Momentum behind responsible investing continues to build with £37 billion invested last year in UK domiciled funds alone, according to data provider Morningstar. Funds incorporating ESG – Environmental, Social and Governance – analysis as a central pillar of their analysis now account for 10% of worldwide fund assets.
That’s despite some recent performance headwinds. Many strategies tend to be tilted towards more growth-orientated companies and smaller businesses, which have underperformed in the weaker markets we have seen over the past year or so. They also lack exposure to some of the better-performing areas such as energy and mining.
Meanwhile, climate-ambitious companies like BlackRock and Volkswagen have scaled back their sustainability goals in response to the ongoing energy crisis. Although responsible investment endures investors might need to modify their objectives – and funds themselves keep to stricter rules to avoid accusations of ‘greenwashing’.
A rational way to invest
Our Research Team has always sought to consider material non-financial factors that could affect a company’s prospects. ESG analysis can highlight key risks and be useful to all investors, even those who ignore non-financial goals. Businesses that don’t address key environmental and social concerns or pay attention to governance issues could be unsustainable in the long run, and in the short term, they are more likely to suffer negative publicity or a customer backlash.
Increasing numbers of investors have been selling out of high polluting or other controversial areas to align themselves with a greener and more sustainable world.
While ESG is a useful tool for analysis, it is important to appreciate the complexity of the many issues involved. For instance, increasing numbers of investors have been selling out of high polluting or other controversial areas to align themselves with a greener and more sustainable world. Confining portfolios to better corporate citizens seems logical as it diverts capital out of unsustainable investments, for instance by making it harder for companies not tackling issues such as climate change seriously to access capital. Yet there could be a downside. If lots of shareholders take this approach then a company could be forced to divest offending assets, or it may even be vulnerable to a takeover as its share price languishes. If so, polluting, damaging or otherwise controversial businesses could end up in the hands of parties far less highly scrutinised and accountable than the boards of public companies – likely a backward step for net-zero and other ambitions.
It underlines the need to understand issues thoroughly and not oversimplify. In most sectors or individual companies, there will be a mixture of positive and negative effects on sustainability issues that need to be reconciled. For instance, Tesla’s use of considerable quantities of rare earth minerals has to be considered alongside its positive contribution to electric vehicle and battery storage development. More broadly, one of the challenges of the ‘green revolution’ is that vast quantities of energy and resources will be required to make the transition away from fossil fuels a reality.
Data is a starting point
A common starting point for asset managers is the ‘ratings’ allocated to companies by agencies such as MSCI. These tools consider companies according to their industry and assign a variety of ESG scores, weighted by the ‘materiality’ of their impact, and aggregate them to produce an overall average.
There is currently no single, industry-standard accepted methodology for calculating an ESG rating and many of the things they are trying to measure are subjective or intangible. This is particularly the case for some of the ‘S’ of ESG - Social. While carbon emissions and diversity may be reasonably straightforward to measure, it is more difficult to assign a value to employee wellbeing or health and safety. Company reporting on some topics is also still being developed and is not necessarily consistent.
MSCI’s ESG ratings won’t always agree with others, indeed correlation between the scores of different agencies is often quite low, but they do highlight many key issues and provide a useful point of reference. Proprietary research may uncover other aspects, both positive and negative, surrounding a company’s activities that are either not captured at all by the ESG rating or ‘buried’ in average headline figures that span everything from climate change and biodiversity to equality and board diversity. Those selecting and managing assets must decide (in conjunction with their clients as appropriate) what is important and why.
Sometimes a more definitive position can be established. While some companies have strong corporate governance and place sustainability at the heart of their operations, there are others whose very purpose is questionable. Many investors feel areas such as tobacco, gambling or pay-day loans have no place in portfolios on ethical grounds. They can be more firmly placed in the ‘bad’ rather than ‘good’ camp according to what it does rather than how it does it and can be screened out accordingly if desired.
Contrast this with companies solving real-world problems that promote less environmental degradation or improved social mobility, which is often the focus of more thematic or ‘positive impact’ funds. Investing in themes, trends and companies that improve the way we live and reduce our impact on the planet can lead to good shareholder returns too. This ‘positive’ screening will reduce the investment universe considerably, so greater compromise tends to be necessary, and it may mean an increase in volatility or leaner returns at times.
Whichever approach is taken, what one responsible investor might believe is of paramount importance doesn’t necessarily register as high, or even at all, for another. A fixed solution, for example, a particular fund, is typically an approximation of an investor’s wishes. Hence the need to understand its philosophy and process to ensure it is in broad alignment, and to avoid any unpleasant surprises in terms of individual holdings under the bonnet.
The power to change
The often-forgotten part of responsible investing is engagement and stewardship where shareholders can help bring about change. Voting on key issues can be a powerful force, as can meaningful dialogue with company management, for example through demanding material progress on carbon emissions and clear transition roadmaps. It is perhaps the clearest approach to balancing head and heart, though a spectrum of approaches and techniques are together more powerful in enacting change than a single one.
Whatever the strategy, the most important thing is that the intention is genuine and considered and that it contributes to raising standards at a company or industry level. Ultimately, what matters is a change in the real world and progress towards pragmatic solutions.
Be more conscious
Building wealth for the future is important, but increasingly people want their finances to do more than make money. Find out more about how you can become a responsible investor.
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.
Responsible investing endures despite performance hit
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