Why Ethical (ESG) Investing?

30 November 2018

We have given this article the title Why Ethical Investing? but we could equally have called it Why Sustainable Investing?. These are some of the terms used to describe ethical investing, many of which are interchangeable:

Ethical - The word “Ethical” indicates doing something in accordance with some moral principles. Typically it was used for investors that avoided (“screened out”) areas of the market which were viewed as having a negative impact on society, but now it includes funds that actively look to “screen in” firms making a positive difference to society and the environments in which they operate.

ESG – ESG stands for Environmental, Social and Governance. There is growing evidence that suggests that ESG factors, when integrated into investment analysis and portfolio construction, may offer investors potential long-term performance advantages.

Green - Green shares or loans (bonds) are those of companies whose primary business is beneficial to the environment. Green investments are likely to be concentrated in areas such as alternative energy, pollution control, carbon abatement and recycling.

SRI – Socially Responsible Investing (SRI), or social investment, also known as sustainable, socially conscious, "green" or ethical investing, is any investment strategy which seeks to consider both financial return and social/environmental good to bring about a positive change. Quite often this term is used to describe an approach which actively looks to “screen in” firms making a positive difference to society and the environments in which they operate.

Whether it is clean energy, water, climate change, better healthcare or improved infrastructure, investors are actively seeking ways to invest in companies that supply solutions to these major global challenges.

Ethical investing continues to be a popular way of screening out investments such as alcohol and arms, or screening in investments that make a positive impact. It is a way that investors make their money work for the Planet, as well as themselves!

We are now living in a time when seeing solar panels on the roof of a house, wind turbines and electric cars are commonplace. These are examples of many industries that are growing and are likely to become more attractive investment propositions as the years go by.

Many people want change due to the wanton disregard for the environment by humans and the negative impacts of plastics etc. Whether you believe in climate change or not, there is no doubt that mankind has an unenviable record of heavily polluting the Planet on which we live and upon which we are totally dependent.

Most people (possibly brought home more so to parents and grandparents) do not want to leave a legacy to future generations of a ‘broken’ world. A sea change of thought and action is gradually gaining traction and pressure is being brought to bear upon the business world for changes to be brought about.

Even the youth of today (many of whom will be the captains of industry and investors of tomorrow) are more ingrained into the environment than previous generations; they don’t want it damaged and their voices will be heard.

We live in a world of 24 hour news coverage; social media gets messages out to more people and more quickly – reputations can be made and lost – globally – sometimes at a moment’s notice. Corporations have to act and react responsibly otherwise there may be no corporation.

Companies cannot survive without sales and profits and the next generation of investors, customers and suppliers will demand positive environmental change. They will vote with their (increasingly global) wallets when it comes to purchases.

Ethics is a global issue. In the short-term they will happily pay more for companies that care – forcing change to happen, in the long-run it will become standard. In the future, it likely won’t be called “ethical investing” it will just be called “investing”.

Ethical investing can have positive or negative bias – it can screen in, or screen out companies by looking at characteristics, principles or factors.

Some funds use both approaches favouring companies with good or improving environmental, social and governance characteristics, while avoiding those with exposure to unsustainable business areas such as tobacco or controversial weapons, or who are breaching global norms (utilising child labour, for example).

Funds with ethical or ESG objectives can be a force for change in the world. For example, an investment may be made into a packaging company that currently produces plastic packaging but is directing their innovation efforts to developing more sustainable packaging. Also investment managers can take a firm stand on environmental issues and vote against company management if its ethical concerns are consistently ignored.

Ethical investing has changed dramatically over the last few years. Investors used to be put off believing that the restrictions imposed by ethical investing would limit the returns (which sometimes used to be the case). These (ethical) restrictions obviously do limit the potential investable universe whether the fund management team use a screen in or screen out strategy (or both) when choosing investable companies.

As mentioned above when describing ESG investing there is, however, growing evidence suggesting that now ethical factors, when integrated into investment analysis and portfolio construction, may offer investors potential long-term performance advantages.

One of the most successful active fund managers in recent years, who invests in global equities (company shares), is Terry Smith. He launched his Fundsmith Equity fund on 1 November 2010 and up to 30 November 2018 this fund returned a very impressive 301.12% versus 93.73% for the sector average of the Unit Trust Global sector.

On 1 November 2017 Terry Smith launched an ethical version of a global equities fund called the Fundsmith Sustainable Equity fund which will not invest in businesses which have substantial interests in any of the following sectors:

• Aerospace and Defence

• Brewers, Distillers and Vintners

• Casinos and Gaming

• Gas and Electric Utilities

• Metals and Mining

• Oil, Gas and Consumable Fuels

• Pornography

• Tobacco

In addition, the fund management team applies further criteria to screen investments in accordance with the fund’s sustainable investment policy. They evaluate sustainability in the widest sense, taking account not only the companies handling of environmental, social and governance policies and practices but also their policies and practices on research and development, new product innovation, dividend policy and the adequacy of capital investment.

You could be forgiven for assuming, then, with such strict criteria limiting its potential investable universe that the Fundsmith Sustainable Equity fund has underperformed the Fundsmith Equity fund. As at 30 November 2018, however, the opposite was true as the chart below illustrates:

Although it is early days for the Fundsmith Sustainable Equity fund it can be seen that so far it has outperformed its more mainstream sister fund perhaps highlighting the changing (for the better) fortunes of companies with good or improving environmental, social and governance characteristics.

At Charlwood Leigh we generally recommend multi-manager funds for our clients. Unfortunately there are hardly any multi-manager funds in the ethical space for us to use. We are hoping that this will change.

For those clients who require an ethical portfolio we therefore do, of necessity, incorporate what we would describe as ‘single strategy’ funds i.e. those that purchase assets directly rather than via specialist third party funds. These well managed ‘single strategy’ funds are generally, however, diversified multi-asset funds and so risk is spread through holding a variety of assets that are invested globally.

We have written this article for a number of reasons, not least because of the increasing interest in ethical investing. One of the main ones is to highlight the fact that an ethical portfolio does not necessarily mean that you are compromising on returns and possibly as markets develop this approach may pay investors an added premium.

Ethical fund managers consider that companies which have compelling long-term strategies and take seriously their responsibility to their customers, staff, local communities, the environment and their shareholders will tend to outperform operationally those that do not over the long term and create more durable economic value.

We are very happy to recommend a suitable ethical portfolio for those of our clients who wish to adopt this growing approach to investing.

For existing Charlwood Leigh investors who hold a number of multi-manager funds that do not have a specific ethical or ESG remit, adding an ethical fund to the portfolio can increase diversification as there are likely to be some ‘sustainable’ assets within the ethical fund that are not present within the existing multi-manager funds.