Given how extensively the sustainable funds offering has grown, we help you navigate the many confusing labels associated with ESG investing
- Regulation tackling confusing labels
- Navigating the ESG maze: stewardship, ESG integration, tilting, best in class, exclusions, positive impact
Navigating the ESG investing maze
ESG investing or sustainable investing has ballooned in popularity in recent years. These types of investment seek companies with strong environmental, social and governance credentials for those who want to invest with a conscience. But there’s a multitude of approaches to sustainable investing. Appreciating the marketing opportunity, it means fund management firms have rushed to stamp their funds with varying ESG labels to describe their differing approaches. As a result, the growing vocabulary has made it very confusing for investors. It’s why the Financial Conduct Authority – the regulator – is consulting on a sustainable investing labelling regime, and from what’s been seen in Europe, it’s likely most funds will end up incorporating ethics into their investment process.
In the meantime, we spoke to Laith Khalaf, Head of Investment Analysis at AJ Bell, and assessed the labels currently used and described them below. Some funds will combine a number of these different approaches, and within each there is a spectrum of ESG activity, from weak to strong. It just goes to show that if you do wish to invest ethically, you do need to roll your sleeves up and look under the bonnet of prospective funds if you want your fund to be ticking a lot of the right ESG boxes. You might not get a perfect match, but you can certainly find a fund which is significantly more aligned with your ethical preferences than the market as a whole.
Stewardship basically means looking after the investments you manage from the point of view of the environment, society, or the economy at large. At its weakest level this would mean simply voting on proposals made by companies in an investment portfolio, at its strongest it would mean lobbying investee companies for change, either in private or in public, or both. It’s probably hard to find an active fund that couldn’t claim to engage in some form of stewardship, so it’s a pretty broad church. Stewardship is an important component of responsible investing, but usually supplemented by further measures in ESG investments.
In this approach, ESG factors are considered when making investment decisions. The effect ESG integration has on a portfolio can be minimal, or quite substantive. For instance, a fund manager could simply receive an ESG rating for each stock, alongside other financial information which informs their investment decision. The ESG rating may therefore be a very small part of the overall decision-making process, and hardly reflected in the portfolio. It’s therefore easy to see why accusations of greenwashing might arise around ESG integration. At the other end of the spectrum, ESG integration can mean a more robust approach. For instance, a fund may decline investment in companies which don’t carry a minimum ESG rating, no matter how appealing their other characteristics.
Some funds use ESG scores to tilt their portfolio away from companies with poor ratings, and towards companies with good ratings. This approach clearly means that some of your money may still be invested in some companies and industries which you might take issue with, but you’ll have a significantly lower exposure than the market, so it strikes a balance between ethics and pragmatism.
Best in class
This approach permits investment across a range of industries, even carbon intensive ones, but picks a portfolio of companies which are leading their sector in terms of their ESG credentials. The benefit of this approach is that it’s easier to produce a balanced portfolio, and probably suits those people who believe the likes of BP and Shell are critical to the transition to cleaner energy, and so might still merit investment.
One way to invest ethically is for a fund to exclude certain industries from its portfolio. Typical examples would be tobacco, oil and gas, gambling and defence companies. This might suit investors who don’t mind too much where they invest, as long as their money isn’t held in companies which they believe are doing harm. This is a traditional way of investing ethically, and it’s also straightforward to understand and implement.
Some funds go a step further and seek out companies that are actually working towards solving some of the ESG problems facing the world, whether that be climate change, financial inclusion, or poverty. These funds can be more risky, often because they can invest in fairly specialist areas. Indeed, included in this category are funds which target investment in specific themes, such as renewable energy, or clean water, and which may therefore have a very focused portfolio.