Ethical investing is a central fixture within the global investing landscape.
Once regarded with disdain as a do-gooding concept as likely to compromise returns as enhance them, ethical money-making’s recent move to prominence is due, in no small part, to the role played by environmental, social and corporate governance investing - ESG for short.
From concerns about a range of issues from climate change to general corporate behaviour, ESG criteria are top of the agenda for many investors, with companies taking action to ensure that people and the planet are treated fairly.
A good example of this has been in Russia, where hundreds of Western companies - under pressure from investors and consumers alike - have unwound their investments, closed stores and paused sales because of the country’s invasion of Ukraine.
In the FAQs below, we explain how ESG funds work and the reason for their surge in popularity among investors. We also run through different types of ethical investing styles, including ‘green’, ‘impact’ and ‘stewardship’.
We’ve also asked Nick Wood, head of fund research at investment managers Quilter Cheviot, to identify five ESG funds for different types of would-be retail investor. In other words, the likes of you and me.
Below are Nick’s selections (in alphabetical order) and, below these, is the thinking behind his choices.
Federated Hermes SDG Engagement Equity
Fund size: £1.6 billion (March 2022)
Fund type: UCITS
Target index: MSCI ACWI SMID
Annual fund charge: 0.83% pa
The fund invests in around 50 companies, each of which aims to have a positive impact on society.
Federated Hermes is a pioneer of responsible investing and has a pedigree in company engagement and enacting change on behalf of investors.
The fund is run by seasoned investor Hamish Galpin supported by Federated Hermes EOS, the stewardship services team that currently has around £1.3 trillion of assets under advice.
This is a global fund that invests in small and mid-cap companies operating in niche markets with good growth prospects, each with clear potential to make a positive impact or reduce harm in ESG terms.
Hermes is a leader in both ESG integration and active company ownership. Its scale/resources make the team well placed to run this fund which invests in areas usually avoided by typical, positive impact funds. The overall effect is good diversification benefits to investors.
The fund has underperformed in recent months, but has been more resilient than more typical, growth-biased, sustainable investment funds.
Who should invest?
A fund worth considering by investors who want their money to contribute towards pushing companies across industries to improve. The bias is towards small and mid-cap companies, so investors should bear this in mind and look to include it as part of a diversified portfolio.
Legal & General Future World ESG UK Index
Fund size: £862 million (Feb 2022)
Fund type: UCITS
Target index: Solactive L&G ESG Developed Index
Annual fund charge: 0.15% pa
The index is a tailored benchmark for this fund, one that invests in companies from developed countries. The index is weighted to give greater exposure to companies that score well against ESG criteria and lower exposure to companies that score poorly.
Legal & General Investment Management (LGIM) is a market leader in active ownership, engaging with companies on behalf of investors and driving change on ESG issues.
The fund is part of LGIM’s Future World range that divests from a select list of global companies, named annually by its corporate governance team, for failing to make progress as part of LGIM’s climate pledge.
In addition to climate pledge exclusions, the fund omits stocks on LGIM’s Protection list (for example, pure coal miners and perennial offenders of the UN Global Compact). There is also an exclusion on tobacco and armaments.
Who should invest?
Although this is a passive fund, it doesn’t take a back seat in terms of engaging with its holdings. The fund is a good option for investors who want active ownership and stewardship as part of their investment philosophy. It offers diversified exposure to the UK market, including to fossil fuels.
Legg Mason ClearBridge US Equity Sustainability Leaders
Fund size: £1.22 billion (March 2022)
Fund type: OEIC
Target index: Russell 3000
Annual fund charge: 0.68% pa.
The Russell 3000 is a benchmark for US funds looking to invest across the entire US stock market. The index tracks the performance of the 3,000 largest US listed companies and, as a result, performance is largely driven by the largest of those businesses.
This is an all-cap US equity fund with a quality growth bias managed against the Russell 3000. The portfolio is made up of companies that are either leaders, or emerging leaders, in their sustainability profile and policies. The fund holds around 50 companies from the US.
With about £150 billion under its control, ClearBridge has regular access to company management which, together with its long history of integrating ESG factors into its investment process, means it is recognised by many companies as an ESG resource. The firm is therefore able to take a partnership approach towards driving change within companies.
With its sustainability mandate, the portfolio has hard exclusions that include oil, gas, coal, tobacco, gambling, alcohol and armaments. The fund is also biased to companies that make a positive impact via their products or services.
Fund performance has been strong since launch in 2015. But the portfolio’s sustainable, thematic exposures now face headwinds from a rising interest rate environment. To counter this development, the portfolio’s typical bias towards growth has been reduced of late to more of a core positioning which should help relative performance.
Who should invest?
The fund can be a relatively core holding for investors who have ESG interests or want their portfolio to have a bias towards sustainability themes.
Royal London UK Sustainable Leaders
Fund size: £3.24 billion (March 2022)
Fund type: Unit trust
Target index: FTSE All-Share
Annual fund charge: 0.76% per annum
The All-Share index is a broad benchmark for UK funds that invest in both large and small companies.
The fund itself invests in around 40 companies and holds up to 20% in non-UK companies in areas where it struggles to find good domestic businesses (such as technology companies).
Managed by Mike Fox since 2003, the fund takes a positive approach looking for companies with products and services that help towards a transition to a cleaner, safer and more inclusive society.
This isn’t an ethical fund with traditional negative screens. But the positive approach results in several sectors being excluded including tobacco, armaments, nuclear, (not for medical purposes) animal testing, fur, pornography and irresponsible gambling/alcohol. Neither oil nor gas companies appear in the current portfolio, but they are not excluded outright.
The concentrated nature of the fund, its sector biases, avoidance of ‘sin’ stocks and being overweight in growth sectors resulting from the sustainability process, can cause performance challenges in certain environments, such as the one we have seen year-to-date.
Long-term performance is robust and the portfolio has demonstrated a successful, sustainable UK equity strategy for nearly two decades.
The manager also has a strong record on engagement and has been active in areas such as consumer data privacy, cladding, governance and remuneration.
Who should invest?
The strong returns delivered over the long term demonstrate a repeatable, pragmatic process. The UK market is challenging for funds with exclusions given the FTSE’s exposure to sectors such as fossil fuels, tobacco, and armaments. For those looking to invest more sustainably, this fund is a good option. But note the strong style bias, sector exclusions and up to 20% overseas exposure.
Schroder Global Energy Transition
Fund size: £1.23 billion (March 2022)
Fund type: SICAV
Target index: No target benchmark
Annual fund charge: 0.90% pa
This fund does not have a single target benchmark and performance is instead compared against the MSCI Global Alternative Energy index and the MSCI AC World index as the fund itself overlaps both of these comparators.
The fund has a wholly unconstrained investment approach. It invests in the various ways of gaining exposure to the low carbon energy transition across the industrials, utilities, technology and materials sectors.
The focus is on renewable energy equipment and generation, transmission and distribution, energy storage and electrical equipment. The fund holds neither fossil fuels nor nuclear power.
The fund is managed by Mark Lacey who has a 25-year background in energy & resources and experience built up in renewable energy since 2010.
Rising interest rates, rising commodity prices, and supply and freight bottlenecks reflect a continued challenging backdrop for this fund’s focused, energy transition universe.
However, the team’s disciplined approach to valuation, focus on cash generative companies, along with their understanding of the dynamics of the energy transition, will be beneficial for performing from here.
There is conviction in the long-term structural drivers underlying their exposures but expect performance to remain very volatile.
Who should invest?
Given the fund’s higher risk, we see this as a small part of a wider portfolio, giving investors access to a structural long-term trend while being able to dampen any volatility the fund brings.
Nick Wood, Quilter Cheviot’s head of fund research, says there are multiple aspects to bear in mind when selecting ESG investments: “Performance remains a critical consideration, but we might also consider the potential for positive impact, alignment with sustainable development goals, divestment, or company engagement.”
He adds that the ‘best’ funds may be a combination of these factors, and many do not just have the sole objective of providing an investment return over the long-term. “Within the selection we have also looked to be diversified by region, as well as offering some diversification in terms of style bias. Lastly, fees are as ever a key consideration.”
There’s nothing particularly new about so-called ‘ethical’, ‘socially responsible, or ‘green’ investing strategies. Such concepts can trace their roots to the 1960s, when stock market investors began to exclude both individual companies, as well as entire industrial sectors, from their portfolios because of specific business activities.
Examples included avoiding companies with an involvement in South Africa’s then apartheid regime, as well as swerving businesses involved with tobacco production and armament manufacture.
Why invest ethically?
In 2020, the ESG movement was given a boost when Larry Fink, the boss of BlackRock, the world’s largest investment firm, said that a fundamental shift in capitalism was under way to which companies and investors needed to respond if they wished to prosper.
Fink argued that principled investing was neither ideological, nor woke, but the best route to obtaining long-term rewards from businesses.
What is ESG investing?
In a nutshell, it’s an extra layer of corporate scrutiny that’s incorporated into the overall fund management process.
Professional fund managers typically put together equity investment portfolios - that is, ones with exposure to stocks and shares - according to strict criteria and themes. Investment portfolios tend to be categorised by the country, region, or industrial sector, in which they invest.
ESG investing adds an extra filter to the potential stock choices made by a fund manager. But in this scenario, the screening takes into account a potential investee company’s environmental, social and corporate governance practices.
With other credentials being equal, companies that actively support positive change across a number of measures - as determined by independent ESG research - will find themselves nearer to the top of a fund manager’s ‘buy’ list than their rivals.
Key ESG measures
For the purposes of ESG, the three key measures are:
Environmental. How a company acts towards the planet. What kind of impact does it have on the environment?
Social. How a business treats its employees, customers, suppliers and local communities. Includes factors such as racial diversity, inclusiveness and recruitment practices.
Governance. How a company is run, including the way it is audited and the way it administers shareholder rights. Also covers attitudes to executive pay as well as how a business communicates and generally interacts with its shareholders.
How is ESG performance calculated?
The above measures make excellent sense but finding companies that apply them in practice is more challenging.
It’s also worth bearing in mind that the metrics the investment industry uses to work out whether a business can be described as ESG worthy are often subjective.
More than a dozen different frameworks are used to assess the credentials of a business. Because
ESG measures are calculated using varying methodologies, there is no one authority when it comes to evaluating absolute scores, often making it difficult to know how ‘green’ a company is.
The Financial Conduct Authority, says ESG assertions should be ‘reasonable and substantiated’.
Data providers help inform fund managers of their decisions. For example, MSCI provides a grading system ranking businesses from AAA (best) to CCC. Data is collected from company disclosures, as well as government, academic and NGO databases.
Where do you stand on ESG?
We all have our own ideas about what constitutes appropriate corporate behaviour and whether a particular company or investment fund matches the values we hold most dear.
An industry that appears repellent to one person might seem like a necessary evil to another. Think pharmaceuticals, animal testing, vaccine production, and so on.
Would-be ESG investors should therefore think hard about their investment decisions before they start allocating cash to perceived feel-good stocks and funds.
This can lead to some challenging dichotomies. Take arms manufacturing, for example, a timely consideration given the events in Ukraine.
Companies making arms and military hardware have long been on the ‘to avoid at all costs’ list for many ESG funds. But what if, say, an arms manufacturer supplies missiles to a country perceived as the ‘wronged nation’ in a conflict?
A research note from analysts at Citi noted earlier this year that: “Defence is likely to be increasingly seen as a necessity that facilitates ESG as an enterprise as well as maintaining peace stability and other social goods”.
ESG investing – DIY or take advice?
Apart from the nature of their holdings, would-be ESG investors also need to decide whether they are going to pursue a DIY approach - and select their holdings themselves - or rely on (and pay for) professional advice.
If you’re looking to be ‘hands on’ and are keen to ensure your investments are aligned exactly with your moral compass, you’ll probably want to build your own DIY portfolio.
To do this you’ll need to open an investment account with an online trading platform. To shield your investments from tax, up to a maximum of £20,000 a year, you could consider making them via a stocks and shares ISA.
As a DIY investor, when weighing up potential funds, it’s important to check where your money is going to be invested.
You can find out more by reading the fund factsheets supplied by investment management firms, or from the research tools offered by your investment platform. Alternatively, consult data providers such as Morningstar and Trustnet which also supply information in relation to a fund’s holdings.
Building a portfolio from scratch takes time, effort and regular monitoring and review. If that’s not for you, an alternative way to create an ESG investment portfolio is to seek help either from a so-called ‘robo-adviser’, or by employing the services of an independent financial adviser (IFA).
Robo-advisers are digital advice services that build and manage investment portfolios based on your risk appetite and investing aims. They tend to cost less than the in-person advice offered by IFAs.
IFAs, however, are able to research the entire funds market and make investment recommendations according to both your financial goals as well as your principled investing requirements.
Does ESG have its detractors?
Yes. Tariq Fancy, BlackRock’s former chief investment officer for sustainable investing, has been critical of ESG investments, saying they overstated their impact and that market-led solutions were a distraction from government-led ones.
The subjective nature of measuring ESG also means that while a company may fulfil certain criteria, it falls short on others. This can leave fund managers with the tricky choice of deciding which stocks to include within a portfolio and which ones to omit.
Aside from the issue of whether a particular company or fund passes the ESG test, there are other considerations for investors to bear in mind.
Screening out individual companies and entire industrial sectors can increase the risk that your investment will miss out on growth and opportunities. On the flip side, the extra analysis associated with ESG measures means investors may end up with exposure to better-managed companies.
Does ESG affect investment performance?
Some commentators believe incorporating an ESG strategy involves accepting a trade-off, in other words, accepting lower returns as a trade-off for doing good. Others believe the opposite.
For example, last year, a group of academic researchers from the universities of Pennsylvania and Chicago predicted that green assets are likely to underperform in the future. They explained that, while returns from green assets had been buoyed by money flooding into the space due to climate change shocks in the previous decade, this alone would not be enough to sustain future expected returns.
In contrast, fund manager abdrn says it strongly believes that ESG can have a positive effect on both corporate financial performance and on portfolios. It adds that companies that are well managed and which consider long-term risks and opportunities around ESG issues should outperform over the long-term.
How do various types of ‘principled’ investing differ?
There are various forms of principled investment, often with overlap between one version and another.
Ethical investing involves selecting investments that avoid dealing with products and services that may be considered harmful or fall short of upholding personal values, such as tobacco, adult entertainment and gambling. Many ethical funds will also screen for a wide range of environmental issues such as deforestation or negative social issues such as low labour standards.
Faith-based investments align with the principles of certain religious groups. To build these funds, a negative screening process is used to exclude practices that could be deemed unsuitable by religious standards, for example, alcohol and gambling.
This involves investing in companies that either directly focus on improving the environment or avoid investing in those that damage it (eg, oil and mining companies).
Impact investors aim to generate positive, measurable influences on society and/or the environment, alongside a financial return. Typical areas that impact investing might aim to challenge include traditional (ie non-renewable) power generation and gender inequality. Impact investing can be associated with lower financial returns, though this is not always the case.
This is an alternative term for a range of investment approaches including responsible, sustainable or ethical investing. It usually means that ESG factors and values have been integrated into the investment process. Some examples may include human rights and environmental sustainability.
An investment approach that considers ESG factors, with a focus on companies seeking to improve wellbeing and have a positive impact on society and the physical environment.
Fund managers practising good stewardship often regard themselves as part-owners of the businesses in which they invest and look to make sure they’re run in a way that benefits all shareholders. They vote at company annual general meetings (AGMs) and engage with management holding it to account, while using their bargaining power to promote positive change.
What are unit trusts, OEICs, etc?
The above fund recommendations refer to different types of investment. A unit trust is a type of pooled fund where money from many different investors - unit holders – is run to a particular investment brief by a professional manager.
Whereas a unit trust is governed by trust law, an Open Ended Investment Company (OEIC) is a similar kind of pooled investment but is governed by company law. An OEIC is similar to a SICAV – or, Société d’investissement à capital variable – but while OEICs are run from London, SICAVs tend to be run from Luxembourg or another offshore equivalent.