Five things investors should know about when investing in ESG-focused funds

Ethical investing arose from the desire of some individuals who wanted to invest in line with their ethics and principles. The initial goal was to avoid companies perceived to be “unethical”, but as the whole concept of investing for good becomes more popular, definitions and attitudes have changed.

Ethical investing is no longer about excluding companies perceived to be harmful to the environment or have poor working practices, for example. Instead, it is very much about what companies can have a positive impact on the climate, and the way we interact with it, or which have excellent approaches to governance.

Amid this shift, the investment universe has also grown immensely over the past decade, and sales in responsible funds have risen 230% (Over 12 months to August 2020) on the back of strong performance of funds in this space.

However, while there is a lot of growth in the sector, there remains much confusion about what ethical investing actually is. From ethical, to impact, to sustainable, there are a litany of names and approaches to investing in ESG, which can be confusing.

Below Adrian Lowcock, head of personal investing at Willis Owen, highlights five important things investors should be aware of when they approach this sector and the funds that invest in ESG. 

Greenwashing

“Greenwashing is an undesired consequence of the growing popularity of ethical, sustainable or responsible investing. It is where a fund manager, or a company, tries to make their fund look more ethically sound than it actually is – essentially jumping on the green bandwagon.

“Greenwashing is a tricky element for an untrained eye to spot. Companies that pollute the environment or are low on social responsibility may do whatever is possible to sell consumers and investors a greener vision of their businesses, and it is up to fund managers to find the winners and losers if they have mandates which promote their green credentials.

“However, investors can help themselves by reading more into what specific funds do regarding ESG. It is necessary in this space in particular to go beyond first impressions, and investigate subtle communication changes, how managers measure sustainability, and what parameters they are sticking to.

ESG does not necessarily mean ethical

“ESG stands for Environmental, Social and Governance. Managers that invest using ESG criteria do not necessarily have an ethical mandate. It is becoming increasingly common for fund managers to invest in companies that have the best, or one of the best ESG scores in their industry, but they could still operate in “unethical” sectors such as Oil and Gas or Pharmaceuticals.

“Investors need to make sure they know what they are buying into. Look into top 10 holdings and sectors in the funds, and making sure they are happy where the fund is invested.”

ESG can help improve investor returns

“By focusing on good corporate governance and investing in sustainable businesses, investors in ESG funds can avoid businesses which make mistakes and end up on the wrong side of consumer opinion.  ESG is often about making better investment decisions and therefore investing in businesses with long-term sustainable goals. Having a long-term approach can only be beneficial for investors, especially when looking at investing for retirement. It also means you have a longer-term horizon to reach those high returns.”

ESG investing is about positive change

“Investing ethically has, for a long time, been about avoiding certain sectors such as Arms or Tobacco. It is fairly easy to exclude those sectors from a portfolio, but if you want to invest to do good, then the lines can get blurred. Some things are necessary in life, but they might not meet your ethics. However, by engaging with businesses investors can influence the management team or on occasion demand change. ESG investing is  about looking to a sustainable future, and therefore it can be good to invest with managers who are looking at companies which have a forward-looking plan to become sustainable, even if they don’t quite tick the right boxes currently.”

Tolerance is key

“It is very hard for a company to know exactly what is going on in their supply chains all of the time. Sometimes they may make a mistake, or something may have been hidden from the company that they couldn’t have easily found out. ESG investors often look at the tone and attitude of management to determine whether it was a mistake and the company can take steps to avoid it happening again, or is it more a deep-rooted cultural issue.

“Understanding how the management react to events like this can be crucial and will ultimately show how committed they are to ESG, and so watching your own fund manager’s response to these events is vital.”