Ethical investing is now a driving force in the world of finance, with investors demanding high standards in environmental, social and governance (ESG) issues. However, the market remains immature, with a lack of consensus on how ESG should be defined and measured.
Every year more money flows into funds that meet ESG criteria. Total ESG assets under management (AUM) surpassed $35tn (about £26bn) globally in 2020. That was a third of overall AUM and up from $22.8tn in 2016, according to the Global Sustainable Investment Association.
At one time, the received wisdom was that profits and principles didn’t mix. However, a growing body of evidence suggests companies with good ESG practices tend to outperform their less ethical peers. Analysts S&P Global Market Intelligence tracked 27 US-based ESG exchange traded funds and mutual funds between December 2020 to May this year and found that 16 outperformed America’s S&P 500 index. The funds – which each had more than $250m in AUM – rose between 11% and 29.3% during the period versus 10.8% for the benchmark.
It’s clear that investors today expect companies to take a stand on issues like climate change and workers’ rights, a trend that’s been further fuelled by Covid-19. According to a survey this year from ethical bank Triodos, about a third (32%) of Britons who have investments said the pandemic had motivated them to explore investing in an ethical fund, up from just 22% in 2020.
Stuart Kirk is global head of research and responsible investments at HSBC Asset Management, which has $621bn of AUM. Its data, which covers the last 10 years, shows that in the US, Europe and Asia (excluding Japan), a long-only portfolio of the top 30% of companies by ESG score, equally weighted and relanced monthly, produced excess risk-adjusted returns, he says.
“Over time, as this story becomes better known, we believe that ESG strategies will comprise a growing proportion of outstanding assets.”
Despite the strong returns on ESG-linked investing, there are barriers to its adoption. It’s very hard to measure the real-world impact of such investments, while there’s also a lack of firm, shared definitions of ESG. This allows some firms to present themselves as more ethical than they are, known as ‘greenwashing’.
Currently, listed companies can decide how much information they disclose about their ESG performance to the market. Many report selectively, critics say. Ratings agencies offer independent assessments, but they have to work with the information available to them and can be imprecise.
It’s led to striking anomalies. For example, oil companies have appeared in the holdings of ESG investment funds because they’ve invested heavily in renewables and thus have high clean energy scores. The fast fashion firm Boohoo was also popular among ESG funds until it was caught up in a worker exploitation scandal in 2020. The company, which at the time said it was unaware of the alleged issues in its supply chain, had been rated highly by agencies for its treatment of workers.
Cathrine De Coninck-Lopez is global head of ESG at Invesco, an investment management company with $1.5tn in AUM. She says the ESG market “suffers from lack of common definitions, interpretations and education” and data availability is an issue.
“In addition, it is a fast-moving area that is trying to match real-world issues such as climate change, biodiversity, diversity, human rights to a more traditional and in some ways arms-length financial services industry. As such we are finding a need for constant innovation in processes, data and systems.”
Aware of the problem, regulators are seeking to change the rules on disclosure, with the Sustainable Finance Directive Regulation in Europe and the Sustainable Disclosure Requirements in the UK. De Coninck-Lopez says “a common baseline” should help set a minimum standard and raise the bar for the industry overall.
However, many newcomers to ESG find the myriad different approaches taken by funds bewildering. There’s an alphabet soup of ESG strategies out there, from negative screening and socially responsible investing (SRI) to impact and sustainable investing, all of which determine how portfolios are constructed, the degree to which philosophical views are expressed and the extent of social impact.
The most popular approach currently is “ESG integration”, where ESG criteria is incorporated into investment decisions to help enhance risk-adjusted returns, regardless of whether a strategy has a sustainable mandate. It’s more light touch than something like impact investing, which measures environmental and societal outcomes against specific KPIs, but may not generate such reliable excess returns.
Integration chimes with what many investors want, research suggests. About 90% of HSBC Asset Management’s ESG assets are managed this way, says Kirk.
For someone looking to invest in ESG, it’s crucially important to understand whether they’re investing in such factors primarily because they believe the approach generates excess returns or whether they’re doing it solely with responsible or sustainable objectives in mind, Kirk says. “These are two very different ideas about ESG, and they are not always aligned.”
For now, investors must do their own research on whether an ESG investment is right for them. Scepticism is growing about how virtuous investments really are, which some fear could limit the sector’s growth potential. According to Triodos’s research, a quarter (26%) of consumers who say they would not currently invest in an ethical fund also question how ethical many ESG investments truly are – up from 17% in 2020.
Yet while greenwashing fears may be valid, the very fact that some firms feel they must pretend to be ethical shows just how much attitudes have changed. With every passing year listed companies face growing pressure to act more responsibly. Those who shirk such obligations pose a growing risk to their investors, says Ainslie McLennan, head of balanced funds UK at Nuveen, a fund manager with $1.2tn AUM.
For example, as we shift towards a low carbon economy, investments in fossil fuel intensive assets will become higher risk, losing value at some point, she says.
“It is very difficult to identify exactly when that point will come, but there is an obvious danger of a tipping point. Conversely, assets that have a clear pathway to net-zero carbon present the greatest potential for long-term value growth. Therefore, ethical investment seems to present better risk-adjusted returns.”