Sustainable investment has been on a long journey to become the major theme it is today. But there are still some challenges investors considering ESG options need to be aware of, according to Tilney Investment Management Services’ Jason Hollands.
Investing with an overlay of “non-financial criteria to reflect investor’s values”, as Hollands puts it, first emerged in UK markets in 1984 with the first ethical investment fund.
The Stewardship fund – which is now the BMO Responsible UK Equity fund – was originally aimed at investors who wanted to screen out ‘sin stocks’ such as tobacco, gambling, pornography and arms manufacturing from their portfolios.
The BMO fund still runs an ethical screening of FTSE 100 companies as part of its investment process.
But over the years sustainable investing has evolved into various forms.
“This growing segment of the financial services industry has however struggled with an ongoing identity crisis, periodically adopting new terminology to describe itself,” Hollands said.
The current evolution of the trend is ESG – or environmental, social and governance – approach.
“There are a very wide range of approaches lumped under this broad banner,” Hollands said.
ESG includes the ethical funds with negative screening processes but it also covers those that focus on the positive attributes of companies to find the ‘best in class’ for environmental and social impacts.
It also covers impact investing, which Hollands described as funds proactively targeting businesses that are making a positive social impact through its products or activities.
Today, there are 148 open-ended ESG funds, according to Hollands. Of those 148 a third of them have been launched in the last three years.
This is indicative of the substantial swell in interest to tackle sustainability issues both socially and via investments.
According to the latest data from the Investment Association (IA), responsible investment funds saw a net retail inflow of £897m in August. Responsible investment funds currently make up 2.7 per cent of total funds under management.
But while there are variety of different ESG funds available, Hollands said there are several factors investors should consider for any ESG fund.
Understanding their policies and approaches
The firs things investors need to do is gain an understanding the different ESG processes and policies available.
“Selecting any investment fund requires careful research and due diligence to understand the investment approach, the way risks are managed and whether the past performance is down to luck or skill,” Hollands said. “The challenges are even greater with ESG funds, because of the additional criteria used.”
The investment criteria will vary firm to firm, and fund to fund, so it is important that investors are sure whether the fund’s approach to ESG matches their own.
“This is particularly important for investors who may have some red line issues that they care strongly about,” he said.
For example, while tobacco companies are commonly screened out, funds may vary in their policies on animal testing.
“And it is important to understand that policies are not set in stone for ever and may evolve over time, so what is the process involved?” Hollands said.
“Navigating this maze requires investors to think carefully about what issues really matter to them and then the difficult job of finding the right combination of funds that will be consistent with their desired approach.”
Greenwashing
With the swell of interest in ESG, Hollands said some providers have moved to take advantage of these sustainable inflows without fully adopting ESG.
“Many providers have clamoured to tick the box and offer funds that are badged as ‘sustainable’ or ESG-focused to get in on the action,” Hollands said.
This is known as ‘greenwashing’.
The same issue occurs in companies looking for sustainable investment. Some companies have begun ‘window dressing’ their reports and accounts to make them appealing to ESG investors.
To avoid these funds or companies, Hollands said “effective ESG investing involves delving beneath the bonnet, engaging with companies on their policies and practices and at times actively using their votes to influence companies”.
For this to be done properly it should not be a “tick-box exercise” but requires resources and commitment.
Therefore, Hollands said investors “should be wary of funds that take a superficial approach and appear light on detail of how they go about ESG investing”, The core components such as the screening criteria, engagement commitment and transparency on its reporting should all be present if ESG is being fully implemented.
Short-track records
As mentioned above, around a third of open-ended ESG funds have been launched in the past three years, meaning that many funds will have a short track record. This makes it difficult to fully judge how successful they are, according to Hollands.
He said: “ESG investing is very much in vogue and while I believe interest in this space is here to stay and grow, there are a lot of funds with very short track records which are difficult to assess.”
The launch of these new funds has also occurred with a highly supportive backdrop for ESG.
In 2020, the oil price tanked because of the Russia/Saudi Arabia price war at the start of the year followed by a crash in demand because of the coronavirus lockdown. Looking at the commodity markets benchmark year-to-date, the S&P GSCI index has lost 29.72 per cent.
Performance of S&P GSCI index YTD
Source: FE Analytics
Since ESG funds do not invest in fossil fuels, they had much less exposure to this downturn, so its performance compared to broader markets which include these sectors looks especially strong, Hollands said.
This means that for investors considering an ESG allocation, especially for the long term, they need to be aware they just as the funds can widely outperform the indices, they can also severely underperform too.
“In recent years it has been a case of the latter, but this won’t necessarily remain so at all times in the future. The important thing is to focus on the long term,” he said.
Still some gaps in available funds
The final thing to remember is that while the range of investment options has increased in recent years, there are still some gaps in certain areas of the market.
Areas such as Asia, Japan or absolute return funds have “very little choice” for an ESG investor, Hollands said.
This means that investors may have to accept some compromises in their sustainability outlook in order to ensure that their portfolio is sufficiently diversified.