Sustainable investing is not limited to buying “green” and avoiding “sin” stocks. It is also based on the recognition that material sustainability issues can affect a company’s performance. Therefore, it makes sense to consider environmental, social and governance (ESG) factors when investing, particularly if we take a long-term perspective.
No company is perfect when it comes to the products and services it offers and the way it operates its business, but some are better than others. And typically, companies with high ESG credentials are better at managing operational and environmental risks and less likely to suffer incidents that can erode their share price.
An increasing number of investors want their investment portfolio to lean towards the best-behaving companies while also benefiting from the long-term benefits of low-cost ETFs. But for ESG-minded investors considering their options in the UK equity market, choice is limited.
In fact, UBS MSCI United Kingdom IMI Socially Responsible is the only ETF with a designated tilt towards the most sustainable UK companies. The ETF carries the highest Morningstar Sustainability Rating of five globes and was recently awarded a Morningstar Analyst Rating of Bronze.
To select the most sustainable companies, the ETF relies on MSCI ESG Ratings; the higher the ESG rating, the higher the chance that the company manages ESG risks and opportunities well.
For example, one of the top three holdings of the ETF is Reckitt Benckiser, the producer of well-known brands such as Strepsils, Calgon and Vanish. Compared to other large peers in the household and personal products industry, Reckitt has been identified as having one of the lowest product carbon footprints and the highest chemical safety and corporate governance ratings.
By contrast, HSBC, the UK’s largest bank, has been excluded from the fund’s holdings because of its record of repeated controversies. HSBC have been involved in several scandals, mainly involving money laundering, but also unfair dealing and financing practices.
Avoiding ESG Risks
Unearthing ESG-related risks can protect long-term returns. Compare, for example, the returns and volatility of Reckitt Benckiser and HSBC. Of the two, Reckitt has achieved higher returns over the past 10 and 15 years, despite lagging the HSBC significantly over the past three. Reckitt’s shares have also experienced lower volatility over the same periods.
Over time, the fund’s portfolio has consistently avoided the UK energy sector – unsurprising given the substantial environmental risks faced by companies involved in oil exploration and production – and is underweight the energy sector by about 9% compared to the broader UK large cap equity universe, which is predominantly represented by Royal Dutch Shell. This does mean, however, that investors would miss potential returns if the oil and gas giant rallies.
Apart from energy, the ETF’s largest exclusions are tobacco companies British American Tobacco (BAT) and Imperial Brands (a standard exclusion for any ESG fund), mining giant BHP Billiton and commodities trader Glencore.
Am I Sacrificing Returns?
Focusing on the best-behaving companies means the ETF only includes 50% of the market capitalisation of the UK market. As a result, investors could well miss out on returns if some of the companies that are not included in the index do well over the short-term, as has been the case with HSBC.
However, apart from the underweighting in energy, the fund does not have other significant sector bets. The weight taken away from the energy sector is evenly distributed across other sectors to ensure broad diversification. This makes us think that over the long-term, the fund’s risk-adjusted returns are unlikely to be much different than those of the broad market, while investors would likely experience a less volatile ride. Said differently, doing good doesn’t necessarily mean having to lose out on performance.
