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ESG investing: How does it work and are your returns constrained?

Market Update

ESG investing: How does it work and are your returns constrained?

The world of finance loves its acronyms. One of the newest is "ESG" which stands for environmental, social, and (corporate) governance. This has recently supplanted socially responsible investing (SRI) as the latest buzz term. ESG and SRI are used to cover companies that prioritize responsibility and sustainability while ensuring an overall positive environmental impact on the planet. Both are considered a giant leap forward from the old investment ethos where shareholder value was paramount. Now the feeling is that companies can benefit by going the extra mile to keep their workers and customers happy, putting the health of the planet at the forefront of everything they do, while ensuring that the management is transparent and fair in all their dealings.

But is it ethical?

Of course, ethical investing has been around for many years, but it was generally considered the preserve of charities and church pension funds. Back in the ‘90s, usually under pressure, a fund manager would announce that they were divesting their portfolios of shares in companies linked to the arms trade or defence. Then it was tobacco stocks, and more recently miners and oil producers. But ethical investing has always been controversial. For instance, is Rolls Royce a straightforward engineering concern, or an arms manufacturer? And one person’s ‘green’ company may be another’s ecological vandal. Consider Tesla. Yes, it’s a pioneering electric vehicle manufacturer, but the batteries it relies on require rare earth metals such as lithium and cobalt which are mined at great human and environmental cost. For some funds it can be difficult to sort out what you’ve got in your portfolio. It wasn’t that many years ago that the Archbishop of Canterbury promised to put payday loan providers out of business, only to find that the Church of England held an indirect interest in Wonga, one of the leading companies in that sector.

What’s meant by ESG?

Defining what is meant under each section of ESG would take up all this article. Suffice to say that ‘Environment’ includes a company’s carbon footprint, its greenhouse gas emissions and climate change policies. The ‘Social’ component includes company culture and issues that impact employees, customers, suppliers, and the wider society. ‘Governance’ covers the way that the company is managed. A company with good corporate governance and a strong board of directors should relate well to different stakeholders, run its business effectively, and align the management team's incentives with the company's success. This will also include diversity in the board of directors and management team, along with transparency in communication with shareholders.

Check the data

It’s difficult to think of companies which will be outstanding in everything. Some companies will score well in some areas and do badly in others. Also, some factors can be measured and certified while others can’t. Be wary of companies that state wholesome-sounding ‘goals’ but fail to provide hard evidence. This can be difficult to track down, but it’s possible to find data prepared using respected sustainability standards, such as those established by the Global Reporting Initiative (GRI) and the United Nations Principles for Responsible Investment (PRI). When companies make statements about their commitment to mitigating climate change, ensuring good governance by looking after their employees and protecting the environment, then their track record can be examined. But there are voices out there suggesting that there’s a considerable amount of hubris around this issue, along with plenty of greenwashing.

Well, it’s a start

Despite such difficulties, the modern ESG investor attempts to set themselves apart from the investing herd by integrating a company’s record in these three key areas, along with its financial performance, when deciding whether to invest or not. It’s not hard to see why. For a start, it avoids the issue of being caught out trying to profit from companies that, say, exploit their workers or pollute rivers. But more than that, there’s a growing body of evidence that suggests ESG investing provides competitive returns while reducing portfolio risk. The coronavirus pandemic showed that stocks of companies with strong performance on ESG issues are often less volatile. The pandemic also raised public awareness of ESG issues such as worker health and safety. What’s not to like? You invest to make money. But if you can also make money ethically and help to save the planet, surely that’s the best of all worlds.

What works for you?

The bottom line? Without doubt there’s a considerable degree of bandwagon-jumping going on here. There’s been a big rush to push out funds containing companies that are ‘ESG-compliant’. Many will be, but plenty of others are stretching the definition. If you are an investor who’s genuinely keen to invest in a company claiming ESG compliance, then do your own due diligence. If you’re looking at an ESG-compliant fund, investment trust or ETF, the same caveats apply. Unlike a sausage, it’s vitally important you know what any fund contains.  But you must also have your own view on what within ESG is important to you. Because at this stage in the game, ESG investing is still open to different interpretations.

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