It had looked like 2020 would be a big year for the ESG (environment, social, governance) industry. Now the sole topic of conversation among investors is the financial carnage caused by the global health emergency. Are ethical investing considerations a luxury in the current environment? Or is the current crisis proof that ESG issues are too big to ignore?
Covid-19 “reminds us that the natural world can surprise us, and very quickly”, Harvard economist Rebecca Henderson recently told the Financial Times. The business of business is not merely business, she says. Investment managers cannot worry only about the health of the free market and hope that “someone else will take care of everything else”.
That’s echoed by JUST Capital, which says companies need to do what they can to flatten the coronavirus curve, whether that is through paid sick leave and work-from-home policies or by providing leadership, as Louis Vuitton did by creating free hand sanitiser.
Investors are often surprised to see that technology giants like Apple and Microsoft feature heavily in ESG funds. It’s often assumed ethical funds always exclude certain sectors, such as tobacco, oil, and arms among others. Some certainly take this approach -- Cantor Fitzgerald’s Green Effects fund, for example, only invests in shares on the 30-stock Natural Stock Index.
Most funds, however, opt for a policy of engagement. Instead of automatically excluding certain companies, they use their influence as shareholders to improve companies’ ESG policies. Therefore, oil and gas stocks appear in the indices maintained by ESG index providers such as FTSE4Good, S&P Dow Jones, MSCI and Stoxx.
Certain funds, like Friends First’s Stewardship Ethical fund, combine these approaches. It conducts ethical screening and avoids companies with “damaging or unsustainable business practices”, while also engaging with less-than-perfect companies on how to improve their ESG practices.
As for returns, can investors do well by doing good or will plumping for ethical funds end up denting your net worth? Sceptics note that so-called sin stocks have traditionally outperformed; tobacco, for example, has historically been the best-performing stock market sector.
Advocates, however, argue it makes good business sense to stock up on socially responsible companies. Indeed, increased urgency regarding climate change means some companies and industries will “fail to exist” if they don’t change their ways, former Bank of England governor Mark Carney warned last year.
Both arguments may be flawed. Research from fund group Robeco suggests certain sin stocks have done well because they were highly profitable, high-margin businesses. Ethical investors could do just as well if they screened for similarly profitable stocks in other sectors.
That said, the argument that you will outperform by buying ‘good’ companies may also be weak -- some may be worth it, some may not. Most experts agree that anything that restricts your investing universe could hamper your returns, although research from fund group GMO suggests removing one sector – for example, oil – from your portfolio will make little difference.
Overall, however, ESG investors are unlikely to pay a price for their principles. Deutsche Asset Management analysed 2,200 studies on the subject and said 90 per cent found that ESG investing didn’t hurt returns.
Conscientious investors who want to earn the best possible returns may prefer funds that opt for engagement over divestment. London Business School research shows that when institutional investors persuade a company to improve ESG practices, its financial performance improves and its stock price gains. Moreover, a 2019 Bank of America report found that firms involved in 24 ESG controversies lost $534bn in market value.
Finally, it’s worth remembering that costs are the biggest determinant of investment returns – hefty annual fund fees can seriously hurt long-term returns.
Exchange-traded funds (ETFs) tend to be inexpensive and investors shouldn’t have much difficulty finding specific ETFs that matches their particular area of interest, whether that’s green energy, water management, gender diversity or anything else above the ethical water line.
Alternatively, investors may prefer a broad fund offered by an ESG index provider. One is Vanguard’s SRI (Socially Responsible Investing) Global Stock Fund, which contains over 1,800 companies around the world. The annual fees with this fund are almost identical to Vanguard’s non-SRI global stock fund, notes Dublin-based Moneycube, and returns have only slightly trailed its non-SRI counterpart over the last three- and five-year periods.
Whatever fund you are considering, be sure to check under the hood and see what stocks you’re buying. Different funds take different approaches, and ethics are very much in the moral eye of the beholder.