Fit for the future: how ethical investing went mainstream

published 15 February 2018

Ethical and sustainable investing is no longer simply about ditching cigarettes or saving trees. Investors are increasingly concerned about better returns and lower risks, says Sarah Moore.

Late last year, Norway's sovereign-wealth fund announced that it plans to dispose of all its oil and gas investments, worth more than $35bn. The proposal has yet to be approved by the Norwegian parliament, but if it goes ahead it will be a remarkable switch, given that the fund which controls more than $1trn in assets was originally created to look after the surplus revenues of Norway's oil industry for future generations.

Activists who have been pushing pension funds and other investors to divest all holdings in companies that produce fossil fuels are, of course, delighted. But the fund's plan is not based on ethical considerations or at least, not officially. Instead, it's about the long-term risks of holding firms such as these. The fund wants to hedge its bets against a future in which these fuels give way to renewables and oil and gas revenues can no longer be relied upon to keep Norway's finances in good shape.

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Norway's dilemma is a good example of the way in which views on ethical, responsible or sustainable investing are evolving. In the past, these approaches were usually identified with a desire to avoid industries that investors considered especially unethical (for example, an investor might choose to steer clear of tobacco stocks or weapons manufacturers). Investment performance often took second place to being consistent with your principles. However, today, ethical considerations are informed by a broader and more useful trend. Increasing numbers of institutions and individuals are keen to avoid certain sectors because they believe that these face structural problems that make them poor long-term investments. These structural problems may be closely linked to the same issues that see them labelled as unethical but it is the financial implications rather than simply the ethics that are important for many investors.

Words such as ethical and sustainable are thrown around quite a lot, without much agreement on what they mean. The most commonly used terms are sustainable, responsible investing (SRI) and environmental, social and governance (ESG) factors. They often imply the same thing, but some investors suggest that the former term refers to exclusionary screening weeding out "sin" stocks while the latter term means inclusionary screening (actively seeking out companies that reduce fossil-fuel footprints or promote workplace equality, for example). However you want to define it, it's clear that this is a booming market.

A heightened awareness of climate change is one significant driver behind the increased interest in SRI investing, as well as growing scrutiny of what we eat and drink, says Stephane Soussan, manager of CPR's new Food for Generations fund, which will invest in all stages of the food chain, from agriculture and water to food and drink production and distribution, and restaurants. Millennials are also more concerned than previous generations about putting their money into investments that are sustainable and not harmful, argues Terry Smith, founder of asset manager Fundsmith, which has recently launched a sustainable investment fund for institutions. This conclusion is backed up by research from Morgan Stanley, which found that 82% of high-net-worth millennials express an interest in SRI approaches, compared with 45% of all high-net-worth individuals.

The rising demand for sustainable assets also reflects a return to long-term investing principles, Amin Rajan, the author of a report into long-term investing in the age of political risk, suggested in the Financial Times recently. This is replacing a period of short-termism brought about by intense volatility immediately after the financial crisis, he reckons. "The result of this shift in attitudes is increased demand from investors for asset managers that are able to spot the... risks associated with poor environmental or governances practices, as illustrated by scandals such as the Deepwater Horizon oil spill or the investigation into Volkswagen's emissions".

The big question for investors is whether SRI and ESG strategies mean accepting lower returns. Investors have often assumed that they do, since sectors such as tobacco and weapons have often performed strongly over the long term. However, over the past five years the FTSE4Good UKindex has returned 60.31% (with dividends reinvested) against the FTSE 100's 50.85%. This index measures the performance of companies demonstrating strong ESG practices and constituents need to show that they are working towards improved environmental management, climate-change mitigation and adaptation, countering bribery, upholding human and labour rights, and improving supply-chain and labour standards.

Meanwhile, in the US, the KLD400, the main ethical benchmark, returned 109.19% relative to 107.65% for the S&P 500. For inclusion in this index companies must score well in their management of five factors: the environment, community and society, employees and supplychain, customers (in terms of things such as product quality and safety and marketing practices), and governance and ethics. So over the past five years companies with strong ESG practices have fared better in both the UK and the US stockmarkets (although only by a small margin in the latter).

In part this may be due to superior financial performance. The question of whether high ESG standards has an impact on how well the company performs is still debated and it's common for researchers to claim that results are ambiguous, inconclusive or contradictory, note Gunnar Friede, Timo Busch & Alexander Bassen of the University of Hamburg in a paper in the Journal of Sustainable Finance and Investment in 2015. However, when the researchers conducted a meta-analysis based on 2,200 empirical studies released since the 1970s, they concluded that the business case for ESG investing was "empirically well-founded": of the studies analysed, around 90% suggest a positive relationship between ESG factors and corporate financial performance (CFP). "Investing in ESG pays financially the positive ESG impact on CFP is stable over time," the authors conclude.

Research also suggests that on some level investors believe companies with better performance on ESG measures merit higher valuations. For example, investors in consumer goods, biopharmaceuticals, oil and gas, banking, and technology rewarded the top performers in specific ESG topics with valuation multiples that were 3%-19% higher than those of the median performers in those topics, all else being equal, according to a study by Boston Consulting Group. Most of the ESG topics that were linked to premium valuation multiples were related to minimising risks and other negative impacts, such as health and safety or environmental issues. The study also found a positive relationship between ESG performance and profit margins. Top performers in certain ESG topics had margins that were up to 12.4 percentage points higher, all things being equal, than those of the median performers in those topics.

The conclusion that financial performance and ethics are not always at odds will surprise some investors who see ethical and environmental considerations as costs but they don't have to be, says Audrey Choi, chief sustainability officer at Morgan Stanley. A Harvard Business School study found that if in 1993 you had invested in a select group of public companies that focused narrowly on financial returns, then after 20 years each dollar invested would have been worth $14.46. But if you'd invested in a portfolio of firms that factored in the most important environmental and social issues while growing their businesses, that dollar would have been worth $28.36 after 20 years. These firms "could earn outsized gains because they focused on things that aided their businesses, like wasting less water and energy, giving their CEOs incentives to focus on the long term and providing high-quality, diverse workplaces that lead to greater employee satisfaction, retention and productivity".

Ultimately, investors and firms have shared interests in responsible investing and long-term success that can be achieved through responsible business practices, says Colin Melvin, founder of consultancy Arkadiko Partners (Melvin drew up the UN's Principles for Responsible Investment, which has more than 1,750 signatories, representing assets of $70trn). The solution to the perceived conflict between financial performance and sustainable actions is to recognise that, over the long term, one is not possible without the other.

Investors tend to assume the future will look exactly like the present, says Peter Michaelis, head of sustainable investing at asset manager Liontrust. But we shouldn't assume that the big firms around today will be so big in the future or even still exist. Firms that ignore environmental and social problems risk being damaged in the future by large-scale divestment from areas such as fossil fuels. But at the same time, firms that are not pragmatic about the commercial actions necessary to sustain their business may not be around long enough to make a real difference.

This latter point sums up the limitation that most approaches to sustainable investment still have, agrees Terry Smith. "If you examine the factors most commonly used to measure sustainability, there is no mention of items that do not fall into the ESG forms, but which are equally vital to real sustainability" factors such as the level of capital expenditure relative to a firm's own operations and its competitor; spending on advertising, marketing and promotion of products; the amount of innovation and proportion of revenues derived from new and improved products; and research and development spending. "No matter how compliant a company may be with desired policies on the environment, human rights and corporate governance, if it is not taking the commercial actions necessary to sustain its business, sooner or later there may be no business." We look at some funds with sustainable principles and strong records in the box below.

When you're picking a sustainable fund, be aware that the fund manager or index provider may have a very different idea to you of what constitutes ethical investment. For example, Vanguard's SRI Global Stock Fund excludes stocks that don't meet its criteria on human rights, labour relations, the environment and anti-corruption but has oil and gas firms ExxonMobil and Royal Dutch Shell among its top ten holdings. Some ethical investors will be okay with that, but many won't. If you are, it's fairly cheap, with an ongoing charge figure (OCF) of 0.35%.

If you're looking for funds that focus explicitly on investing in firms that may help to improve the world, rather than doing less harm (known as impact investing), you could consider Impax Environmental Markets (LSE: IEM), a trust that aims to benefit from growth in the markets for cleaner or more efficient delivery of energy, water and waste. Over five years its share price is up 172%, relative to 99% for the MSCI All Country World index. It is trading at a 10% discount to net asset value (NAV) and has an OCF of 1.05%. Others include the WHEB Sustainability Fund, which has returned 107.04% over five years. The fund publishes details of every company it invests in and has launched an impact calculator, which lets investors see what their money has gone towards, in quantifiable terms such as MWh of renewable energy produced and litres of wastewater treated. The OCF is 1.01%

You may also want to look at funds that don't explicitly restrict themselves to sustainable investing, but whose investment approach and holdings are broadly consistent with those principles. For example, Lindsell Train's funds don't have a defined ESG investment policy, but follow a buy-and-hold investment strategy focusing on firms that the managers think will continue to make money over several decades. They have avoided sectors such as tobacco and miners, preferring to invest in consumer brands and internet and media companies. The OCF for the Lindsell Train Global Equity Fund is 1.25%. Or for an emerging-markets fund, consider the Scottish Oriental Smaller Companies Trust (LSE: SST), which is run by First State Stewart and invests in smaller companies (up to around $1.5bn market cap) across Asia, excluding Japan and Australasia. The managers invest on the basis that "companies that do not look after their customers, employees, suppliers and the larger community are unlikely...to be rewarding long-term investments", and aim to engage "extensively" with their portfolio companies on ESG factors. The trust has an OCF of 0.99% and is trading on a discount to NAV of 13%.

Sarah is MoneyWeek's investment editor. She graduated from the University of Southampton with a BA in English and History, before going on to complete a graduate diploma in law at the College of Law in Guildford. She joined MoneyWeek in 2014 and writes on funds, personal finance, pensions and property.