You may remember how we talked about ESG investing being a sort of spectrum going from light green to dark green. Another model that can help make sense of the evolution of ESG investing is the Spectrum of Capital, which was developed by Bridges Fund Management. This model categorises investment styles on a spectrum ranging from traditional investment all the way to philanthropy. The different subsets of ESG focused investing styles fit in between these two extremes. Ultimately, where you stand on the ESG investing spectrum really depends on what you want to achieve with your investments.
A bit of history
As you already know, ESG stands for ‘Environmental, Social and Governance’. ESG investing is the umbrella term for investment strategies that take these factors into consideration in their investment process. It first originated when religious groups such as the Methodists, Quakers and Muslims set ethical parameters on their investment portfolios back in the 1960s. In the UK and US, the Methodists and Quakers launched some of the first ‘ethical’ funds, which used negative screening to avoid ‘sin’ industries such as tobacco, gambling, pornography, alcohol and firearms. Since then, it has evolved to encompass many different facets of investing with specific values in mind.
Today, ESG focused funds consider a company’s impact on the environment, how it treats its employees and other stakeholders and the corporate governance of the company, including executive remuneration. These are all seen as potential risks for future returns, so at a high level ESG focused funds aim to invest more in companies that score highly on these metrics and less in those that don’t do so well.
These scores can be calculated either by third party providers such as Sustainalytics, which is owned by Morningstar, or a fund manager's own in-house specialist ESG team. Unfortunately, at this stage there is no universal standard for how to assess all of these factors and studies have shown how scores for the same companies can vary significantly between providers. But don’t let that discourage you! As an investor in funds, the main decision you have to make is a high-level one, namely what type of ESG focused fund you want to invest in. You can leave the squabbling over ESG ratings for individual stocks and bonds to the managers of the funds. So let’s take a closer look at what they all mean and focus on.
Responsible and Ethical funds
Responsible funds, sometimes also called Socially Responsible Investing (or SRI for short), use negative screening to avoid investing in ‘sin’ industries. They may also aim to invest in companies with higher-than-average ESG scores within each industry, based on external or in-house scoring systems. This approach is perhaps the least rigorous of the ESG focused funds as it tends not to go above and beyond this negative screening process.
Closely related to the Responsible funds are Ethical funds. These funds are the closest to the original ESG focused funds launched by religious groups as discussed earlier. A subset of these are Shariah funds, which are governed by Shariah law and the principles of the Muslim religion.
Sustainable and Green funds
Sustainable funds go a step further by investing in companies that are trying to achieve environmental and social good. For example, some Sustainable funds may have a particular focus on the environment and may invest in renewable energy instead of fossil fuels. Often, funds that have the word Sustainable in their title will invest in companies that are trying to meet specific sustainability targets, such as the Paris Agreement goals, UN Sustainable Development Goals, etc.
One such subset of Sustainable funds are Green funds, which invest specifically in the theme of environmental protection. This could include areas like energy efficiency, pollution control, recycling, clean water, etc. Some funds will focus on just one theme, while others will invest across these areas. This is a particularly popular theme for bond funds, which invest in bonds that specifically raise money for environmental projects.
Impact funds go further than any other ESG focused funds. The aim to have a positive impact in the world alongside generating an attractive financial return for investors. This style of investing is based on a belief that the companies solving some of the world’s biggest challenges are in the best position to grow and produce superior returns over time. The mission to have a positive impact is integral in the funds’ philosophy and process, rather than an afterthought or a ‘nice to have’, as is the case with some of the other ESG focused funds.
Funds investing in this way tend to publish regular reports to demonstrate the positive impact they have achieved. These funds are still fairly nascent, but if successful then they could well be the holy grail for investors by enabling them to do good, without sacrificing financial returns.
Although ESG investing has been gaining popularity in recent years, especially with younger investors, it is still a relatively new style. As a result, the industry is yet to agree on parameters for each of these investment styles as well as the rating system for the underlying assets. But progress is being made and given the popularity of the theme, clarity will hopefully come sooner rather than later. Nothing spurs on the financial industry as much as demand from investors...
We hope this guide gives you a good idea of what these different funds are trying to achieve. It is then up to you to look under the bonnet of each fund to see if it matches your own principles and preferences. Looking at the philosophy and process of the fund as well as its top 10 holdings is always a good place to start.
Date of publication: 16th August 2020
The information in this post is not financial advice, it is provided solely to help you make your own investment decisions. If you are unsure about whether an investment is appropriate for you, please seek professional financial advice. You can find more information here.
When you invest you should remember that the value of investments, and the income from them, can go down as well as up and that past performance is no guarantee of future return.