Until as late as 2000, ethical investing was seen as something of a niche area. But it has taken off in the last couple of decades, with some estimates suggesting that up to £16.7bn is now held in UK ethical funds.
Ethical investing might be good for society, but is it good for your wallet? One person who thinks it is, is Geir Lode. Lode is head of global equities at Hermes, and is lead manager on two of their funds: Hermes Global Equity and Hermes Global Equity ESG. The ESG in the name references the three specific ethical criteria used to judge all potential investments: environmental, social and governance.
Hermes Global Equity ESG selects the 70 to 80 shares in its portfolio using traditional investment criteria, attempting to strike a balance between fast-growing firms and value. However, at the same time it also looks at the ESG (environmental, social and governance) performance of each company, and it considers a low ESG score to be a sign that a firm could be a bad risk. While there are no sectors that it automatically excludes from consideration, in practice process means that firms in certain industries (such as tobacco) will do so badly that they will almost certainly be screened out.
Environmental, social and governance: the criteria
Of the three criteria, environmental impact is the most straightforward for the ordinary investor to understand, as it looks at the impact that the company has on the environment. This includes such things as its carbon footprint, its use of renewable energy and the amount of waste that it produces. However, Lode will also try to get an idea of a company’s wider sustainability, since he believes that “sustainable businesses do well in the long run”.
Lode also examines a company’s social impact. To get a good social rating a firm will have to produce goods and services that do not harm society, and operate in an ethical way. This means that firms with strong health and safety records and good employee relations will score highly. A good reputation matters more than ever, says Lode, “because in today’s marketplace a lot of the value comes from the company’s brand, which could be tarnished by cutting corners”. For example, “people would be much less likely to buy goods from companies that employ child labour”.
Finally, Lode likes to examine a firm’s governance. Unlike the other two elements, this mainly focuses on the firm’s internal structure. It measures how effectively the board of directors are able to hold the company’s management to account, making sure that they don’t reward themselves large salaries and that they manage to effectively do their jobs. It also looks at whether the company has an explicit ethical policy, as well as its performance in terms of boardroom diversity and engagement targets. Lode notes that it is “much easier for companies to change their governance within a short space of time, than their performance on the other two criteria”.
Is ESG investing good for your wealth?
This sounds very nice, but does it actually add any value for investors? Yes, says Lode: it is indeed possible to “make money while being nice”. He points to an internal Hermes study, initially conducted in 2014, and repeated this year, which found that the quality of governance and a firm’s social impact both had a positive impact on share returns. The link between a company’s environmental score and its share performance wasn’t as robust, says Lode, but he is optimistic that this may change, “and we are finally starting to see some major progress in this area as more firms pay attention”.
Lode emphasises that he also looks at the change of direction, as well as the absolute score, when making his decision about which shares to buy. One example of an industry that benefits from this approach is the airlines and aerospace sector. Because flying has been blamed for damaging the environment, many funds would avoid this sector entirely. However, Lode thinks that this would be a mistake because both manufacturers and operators have been taking “pragmatic steps” to reduce their carbon footprint. Indeed, he emphasises that the evolution of aircraft from the “from the DC-10 to 787” has led to a big improvement in efficiency.