How to navigate the ESG maze

Writer,

The performance tide has turned against ESG funds of late, as growth stocks have floundered, and oil and gas companies have profited from rising energy prices. That won’t stop money flowing into responsible investments though. There is genuine consumer demand for these products, and the investment industry has sunk a lot of marketing dollars into launching new funds and rebranding existing ones which now carry the ESG tag. On top of which, longer term performance of ESG funds compares favourably to more traditional offerings, especially in the global fund sector.

  Total return %
1 year
Total return %
3 year
Total return %
5 year
IA Global funds      
ESG 6.6 43.4 66.4
Non ESG 8.7 40 60.6
       
IA UK All Companies funds      
ESG 2.2 14.8 25.3
Non ESG 5.9 15.3 25.9

Sources: AJ Bell, Morningstar to 5th April 2022

Regulation will drive further ESG flows

We’re still in the foothills of ESG investing, and consequently the infrastructure to support investors is still being somewhat hastily erected. The FCA will be consulting on introducing a green labelling regime in the next couple of months, which should add some much needed clarity to what investors can expect the extensive ESG vocabulary to mean in practice. Greater disclosure requirements could well drive further flows into responsible investment funds. Data compiled by Morningstar shows that 42% of European fund assets now sit in ESG funds, even though the EU’s regulatory classification scheme was only introduced in March 2021 (what are known as SFDR Article 8 and 9 funds).

The widescale adoption of regulated ESG classifications in Europe suggests that the endgame is likely to see the majority of funds incorporating some kind of ethical framework into their investment process, especially those offered by large investment houses. Rules governing how advisers integrate their clients’ ESG preferences are also heading down the track, which will encourage asset managers to add a responsible investment lens to even more funds.

What does an ESG portfolio look like?

Investors looking to put money into ethical funds, or indeed those looking for individual stock ideas, might well be interested in the most popular holdings within ESG funds. Within global funds, the top ten most popular holdings have a distinctly technological flavour. That is perhaps unsurprising given the extent to which technology stocks feature in the world index at large, but also underlines these companies do tend to score well on ESG factors too. That’s despite the fact that some of them face questions around anti-competitive behaviour and the levels of tax paid in certain jurisdictions.

What’s most notable about the most popular holdings in UK ESG funds is the number of financial services firms in the top ten. This sector tends to score well on ESG metrics, as it isn’t a heavy industry that needs to consume lots of carbon to conduct its daily activities. However, the inclusion of Lloyds might raise an eyebrow or two, seeing as the bank is still mopping up after past misdemeanours, and had to set aside £1.3 billion in the last financial year for customer remediation. Pharma stocks are also a bit of a shoo-in for UK ESG funds their core business results in better health outcomes for society at large.

10 most widely held shares in global ESG funds

Microsoft Corp Technology
Alphabet Inc Class A Communication Services
Thermo Fisher Scientific Inc Healthcare
Schneider Electric SE Industrials
Apple Inc Technology
Mastercard Inc Class A Financial Services
Amazon.com Inc Consumer Cyclical
Novo Nordisk A/S Class B Healthcare
ASML Holding NV Technology
Taiwan Semiconductor Manufacturing Co Ltd Technology

Sources: AJ Bell, Morningstar

10 most widely held shares in UK ESG funds

AstraZeneca PLC Healthcare
Unilever PLC Consumer Defensive
RELX PLC Communication Services
GlaxoSmithKline PLC Healthcare
Prudential PLC Financial Services
Legal & General Group PLC Financial Services
Ashtead Group PLC Industrials
London Stock Exchange Group PLC Financial Services
SSE PLC Utilities
Lloyds Banking Group PLC Financial Services

Sources: AJ Bell, Morningstar

How to navigate the ESG maze

Right now investors face a bit of a maze when it comes to ESG investing, because there are lots of words and phrases flying around which can have different interpretations. We can expect this to improve over time, especially when the FCA introduces its green labelling regime. As things stand, there are a number of different approaches to investing ethically, and the main ones are described below. Some funds will combine a number of these different approaches, and within each approach 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

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 portfolio companies, 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 in ESG funds it would normally be supplemented by further measures.

ESG integration

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.

Tilting

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.

Exclusions

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.

Positive impact

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.

Past performance is not a guide to future performance.

These articles are for information purposes only and are not a personal recommendation or advice.


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Written by:
Laith Khalaf

Laith Khalaf started his career in 2001, after studying philosophy at Cambridge University. He’s worked in a variety of roles across pensions and investments, covering both the DIY and the advised sides of the business. In 2007, he began to focus on research and analysis, and has since become a leading industry commentator, as well as a regular contributor to the financial pages of the national press. He’s a frequent guest on TV and radio, and for several years provided daily business bulletins on LBC.