A growing number of investors are choosing to put their money in companies with good environmental, social and governance (ESG) credentials and to exclude certain activities such as armaments manufacturing and pornography distribution. But the question for many of them is, how far do they want to go with this?
Cantor Fitzgerald director of investment services Ian Halstead points out that there are many investment products on the market making claims to responsibility and that what defines responsible is a broad spectrum. On a scale of zero to 10 the lowest level would have no sustainability or responsible characteristics, while 10 would effectively be philanthropy and not qualify as an investment at all.
The two-to-five range covers ESG investments, he says. These are investments that look for financial returns but also have a view to ESG considerations. The degree to which ESG aspects are taken into account varies and a certain percentage of the portfolio might be devoted exclusively to investments with strong ESG credentials, while activities such as tobacco production might be excluded.
“If you go deeper into the social area, you might look at International Labour Organisation or UN Global Compact standards,” Halstead points out. “Going higher again, some investors might exclude fossil fuels altogether. Others might want to include religious values. There are all manner of investment products out there catering for those choices and you can buy exchange traded funds (ETFs) that cater for them as well.”
Patrick McLaughlin, head of SRI multi asset solutions with Davy, advises investors to be clear about what they are looking for in a responsible investment. “To begin with, I would recommend speaking with a financial adviser with experience in this area, or an adviser with access to a team with expertise in responsible investments,” he says.
After that, you should consider what characteristics matter to you as an investor. Those characteristics might include the carbon footprint associated with the investment and the behaviours exhibited by companies. “Do you wish to invest in the companies that already exhibit the best sustainability credentials or those that are improving?” he adds. “All of this should be carried out in the context of a broader financial plan, detailing your investment objectives, your investment horizon and risk appetite.”
When it comes to putting a responsible investment portfolio together, McLaughlin explains that the space has evolved considerably, with a variety of approaches now employed.
These include best in class or positive screening: “This involves applying filters to a universe of securities, issuers, investments, sectors or other financial instruments to rule them in, based on their positive performance on ESG factors relative to industry peers or specific environmental, social or governance criteria.”
The ESG integration approach is the systematic and explicit inclusion of material ESG criteria into investment analysis and investment decisions; thematic ESG investing is the identification and allocation of capital to themes or assets related to certain environmental or social outcomes, such as clean energy, energy efficiency, or sustainable agriculture.
Stewardship, meanwhile, involves “the use of influence by institutional investors to maximise overall long-term value, including the value of common economic, social, and environmental assets on which returns and client and beneficiary interests depend”, McLaughlin explains.
These definitions are widely accepted and are drawn from the UN Principles for Responsible Investment.
“Applying these additional approaches provides for a more rounded investment process and can positively impact the risk return characteristics of the investor’s portfolio,” McLaughlin adds.
There is still the possibility of an investor unwittingly buying into something they wanted to avoid, of course. To prevent this, McLaughlin advises investors to become familiar with the investment solution they are considering and to “ask their adviser or investment manager questions relating to how the solution is managed from a sustainability viewpoint”.
Before committing their money, they should ask what activities are excluded, how ESG risks and opportunities are integrated into the investment process, and how the investment manager engages with portfolio companies on sustainability and ESG risk and opportunities, he adds.
Post-investment, they should ask the investment manager to periodically provide holdings reports and ask what sustainability metrics they will report on an ongoing basis.
Halstead points out that the EU Sustainable Finance Reporting Directive is helpful in this regard. It requires asset managers and investment advisers to make standardised disclosures in relation to the sustainability impacts of investments and how ESG factors are integrated into them.
Importantly, it classifies financial products under three categories: Article 6 applies to investments that do not purport to be ESG products; Article 8 products promote, among other things, environmental or social characteristics or both; and Article 9 products – sometimes known as dark green investments – pursue sustainable investment or have a reduction in carbon emissions as their objective.
Article 8 is quite a broad category, says Halstead: “A lot of funds can get in there. You don’t want coal investments and so on but the bar is quite low really.
“Under Article 9, it has to have 100 per cent sustainable investments. That’s pretty challenging and makes it difficult to have a proper investment spread for diversification. When it came out first it was interpreted quite loosely and we saw a whole lot of Article 9 funds back out into article 8 after that. There are very few Article 9 funds out there now. I think one new fund might have been launched last year.”
In the final analysis, however, investors still want a return for their money. “When you create a portfolio, you are trying to strike a balance between financial return and sustainability,” Halstead notes. “There are lots of studies that show that ESG investing over two to five years had a positive return over other investments. But it’s not statistically significant. We don’t sell ESG investing as a driver of returns but it doesn’t have a negative impact either. If you invest in Article 9 funds, you might have OK returns, but you will probably also have higher volatility.”
