms of their own principles.
Assessing how sustainable or ethical a company is complicated. ESG 'ratings' are the result of a series of nuanced judgements and complex analyses. Undertaking extensive due diligence is time consuming and expensive, so an easier route for funds is to use the ESG ratings provided by one of a handful of data providers.
However, these data providers do not necessarily agree on which ESG factors are most important and how to best ascertain overall whether a company does more good than harm. It is hard to distil complex and sometimes subjective issues such as the environment, working conditions and corporate governance into a single ESG score. Different scoring systems are likely to be based on different processes and can end up with different conclusions. As such the consistency in terms of scoring from the data providers can be quite low, even if the underlying data points from the various criteria are similar.
Questions surrounding the limited assessment of actual product impact, the quality of self-reported ESG data and backward rather than forward-looking evaluations are other potential drawbacks of passive funds and portfolios reliant on these scoring systems.
A more holistic ESG analysis of a company prioritises an evaluation of how a company’s core business model contributes to society, but most external ratings services – on which most passive funds are based – do not target this. Instead, they look at a huge range of ESG issues from workers’ rights and environmental impact to governance arrangements and tax policies. The ratings providers have a tough challenge, and they are clear about what they cover, but bundling together a range of complex issues into a single average score can obscure important underlying details or trends.
Issues can also arise when it comes to engagement. Many investors buy ESG funds on the basis that their managers will be better stewards of the companies they invest in. However, it may be more difficult to engage effectively with companies and bring about change for passive funds using mechanical investment processes. In addition, an active manager may have more detailed analysis of the industry and how individual businesses are likely to be affected by ESG issues. This may give them an edge when it comes to engagement, as well as establishing what factors are actually material to both returns and social or environmental impact.
Is active best for socially responsible investing?
Passive funds represent an easy and low-cost route to socially responsible investing but in their current form they potentially come with some shortcomings. While inconsistencies may be ironed out and improvements made, at the present time active fund management has some advantages for socially responsible investors, albeit they often mean higher fees for the investor to bear.
Some investors may prefer funds with stricter and more focused strategies, especially where an attempt is made to measure the contribution a fund’s underlying investments make to society and the environment on an ongoing basis. The best active fund managers in the area have proprietary research, take an ‘evidence-based’ approach and engage in ongoing dialogue with companies. It’s a process of ongoing research, oversight and reassessment that is currently impossible to replicate through basing portfolio construction on ratings alone. Although becoming ever more sophisticated, screening and ESG scoring cannot replace a continual and detailed evaluation of each company in context.
Regular management meetings by active fund managers are often complemented by targeted engagements on specific ESG issues throughout the life of the investment with the aim of improving returns for investors. In addition, with active management the fund manager is more often directly accountable for ESG criteria and decision making, rather than a third-party ratings agency.
Find out more about socially responsible investing on our dedicated webpage, which includes a glossary of common terms.
Nothing on this website should be construed as personal advice based on your circumstances. No news or research item is a personal recommendation to deal.
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