The ESG (environmental, social and governance) theme is heavily in demand with investors looking for ways to profit from companies trying to make the world a better place.

Unfortunately finding suitable investments isn’t as straightforward as you might think. Firstly, a lot of companies say they are embracing ESG principles but they might only be doing the bare minimum such as recycling their rubbish and donating some money to charity. Secondly, many investment funds may talk up their ESG credentials yet they may be heavily skewed to the ‘G’ part, namely focusing on companies with good governance.

In reality, a lot of investors just want to invest in the ESG theme for the ‘E’ and the ‘S’ part. These factors are the most relevant to environmental issues dominating the headlines such as climate change and having a fairer society.

This article will talk through the process of trying to find investments more relevant to ‘E’ and ‘S’ than ‘G’ as arguably all companies and funds should be striving to have excellent governance. If someone or something has poor business ethics, isn’t transparent and doesn’t really care about investors, then you shouldn’t put money into it full stop.

WHY IS ESG IN DEMAND?

Climate risks, resource scarcity, clean energy and the protection of the world’s animals and wildlife are striking a chord with a growing number of people around the globe. Investors want to put money into companies that aren’t contributing to the problems and instead ones providing solutions, viewing it from a moral perspective as well as hoping to generate positive returns over time.

Confusing matters in the search for suitable investments is the number of names used interchangeably which represent similar ambitions to ESG. Sustainable investing, ethical investing, impact investing, green investing and socially responsible investing are among the key phrases used, although responsible investing perhaps best captures the spirit.

You can quickly become overwhelmed with the number of phrases. This suggests you need to define your ambitions and purpose with ESG investing from the start as that will help you narrow down the search for suitable investments.

ESG-RELATED FUNDS

We’ve built a list of keywords that are used across a range of investment funds and trusts in the product name. The definitions can be summarised as follows:

Ethical: Uses moral as well as financial criteria when selecting assets for a portfolio. Typically looks to avoid stocks on the basis of negative criteria, such as screening out companies that produce alcohol or weapons.

Sustainable: Selects companies that have a positive impact on the world, such as developing green technology or undertaking social initiatives in developing countries. Investments can include seemingly ‘bad’ businesses; for example, an oil and gas company could qualify if it is involved in renewable energy, even though it also produces fossil fuels.

Impact: Actively selects companies whose positive impact on the world can be measured. This might be generating a specific amount of recycling or saving a certain amount of water.

Socially Responsible Investing: This is a variation on some of the aforementioned terms. It involves investing in companies that have positive social impacts. For example, this means avoiding ones that produce or sell things that are addictive like gambling and tobacco and proactively seeking companies that are engaged in social justice.

Other terms that might feature in ESG-themed investment fund product names include:

Responsible

Environmental

Social

Climate

Water

Green

Renewable

We analysed funds and investment trusts containing these names in their product titles and found ‘sustainable’ to be the most widely-used phrase, as featured by 63 funds. ‘Responsible’ and ‘ethical’ are the next most popular phrases, while ‘climate’, ‘environmental’ and ‘green’ are barely used. The accompanying table gives you some examples of funds per category.

The fact that ‘sustainable’ features so widely is important for investors looking for ESG investments. As we mentioned earlier, this category can include companies which some people would consider to be harming the environment, such as oil producers. Therefore make sure you look closely at the top holdings for any relevant fund to check you’re happy with the constituents.

Click here if you would like to read about ESG-related exchange-traded funds (ETFs). 

Examples of funds with 'sustainable' in the title

Liontrust Sustainable Future UK Growth (3002876): The asset manager will only pick companies for this fund that meet its rules for environmental and social responsibility. Holdings include pharmaceutical giant GlaxoSmithKline (GSK), housebuilder Crest Nicholson (CRST) and catering provider Compass (CPG).

Guinness Sustainable Energy (B7LWDH1): It invests in stocks in the alternative energy sector, principally those providing power equipment, generating power, and involved in the electric vehicle industry. Holdings include renewable energy provider Ameresco, wind turbine manufacturer Vestas Wind Systems and electrical equipment specialist Schneider Electric.

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ESG-RELATED STOCKS

As for those seeking individual stocks, seemingly obvious investment ideas can also mask underlying issues that don’t fit with an ESG investment theme, so you need to judge each company one-by-one.

For example, water supply should be very sustainable and environmentally-friendly yet the industry is often dragged over the coals by regulators because of network leaks.

A cardboard packaging supplier may look significantly more ESG-relevant than a plastics one, yet manufacturing remains one of the biggest users of energy, which at the moment means burning lots of fossil fuels.

Automating tasks sounds great, but not if at the expense of thousands of jobs.

You then have the issue of companies talking up their ESG credentials which might sound attractive, but ultimately that might not be the driver of earnings. For example, supermarket Sainsbury’s (SBRY) has made several green pledges like cutting plastic and reducing emissions to zero by 2040, but at the end of the day it is just selling food and drink.

In contrast, a company like Water Intelligence (WATR:AIM) which finds and fixes water leaks would be much more relevant to someone who only wants to invest in businesses with environmental solutions.

Index providers such as MSCI have ESG ratings on stocks which investors often use as inspiration. Again, this might only shine the light on businesses doing the right thing but not necessarily having products or services to address climate change, for example.

The top five names in the MSCI World ESG Leaders Index are Microsoft, Google owner Alphabet, Johnson & Johnson, Visa and Procter & Gamble. While most of them invest in sustainability and important research and innovation, products or services which protect the environment aren’t the core part of their business.

So it goes back to the point that you need to establish exactly what you want to achieve from putting money into the ESG space.

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CAN YOU SEARCH FOR FUNDS BY THEIR ESG CREDENTIALS?

Fund rating company Morningstar has leveraged the data that it collects from fund management groups in order to help investors assess ESG risk at the portfolio level.

The score is called the sustainability rating and most of the information is available for free on Morningstar’s website when you look at individual funds. You can also search for funds by high or low sustainability rating.

The rating is based upon individual assessments of the companies in a portfolio and weighted by how much money the fund manager puts into each stock, then aggregated to create a portfolio score.

At least two thirds of the companies within a portfolio must have an ESG risk rating in order to receive a Morningstar sustainability rating. Because some companies within a portfolio might not have an individual risk rating, an adjustment is made which effectively rescales each portfolio to 100%, so that they can be compared.

HOW DOES THE SCORING SYSTEM WORK?

The idea behind Morningstar’s scoring system is to identify the ESG risks that affect the potential economic value of a company and which in turn impacts share price performance.

Because each firm will have explicit mitigation policies in place to address ESG risk, it is the unmanaged risk exposure that the rating is designed to measure.

The scoring system ranges from 0 to 100 with a lower score indicating the lowest ESG risk. The universe is split into five bands; zero to 9.99 represents negligible risk, 10 to 19.99 is low risk, 20 to 29.99 is medium, 30 to 39.99 is high risk and any score above 40 represents severe risk.

Portfolios change through time when fund managers add or remove holdings and when share prices change. So, in order to make the rating more dynamic, the sustainability rating is time weighted, giving historical scores lower weights compared with more recent scores.

This process adds consistency and more actively reflects each portfolio manager’s current decisions, which makes sense.

Different industries and sectors have specific factors that are more applicable to their activities and so Morningstar’s system is designed to allow an apples-for-apples comparison across funds within the same industry.

The rating is normalised so that a third of funds receive the top rating of four or five globes (above average within their peer group), a third receive three globes (average), and a third are given one or two globes (below average).

An example will illustrate how the system works. LF Ruffer Gold (B8510Q9) has a sustainability score of 43.8, meaning it has severe ESG risk (>40). However the fund receives the highest environmental sustainability rating (High) out of similar funds.

Regardless of how well the fund ranks within its Morningstar Global category, the maximum sustainability rating it can receive is three globes (average), because of its poor ESG rating.

Conversely, Fidelity Global Property (B7K2NZ0) has a sustainability score of 17.5, which is negligible ESG risk, but a below-average environmental risk score.

Morningstar will show you the ESG pillars score for each fund. 

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HIGH SCORING FUNDS

With the help of Morningstar’s database we have whittled down the list to find funds which all feature low to medium ESG risk as well as boasting five globes, Morningstar’s highest sustainability rating, which means they represent the top 10% of funds against their global peers.

Here are four examples:

Jupiter Ecology (B4KLC26)

The £500m fund looks to provide capital growth and income over the long term by investing at least 70% of the fund in companies whose core products and services address global sustainability challenges.

Two thirds of the fund is invested in the medium and small cap part of the market with only a third in large and mega-cap stocks. Denmark represents over 6% of the fund’s assets with 3.2% in Vestas Wind Systems and 3.1% in Orsted, an alternative power producer.

Despite very strong periods in 2013, 2017 and 2019, overall the fund has yet to show it is capable of consistent outperformance which is a risk to consider.

Stewart Investors Global Emerging Markets Sustainability (B64TS99)

The fund aims to achieve long term capital growth by investing in a diversified portfolio of companies operating in emerging economies, positioned to benefit from and contribute to sustainable development of countries where they operate.

Over the last five years the fund has delivered average annual returns of 4.9% comfortably beating the benchmark’s 0.6% return.

The fund is predominately positioned in large and mega-cap names, which represent 72% of assets.

Top 10 holdings make up 41% of assets; among the largest weights include Unilever (ULVR) at 7%, India’s Tata Consultancy Services at 6% and Tech Mahindra at 4.6%.

Pictet Global Environmental Opportunities (B4YWLO6)

This €1.7bn fund aims to achieve capital growth by investing across the globe in companies active in the environmental chain, such as agriculture, clean energy and water.

Large cap exposure is 56% of assets with mid-caps representing 40% and the remainder in small cap.

US stocks dominate the portfolio and represent 56.5% with the Eurozone at 18% and the UK at 7%. The portfolio has 52 holdings.

Top holdings include US design software and engineering company Autodesk and French waste and energy services company Veolia.

Read this article for a full analysis of the fund.

Royal London Sustainable Leaders (B8HTH59)

The £972m fund aims to achieve long-term capital growth by investing at least 80% in UK shares that are deemed to make a positive contribution to society. Lead fund manager Mike Fox is head of Sustainable Investments at Royal London Asset Management.

The fund has achieved 8.7% annualised returns over the past five years versus 4.1% from the benchmark.

In addition to UK shares, the fund has an 11% exposure to the US stock market and 6% to Europe. The trust has a large weighting in the healthcare sector including 5% in AstraZeneca (AZN), 4% in GlaxoSmithKline (GSK) and 4% in Smith & Nephew (SN.).

Other top 10 holdings include utility SSE (4.8%) and pest control business Rentokil (4.3%).

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