3 Approaches to ESG Investing

Ethical Investing

Ethical investing began back in the 90s with so-called "green funds" – these funds used negative screening, a simple approach which means simply staying away from companies considered to be “bad” stocks based on criteria such as environmental impact (oil and mining companies) and social harm (tobacco and weapon manufacturers). This approach rules out entire sectors of so-called sin stocks, which are businesses involved in perceived unethical activities. Funds were deemed either "light green" or "dark green" depending on how stringent their screening process was.

But it's unusual these days to find a fund which only uses negative screening. While ethical funds still exist, they now typically also employ so-called positive screening, which looks at the positive impact a company may have.  

Ethical investing may be the right option for investors who know they want to exclude certain industries from their portfolio because they don’t reflect their personal values. 

Ryan Smith, head of ESG research at Kames Capital, says that every two years the firm surveys investors on their views and whether they feel screening has been too thorough or not thorough enough. “There have been shifts over time, for example people are now more concerned about the environment because of climate change,” he says.

The Kames Ethical funds also exclude companies related to animal testing and meat retail such as supermarkets. In the Morningstar ethical fund category, Morningstar analyst Hortense Bioy likes the Bronze-rated Aberdeen Ethical World Equity fund.

The fund had a three-year annualised return of 8.6% and top holdings include Google’s parent company Alphabet (GOOGL) and electrical appliances producer Samsung (SMSN).  

Sustainable Investing

Sustainable investing means focusing on “better” companies based on ESG characteristics, while also avoiding companies with poor sustainability profiles. The conceptual difference compared to ethical investing is that the screening here is positive: rather than screening out, these funds “screen in”.

“It is about doing good, rather than avoiding bad” says Mike Fox, head of sustainable investments at Royal London. Fox explains that, for example, he might consider investing in “an oil company which uses renewable energy and battery technology, thereby de-risking its business.”

The idea behind sustainable investing is that these companies should be better placed to do well in years to come because they are adapting their businesses for the future. This should mean they deliver sustainable, long-term returns for investors. 

In the sustainable category, Bioy likes the Silver-rated Stewart Investors Worldwide Sustainability fund. The fund, classed as “one of the rarer breeds in global equities” by Morningstar analyst Ronald van Genderen, has produced annualised returns of 13.3% over the past five years.

Van Genderen, however, says that the portfolio will go in and out of fashion and investors should be prepared to ride out any bumps. “It’s not likely to outperform in frothy bull markets, but it should hold up well when markets falter, a feature we saw in 2018 pleasingly,” he says.

Impact Investing

Impact investing is for those who want to make a difference and an impact. “It is perhaps the most exciting but also the most challenging part of the sustainable investing space,” according to Bioy.

Leon Kamhi, head of responsibility at Hermes Investment Management, says there is a growing interest in impact investing, which has become "the fastest growing area of responsible investment".

Impact investing is about making a real change in the world. So, alongside generating a good financial return, you might also want to solve the world’s problems – tackle climate change, finance energy transition, or improve people’s wellbeing, for example – and you do that by investing in companies which generate outcomes that benefit people, the planet and investors.

In this space you might find social bond funds, which lend money to companies and governments, which is ring-fenced for particular activities with a positive social, economic or environmental impact. 

“Investing for impact is one of the best ways we can work together to shape the world we all want to live in and invest in the future of the planet,” says Adam Robbins, senior investor relationship manager at Triodos Bank UK.

In this category, Bioy likes the Wellington Global Impact fund. While the fund has not yet been rated by Morningstar, Bioy thinks it has potential to grow. The fund, which has returned 22.8% year to date, invests in companies such as the Chinese electricity producer Huaneng Renewables (HRENF) and solar panel manufacturer First Solar (FSLR). has done very well this year. “Its track record should give investors confidence in the robustness of the strategy,” says Bioy.

…But the 3 Can overlap

Of course, the world of investment is not black and white – these three main approaches that an ESG-conscious investor can follow can often easily overlap, making it confusing to find the fund that best fits your needs. 

For example, an impact fund can be also sustainable or ethical at the same time, because it can screen out or in certain companies. 

“This tendency to compartmentalise investment strategies is very typical of our industry.” says Peter Michaelis, head of the Liontrust sustainable investment team. “It’s true that there are various ways of defining yourself within the sustainability sector, but we’d argue that using a combination of disciplines is in investors’ best interests”.

Investors looking to incorporate ESG into their portfolios should be sure to do their homework - read the fund factsheet and ensure you fully understand its strategy and approach to investing to make sure it aligns with what you are trying to achieve.