When ethical investing was first established in the UK more than three decades ago, those who wanted to invest ethically traditionally focused on excluding certain companies such as weapon manufacturers or tobacco producers from their portfolios.
But over the last decade, the use of environmental, social and governance (ESG) factors has become more commonplace. The term “sustainable investing” is, at times, used to refer to both of these approaches and it is increasingly in vogue among fund firms.
The amount of money invested in sustainable assets globally stood at $30.7 trillion at the start of 2018, according to the Global Sustainable Investment Alliance, a 34% increase since 2016.
The report found that the most dominant sustainable investment strategy is still negative screening, accounting for $19.8 trillion of those assets. It’s the most common approach in Europe. The second most dominant approach is ESG integration ($17.5 trillion), which is favoured in the US and Canada, followed by corporate engagement and shareholder action ($9.8 trillion) in Japan.
It makes sense that exclusion is still a key element of sustainable investing. At the same time, the use of ESG factors is reinforced on the policy level. The European Union recently agreed new ESG requirements under MiFID II, for example.
ESG Scores and How They're Used
Given that the market has been growing for some time, various providers offer ESG scores. These providers range from specialists such as Vigeo Eiris, to the ESG departments of bigger providers of indices such as MSCI. Morningstar provides its own sustainability ratings in partnership with Sustainalytics; these are being refined later this year to allow investors to better compare companies across industries.
ESG scores assess companies’ policies and controversies and increasingly determine how capital is allocated in the space.
So how do fund managers use ESG scores? “We start by asking what the impact of a business is,” says Simon Clements, co-manager on the Liontrust Sustainable Investment team, which manages the five-star rated Liontrust Sustainable Future Absolute Growth fund.
For the best part of the past two decades, his team has used ESG scores of various ratings agencies to help them with the process. The scores can help with efficiency, and they “can save analyst time,” Clements says. “We see it as a resource – sometimes with agree with them and sometimes we disagree with them.” They are one ingredient of the investment overall process.
Meanwhile, George Latham, managing partner at WHEB, which runs the three-star rated FP WHEB Sustainability fund, says his company uses their own ESG analysis “to identify higher quality investment opportunities”.
Audrey Ryan, manager of the Kames Ethical Equity Fund, uses ESG ratings from providers, but she adds “they never drive our investment decisions.” Hamish Galpin, lead manager of the Hermes SDG Engagement Equity fund, argues that investors should ideally consider ESG information alongside traditional fundamental analysis, whenever possible. As with any aspect of investing, a rating is may be a useful tool but it’s important to do your own due diligence.
Some Anamolies
Galpin mentions Brunswick (BC), a US marine engine and boat manufacturer, as a stock that he evaluated differently from the assessment of ratings agencies. “Despite having a below-average ESG rating, we believe it is a high-quality company,” he says. One reason for that is that the company’s manufacturing facilities are cutting-edge in terms of energy usage, air quality and waste reduction. Recent improvements at the firm, he believes, were also not reflected in its score: “While previously lagging in best practice, Brunswick has improved aspects of its corporate governance, including declassifying its board to ensure all directors faced election each year.”
It may not be surprising that many active managers emphasise the value of their own research over or in addition to ESG scores. After all, active managers are trying to add value through their own individual approach.
Perhaps the greatest advantage of ESG scores is that they provide shared definitions in an industry that has often lacked standardisation.
Large Company Bias
It’s worth noting that ESG scores tend to focus on the internal processes of a company, rather than the product or service it provides. That’s how ESG scores can end up providing a counter-intuitive result where, for example, an oil company has a higher ESG score than an electric car company. It is, therefore, important for investors to ask themselves whether there are certain companies or sectors they want to exclude first, or whether they want to consider any company that has good ESG scores.
Ratings agencies have more information about larger companies, which have the resources to produce large quantities of data about themselves. ESG scores are therefore more likely to capture the processes of larger companies. As the sustainable investment industry continues to evolve, so will ESG scores.
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