Understanding ESG Investing

In this month’s article, we look at the basics of ESG investing and what you need to consider if you would like to introduce ESG into your own portfolio.

During the Cop26 climate summit back in November we heard a lot about three letters: ESG. This stands for Environmental, Social and Governance, and it’s a big part of the fastest growing investment story around. 

But even as interest in ESG and related issues grows rapidly, many remain unsure as to what it really means and how it works. So, our aim here is to fill in some of those gaps, demystify the subject of ESG and set out the role it plays in modern investment portfolios.

What is ESG?

Investment research firm MSCI defines ESG investing as “the consideration of environmental, social and governance factors alongside financial factors in the investment decision-making process”.1 The environmental part concerns how companies take account of issues like climate change and the impacts of their operations and products on the living world. The social aspect is about the way in which companies operate, covering issues such as working conditions, health and safety and employee relations. And the governance bit is about company leadership in issues such as executive pay, bribery and corruption and board diversity.

These all sound quite different, but in many ways they can’t be separated. For example, if a company has a poor record on environmental standards or working conditions it may well be an indication of poor governance. It may also provide clues as to a company’s resilience and long-term outlook in a rapidly changing world.

The problem for investors is that ESG is just one of many terms in the responsible investment landscape. Other descriptions under that umbrella include ethical investing, impact investments and socially responsible investing (SRI), while words such as green, environmental and sustainable also crop up frequently and are often seen as interchangeable by investment providers.

This array of terms and approaches can cause confusion. That’s why the financial services regulator, the Financial Conduct Authority (FCA), is consulting on how to label investment products in a way that helps investors understand their sustainability-related risks and opportunities and more easily compare different products.2

Why is ESG investing important?

Investors increasingly want their money to go into areas in which it can make a positive difference, or at least not into companies or industries that do harm. There are a number of reasons for this, not least an acute public awareness of the urgent need to address the climate crisis.

From food and clothes to mortgages and investments, more of us are paying attention to the companies we deal with and how they behave. Research by financial services consultancy the lang cat found that 83% of people say their values come into their buying decisions at least sometimes, while 63% believe their money can make a difference to at least some extent.3 ESG is climbing the agenda of professional investors too. A poll of institutional investors (such as pension funds) found that 75% consider ESG factors an integral part of sound investing.4

Blending profits and principles

Fund managers aren’t just using ESG because it looks good; in fact, there’s growing evidence that paying attention to ESG factors is positive for investment returns.

In the first nine months of 2020 – as the Covid-19 pandemic unfolded – the companies given the top sustainability ratings by Fidelity International outperformed the MSCI AC World Index. The investment management firm found that companies with a deteriorating ESG outlook underperformed those considered either stable or improving. This supported their view “that a company’s focus on sustainability is fundamentally indicative of its board and management quality and its resilience5.”

Investment returns can be boosted by lower costs, and there’s evidence that ESG investing offers an advantage here too. Funds run with an ESG mandate charged lower fees in October 2020 than non-ESG funds, at 0.57% compared to 0.71%, according to investment research firm Morningstar6

Reading between the lines

So, evidence suggests ESG investing can be cheaper and produce better returns while potentially delivering positive non-investment outcomes. What’s the drawback?

Well, one is that the growth of ESG investing brings complications too.

The range of funds under the ESG umbrella is increasingly diverse, making it harder for investors – especially those not using a professional adviser – to identify the most suitable products. It’s important to remember here that ESG is more about the way funds assess the risks to businesses than about selecting or avoiding certain types of companies. Many investors may not understand that some funds with an ESG or similar label will be able to invest in stocks that many would consider unethical (such as tobacco, arms or alcohol companies).

The Boohoo scandal that unfolded in 2020 is a good example of the ESG challenges facing investors. The fashion retailer was held by a lot of the big UK ESG funds, partly because ratings providers gave the company high ESG scores. Yet the firm was associated with ‘fast fashion’, an area with serious concerns over sustainability. And when lockdowns were imposed in Spring 2020, Boohoo told its staff to continue going into work during lockdown, paid them well below the minimum wage and subjected them to poor working conditions. In other words, the firm fell well short of what many investors might expect in terms of all three of the ESG factors.

There is also the issue that cutting investment in certain types of companies can limit their ability to transform their behaviour. For instance, large oil and gas companies could be viewed as problematic environmentally as they contribute to climate change, but many are investing heavily in developing forms of renewable energy. Supporting this transition could be seen as part of the remit of ESG investing.

Next Steps

New ESG-focused products are being launched all the time as the money flowing into the funds continues to gather momentum. There’s more choice than ever for investors wanting to ensure their money can help drive positive change, but that can add to the complexity too.

If you’re interested in ESG investing, our expert financial planners can help you navigate the changing ESG landscape and make good decisions that fit with your wider investment objectives and risk appetite. Get in touch to discuss how you want to invest and how it can be incorporated into your financial plan.

1https://www.msci.com/esg-investing

2https://www.fca.org.uk/news/press-releases/fca-acts-help-investors-make-more-informed-esg-investment-decisions

3https://langcatfinancial.co.uk/wp-content/uploads/2021/01/Crossing-The-ESG-Event-Horizon_-An-Adviser%E2%80%99s-Guide.pdf – pg 9

4https://www.nasdaq.com/articles/factors-behind-the-growing-popularity-of-esg-investing-2021-04-24

5https://www.fidelityinstitutional.com/en-gb/articles/pages/putting-sustainability-to-the-test-esg-outperformance-903013 6https://www.ftadviser.com/investments/2020/12/08/fund-fees-down-31-but-cost-sensitive-advisers-eye-further-cuts/