On 4 October Good Money Week kicks off. A mini-festival of talks and events designed to raise awareness of sustainable investing, an area of the market which is experiencing booming growth.

In 2020, £11 billion was ploughed into sustainable investment funds, and so far this year, a further £8 billion has been invested by retail investors.

The investment industry has responded with a flood of fund launches focused on ESG (environmental, social and governance) themes to meet demand, as more and more people have plumped for ethical investment options.

ESG CAN BE A MINEFIELD

While the additional choice available to investors is to be welcomed, choosing an ethical investment can be a bit of a minefield, and investors should be aware of the risks and limitations of this approach, as well as the benefits.

There are a number of reasons investors have been buying ESG funds of late. Some people don’t want their money funnelled into companies engaged in activities they disapprove of, such as tobacco sales, or oil production. Others want their money to have a positive impact on the environment, or society, by investing in companies that are working to improve health, or forestall climate change.

All these investors would probably like a good return on their money, but for others this is likely to be the only motive. After the US presidential election last November, we saw a wave of money flowing into companies set to benefit from Joe Biden’s green policy agenda.

This wasn’t the action of investors who suddenly decided overnight they wanted to invest their money ethically, it was the result of (mainly institutional) investors placing bets on the companies that would benefit financially from infrastructure spending on renewable energy projects.

PUTTING IN THE ELBOW GREASE

If you’re thinking of investing ethically, you do need to be prepared to put in a bit of extra elbow grease when picking investments.

That’s because as well as choosing a fund which has robust performance potential, you’ll also want to select a fund which is aligned with your ethical principles as much as possible. It’s worth considering what will satisfy you on this front before starting your search. Some ethical funds tilt their portfolio away from companies with poor ESG scores, but may still retain some exposure to sectors like oil and gas, defence and tobacco.

Other funds totally avoid any investment in such companies on the basis that even if they are transitioning their behaviour, their activities are currently harmful to society or the environment. Another approach taken by some ethical funds is to seek out companies which are actively engaged in providing solutions to problems such as climate change, disease, or a lack of financial inclusion. This is sometimes described as ‘impact investing’.

There are then specialist funds which focus in on specific issues, like gender diversity, clean energy, or sustainable water provision. Before you start looking for a fund, it’s useful to have a think about which of these approaches ticks the ethical box for you, as this will help narrow down the options, and make research a bit easier.

CHECK YOUR BIAS

You should also keep in view the investment biases that an ethical strategy can introduce into your portfolio. For instance, the fact that so many of the UK’s biggest stocks are ESG transgressors, like oil majors and tobacco firms, means that if you’re investing in a UK ethical fund, it’s likely to be overweight mid and small caps, and underweight the big blue chips.

That will probably mean greater volatility, but with the potential for higher long term returns too. Global ethical funds are a bit different, because the biggest global companies are the US tech titans like Microsoft and Apple, which tend to score reasonably well when it comes to ESG considerations.

However, picking a global ethical fund could therefore lead to a big weighting towards the technology sector in your portfolio, particularly when you consider that companies offering solutions to climate change are likely to be tech firms too.

Again in this scenario you need to be comfortable with the risks involved in having a portfolio that is highly concentrated in one sector. ESG managers would likely point out that while that might increase risk on one level, by avoiding pollutive companies, or those with poor health and safety records, or weak levels of governance, you’re actually taking other risks out of the equation.

Investors who held BP (BP.) at the time of the Gulf of Mexico oil spill will recall what a devastating impact that had on their returns, as well as the environment.

‘PERFECT IS THE ENEMY OF THE GOOD’

Ethical investors would also probably do well to bear in mind Voltaire’s maxim that the perfect is the enemy of the good. You’re unlikely to find a fund which precisely matches your own ethical preferences, so the best fit is simply a pragmatic reality.

Ethical investors should also be realistic about what can be achieved through ESG investing. It’s going to take some considerable time for the world economy to switch to more environmentally friendly habits.

The recent gas price crunch and knock on effects for fertiliser plants and food supplies are a reminder of how reliant we are on hydrocarbons, even in ways we don’t suspect. Between them, governments, consumers and investors can drive change, but they need to accept it’s going to be a long haul.

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