What could be greener than a tree? For anyone interested in sustainable investment, forestry has obvious appeal. But the allure of investing in forestry goes well beyond its environmental credentials: the potential for competitive returns and a generous range of tax incentives are also turning the heads of long-term investors. UK forestry assets drew record investments last year, attracting hundreds of millions of pounds. Some of that money came from institutional investors, including pension funds, family offices and charities, but there are also a growing number of individuals exploring forestry investment, either directly or through a professionally managed fund.

Investing in forestry is exactly what it sounds like. You’re buying ownership of a commercial forest (or a share of ownership) – either a mature, established woodland, or newly planted land. As the trees grow, you’ll hopefully make capital returns from an increase in the value of the forest; there’s also an opportunity to generate income by selling some of the trees for timber, as Alex Davies, the founder and chief executive of Wealth Club, the investment platform aimed at high-net-worth and sophisticated investors, points out. It’s an investment for the long term.

The returns are highly tax-efficient. There’s no capital gains tax (CGT) to pay on the rising value of the trees, although any rise in land value is potentially subject to CGT. And there’s no income tax due on revenue generated from sales of timber. You’ll also benefit from generous inheritance-tax rules when passing forestry investments on following your death, as long as you’ve owned your trees for at least two years.

Don’t invest in forestry for the tax benefits alone

It’s never a good idea to make an investment purely for tax reasons, not least since chancellors can – and very often do – change the tax rules, diminishing the value of incentives and reliefs. However, even after the impact of tax benefits, forestry has an impressive performance record. “UK forestry has a long-term... record of producing strong performance with relatively low volatility, therefore providing risk-adjusted returns that are in excess of many traditional asset classes,” says Davies.

Indeed, forestry is the UK’s best-performing asset class over the past five, ten and 25 years, delivering double-digit annualised returns over each of these periods. And forestry funds in the UK have produced an average annual return of 11.4% a year since 2008, when the first such fund was launched. That’s after fees, but before the positive impact of tax reliefs.

Past performance, of course, is no guarantee of the future. But forestry is also useful as a way of diversifying your portfolio. Returns from forestry investments tend to move independently of returns from other asset classes, including the stock market; in the jargon, returns have low correlations with other assets. Forestry can, then, be an excellent way to boost the resilience of your overall investment strategy.

It is also a tangible asset that is regarded as a good inflation hedge. Demand for timber often increases during stronger periods of economic growth, as construction projects accelerate. Timber prices, therefore, tend to rise during periods of increased inflationary pressure, protecting investors from the eroding effect of inflation on their portfolios.

In any case, during periods when timber prices are lower or falling, forestry managers and funds can simply choose not to sell any of their timber. Most investable forests in the UK largely comprise Sitka spruce trees; there is typically a 15-year window to harvest these trees, so there’s no need to cut them down in any particular year. And since Sitka spruce tend to add around 5% of volume each year, waiting means there’s more timber to sell when the market looks more attractive.

The risks of investing in forestry

Still, despite these plus points, it’s important to recognise that investing in forestry also carries some significant risks. As with any investment where prices can rise or fall, there’s always the possibility for capital losses. Returns will inevitably vary – and are closely linked to the fortunes of the UK’s construction sector. During slower periods for the building trade – which aren’t always predictable – investors may see losses.

Another risk is that this is a natural asset and so vulnerable to environmental factors. Sitka spruce is considered a hardy type of tree, but it’s not immune to problems such as forest fire, wind damage, or even disease. And while it’s possible to insure trees against the risk of fire and storms, there is no cover available against disease; in the worse-case scenario, your investment could be wiped out entirely.

Perhaps the biggest issue of all for many investors will be liquidity risk – forestry is a physical asset that can be difficult to trade. If you own a forest directly, you’ll need to find a buyer when you want to realise the value of your investment, and that may take months, or even years. If you invest through a fund, there may be a set time period for return of capital; in the meantime, the manager may operate some sort of secondary market to help investors get out early, but there are no guarantees. At the very least, think of forestry as an investment you’ll hold for at least ten years.

This is, therefore, not an asset class for investors who feel uncomfortable with risk and illiquidity. Forestry will, though, continue to prove popular and potentially get even more of a boost from recent tax announcements, says Davies. “Forestry has long been a favourite among tax-efficient investors in the know. And its appeal is likely to increase now that the government has upped the inheritance-tax-free business property relief.” Even before the chancellor’s Christmas intervention, more investors were getting on board. Gresham House, one of the UK’s most established forestry investment managers, raised £375 million for its Forestry Fund VI fund, which closed to new investors last year. That was the largest fundraising in forestry ever conducted in the UK. Gresham House now plans to launch a new vehicle in April.

“We’ve had a lot of interest from private-client investors, but we increasingly have an institutional client base too,” says Anthony Crosbie Dawson, director of forestry and private clients at Gresham House. He sees that as a vote of confidence in forestry investment, since institutions don’t qualify for the same tax reliefs as individuals and therefore can’t be investing for that reason. “We raised from UK institutions, but also [from] international investors,” says Crosbie Dawson – “one of our fund investors was a Japanese institution, for example.”

The collective-fund approach makes sense for most retail investors, who get access to professional forestry-management expertise and diversification – managers will invest across multiple forests and woodlands – as well as much lower minimum investments. Buying your own commercial forest is likely to require an upfront investment of hundreds of thousands – and often millions – of pounds, plus you’ll need to manage the woodland yourself, or appoint a manager. By contrast, funds typically have minimum investments of around £50,000.

Clearly, that’s still a significant sum – and Financial Conduct Authority rules only allow forestry funds to take money from sophisticated or high-net-worth investors – but it’s a more accessible entry level than investing directly.

Par Equity – now part of PXN Group – is the other major name in UK forestry, having raised two funds already. The formal launch of its third vehicle, Par Forestry III, is expected soon, and is targeting an average annual return of 7% after charges. “The historic long-term returns from forestry have been extremely good,” said Par Equity’s investment manager Paul Atkinson in a recent interview on the Wealth Club platform, which provides access to forestry funds. “It’s also completely uncorrelated with other capital markets and a pretty good hedge against inflation and, of course, there’s increasing interest in the asset class” due to concerns about climate change.

It’s not just that planting trees and maintaining forestry is a good way to remove carbon dioxide from the atmosphere and store it, although this is important. (Indeed, some forestry funds may generate extra income from the carbon credits available from government schemes aiming to increase carbon sequestration.) It’s also that timber is far less carbon-intensive than steel, concrete and other materials that the UK construction industry has traditionally depended on. The packaging industry, also looking to reduce its environmental impact by moving away from plastics towards recyclable materials, is an important customer too.

The big picture is attractive

In that sense, the big-picture outlook for timber prices is encouraging, with increasing demand from industry buyers likely even if overall levels of activity in their sectors remain relatively flat. There will be short-term ups and downs – prices fell 5% or so in the final quarter of 2025, their first declines for two years, largely because of supply factors – but as homebuilders, for example, start to use more timber, and to work towards the UK’s ambitious new-homes targets, there should be no shortage of customers.

Not that timber prices are the be-all and end-all for investors. “The price of timber can be volatile, as with all commodities, although it’s a lot less volatile than some, but there’s not actually much correlation with the value of the asset because we own the land as well as the trees,” explains Crosbie Dawson. “Forest valuations are based on discounted cash flows over a 35-to-40-year rotation, so what the timber price is today, or in six or 12 months’ time, is not particularly relevant.” In that context, Gresham House has forecast a near doubling in global demand for timber over the next 20 years, providing an encouraging backdrop for investors considering forestry. “People do want more of their portfolios allocated to sustainable assets, but only if those assets are delivering compelling returns,” says Crosbie Dawson.

Reeves’ inheritance-tax U-turn is more good news for forestry investment

One potential driver of the renewed interest in forestry investment is the recent government U-turn on business property relief (BPR) and agricultural property relief (APR). This will enhance the appeal of forestry as a tool for families planning for inheritance tax (IHT). The two reliefs work in the same way, allowing the owners of a wide range of business assets to pass these assets on to their heirs with no liability for IHT, as long as they’ve owned them for at least two years on death. In her first Budget, in the autumn of 2024, chancellor Rachel Reeves unveiled reforms of BPR and APR; from April 2026, she announced, only the first £1million worth of assets would qualify for the reliefs at 100%, with any excess getting only 50% relief. That prompted a huge backlash from farmers worried that they would no longer be able to hand family farms down to the next generation because their children wouldn’t be able to pay the tax bill.

In December, the chancellor backed down, announcing that she would raise the planned £1million threshold to £2.5million – or £5million for couples, since the cap can be transferred between spouses and civil partners. That’s good news for farmers affected by the original proposals – but also for investors in forestry, since most investments in woodland and forestry are qualifying assets for BPR. The chancellor’s decision therefore, substantially increases the attractiveness of forestry from the point of view of IHT planning.

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The UK renewable energy sector cannot catch a break. At the end of October, the government launched a consultation on changing the Renewables Obligation Certificate (ROC) scheme that subsidises some renewable-energy production. At present, the subsidies are linked to inflation using the retail price index (RPI) measure, but they may now be switched to the consumer price index (CPI). RPI usually rises faster than CPI (the gap varies, but one percentage point is a rough rule of thumb), and so this would mean that subsidies rise more slowly in future.

The government has proposed two options for this. One is to switch to CPI in 2026. The other is backdate the change to 2002 (when ROCs were introduced) by freezing the current price until a new “shadow price” linked to CPI since 2002 catches up with today’s RPI-linked price, and thereafter increase with CPI. Neither are good, but the latter option is clearly worse. Hence shares in listed renewable energy investment funds (REIFs) slumped further, having already been battered by a series of setbacks and problems in recent years.

The changes would have no direct impact on new investments – the ROC schemes closed to most new applications in 2017. However, existing wind and solar farms have been promised subsidy payments until 2037 in some cases, so the changes will affect their earnings. More broadly, making retrospective changes undermines the assumptions on which existing investments have been made. That will erode investors’ confidence in committing future capital.

While the subsidies are ultimately paid by users as part of their energy bill, the change from indexing on RPI to using CPI is likely to mean a minimal reduction in the average household bill. At the same time, it will probably raise the cost of capital for future projects, making it ultimately self-defeating, argue infrastructure funds. Certainly, one has to feel that the government’s Clean Power 2030 (CP30) plan – which assumes £40 billion of private investment a year in green energy between now and 2030 – now seems wildly optimistic.

Losing patience with renewable energy funds

The direct impact of the change on listed REIFs will depend on which option is chosen (and on how much ROCs contribute to their income – typically 40%-50%). For many investors, this may feel like the final straw – yet more evidence that the sector is both unlucky and dysfunctional. While the government is clearly to blame for this particular shock, the way that the REIF sector has developed in recent years hasn’t encouraged investors to give it the benefit of the doubt. One can’t treat all REIFs as exactly the same and I’m going to focus largely on the solar funds here, but many of the problems apply more widely.

Bluefield Solar Income Fund (LSE: BSIF), Foresight Solar Fund (LSE: FSFL) and NextEnergy Solar Fund (LSE: NESF) put out statements saying that the impact on net asset value (NAV) would be around 2%, 1.6% and 2% respectively under option one and 10%, 10.2% and 9% under option two. This sounds manageable. However, we immediately get onto the question of how much investors trust these reported NAVs, which are based on fair value accounting and “mark to model” assumptions. The fact that most REIFs trade on 30%-40% discounts to NAV implies some scepticism about these valuations, while the fact that dividend yields are in the 10%-15% range suggests some concerns about their sustainability.

The original sin in the REIF model is that it was built around being able consistently to issue shares at premiums to NAV to fund new projects. REIFs were marketed as a growing income story in a low-yield world, with the added bonus of a green angle during the economic, social and governance (ESG) boom. Yet they were always paying out cash with one hand while taking it in with the other (hence NESF’s shares outstanding have doubled from 278 million 10 years ago to 555 million currently). This model only worked when the shares traded at a premium to NAV – now that they don’t, the REIFs no longer have access to cheap equity. Debt is no longer cheap either. It might make sense to cut dividends and reinvest the cash, but that would alienate investors who bought for income.

While this explains their growth problem, the opaqueness of returns explains why many investors are wary of them even as a limited-life income asset. In theory, the NAV represents the current value of future expected cash flows. The focus on this – and on paying steady dividends – makes it look as if REIFs have very simple, predictable economics. Reality is more complicated. Projected revenues depend on power price forecasts that come from third-party forecasters. When these change, so do NAVs. Meanwhile, actual performance has plenty of real-world complications.

For solar, there’s the amount of sun that falls on the panels. There’s whether it all gets used or whether grid outages means some gets wasted (FSFL had UK production 8.9% above budget in the first half, but would have been 13% higher without outages). On sunny summer days, there will be points when a surplus of solar power floods the system and sets the marginal price (at extremes the unsubsidised price can even go negative). Hence the “capture price” that solar farms get can sometimes be less the base load price (the price for steady, always-on power) – this summer, capture rates have frequently dropped to 80%. And if the grid physically can’t cope with the power being supplied, producers may be curtailed (turned off) by the system operator, meaning lost revenue.

Since the REIFs’ lenders and shareholders prioritise stability, the managers fix prices for much of their output in advance with power purchase agreements (PPAs). However, this means that they don’t capture much upside from spikes in spot prices (driven by higher gas prices, which set the marginal UK power price most of the time). All these factors come together in a bewildering series of assumptions. To take just one example, NESF’s short-term power price assumptions have fallen 56% from £139 per megawatt hour (MWh) in September 2022 to £61/MWh in September 2025. Longer-term power price assumption has risen 22% over the same three-year period. Yet its 20-year average price forecast has halved since it floated in 2014, pointing to long-term downward pressure.

Can renewable energy funds win back nervous investors?

What is the result of trying to distil such complexity into a single NAV that constantly changes? It is doubt about whether management are trying to mask poor economics with financial engineering, unconsolidated statements, fair value accounting and unverified assumptions. The accounting might technically be correct, but it is opaque and hard to compare between funds. Each time forecasts prove too optimistic and NAVs get downgraded, scepticism grows. This is why the REIFs now trade at huge discounts to NAV. (Policy risk – as demonstrated by the government’s proposed ROC change – may be another factor.)

Most of the REIFs seem to have little idea of how to get investors to trust them. They have tried to address the discount to NAV with share buyback programmes, but these have been too insignificant to counter the wave of selling. What’s more, buybacks often increase leverage: in May this year, NESF had to pause its buyback as leverage would have increased beyond its 50% debt-to-gross asset value policy limit. Rising debt is exactly what nervous investors don’t want to see.

Many have tried to sell assets, which would raise cash to pay down debt and fund buybacks while also validating NAV through real-world selling prices. This process has been slow, suggesting it may be hard to achieve prices respectably close to NAV. For example, in April 2023 NESF said it would sell 246MW of UK subsidy-free solar capacity across five separate projects. At present, there are still two project with 100MW yet to be sold. Last year, FSFL said it would sell its Australian portfolio (170MW across four sites), but the process has now been paused. A small number of bids for the portfolio were received, but none were deemed deliverable. In March this year, it earmarked a further 75MW for sale, with no results so far.

More recently, Bluefield proposed merging with its manager to focus on developing a 1.4GW pipeline of projects. However, that model implied a cut to the dividend and was quickly rejected by shareholders (if they were sceptical about the potential returns on capital, it is not surprising given the sector’s record). The fund was forced to ditch this and put itself up for sale. This has not steadied the decline in the share price, which has fallen to new lows below 70p, with a yield of 13% and a discount to NAV of 39%.

Until now, REIFs that have faced continuation votes have largely won them despite these woes – probably because investors are sceptical that they can sell their assets, pay back the debt and achieve a decent return for shareholders. This detente may be changing as investors get more anxious. The chairs of NESF, FSFL and BSIF have all stepped down in the past year and new brooms may be minded to sweep clean.

We could be reaching the point of maximum pessimism, as seems to have happened with battery funds. I have a position in NESF, bought on the basis that the dividend could well be cut, but that much of the bad news was already in the price with a yield in the mid-teens. Still, if the REIFs’ accounts clearly told us how much cash is being generated per pound invested per MW and whether it is declining, it would be much easier for investors to decide whether they still want to back these “sustainable” investments.

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Federated Hermes Sustainable Global Equity invests across a diverse mix of growth, quality, and value companies, and across developed and emerging markets. It seeks out firms whose products, operations and activities contribute towards a more sustainable future. These companies are well placed to benefit from structural sustainability trends that are reshaping industries.

One such trend is electrification, a powerful yet often overlooked investment theme. As industries shift from fossil fuels to electricity, demand is accelerating, unlocking exciting investment opportunities in areas ranging from transport and heating to mining and steelmaking. Importantly, electrification represents one of the easiest and most cost-effective ways to enhance energy efficiency and reduce emissions – especially when powered by renewables.

Thanks to decades of innovation, the cost of core components such as batteries and power electronics has fallen by 99% since 1990. This has transformed the economics of electrification and accelerated adoption. This is just the beginning. Continued innovation will drive stronger returns and broader uptake, and the most compelling opportunities lie with companies enabling the transition: delivering the means to power an electrified future.

Three stocks to watch in electrification

Taiwan Semiconductor Manufacturing Company (Taipei: 2330) supplies 90% of advanced chips globally and is a critical partner to technology giants such as Apple and Nvidia. Its cutting-edge innovations deliver the enhanced performance and reduced power consumption vital to compact electrified systems.

The firm’s technological superiority and scale position it to benefit from rising demand across sectors. Exposure to electrification, supported by its diversified customer base and sustainability-driven innovation, boosts TSMC’s growth prospects. The Industrial Technology Research Institute estimates that by 2030, each TSMC chip will save the world nearly seven times the energy needed to produce it.

Trane Technologies (NYSE: TT) is a global leader in heating, ventilation and air-conditioning systems, with a strong focus on electrifying building infrastructure. Trane’s systems cut energy costs, improve comfort and help meet emissions regulations, significantly reducing energy use in existing buildings. Heating and cooling comprise 40% of a building’s energy consumption, making Trane’s impact especially significant. Its thermal management systems are between three and five times more efficient than conventional solutions, making up for the higher upfront cost of their units. The company’s service and controls business provides recurring revenue and strengthens relationships with customers.

Schneider Electric (Paris: SU) is a global leader in the digital transformation of energy management and automation. Its platform provides an integrated, hardware, software and services solution enabling electrification across buildings, data centres, industry and infrastructure, cutting emissions and energy costs.

Schneider worked on JPMorgan’s new headquarters in New York, Manhattan’s largest all-electric skyscraper, which is expected to achieve net-zero operational emissions powered by renewables. The firm’s effective strategy and positioning in a market with high barriers to entry has fuelled strong returns for shareholders and consistent dividend growth.

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Investing with environmental, social and governance (ESG) purpose was all the rage a few years ago. Hundreds of exchange-traded funds (ETF) have emerged to capitalise on this demand, many sporting shiny ESG credentials.

However, in recent months articulate critics – such as HSBC’s former sustainability adviser, Stuart Kirk – have come out attacking many of the core tenets of the ESG shift, arguing it would be better for funds to focus on a small number of properly-tracked core objectives.

Fund managers are responding by being specific about their impact. The most common reaction is to focus on reducing corporate carbon-footprints with some direct measures (such as more renewables).

That’s pushing most funds towards the “E” bit of “ESG” – the environmental. However, if you’re interested in a more focused framework for sustainable businesses, it’s worth looking out for the UN’s 17 sustainable development goals (SDGs).

A new ETF issuer called Circa5000 is planning to bring five ETFs to market over the next year, which focus on SDGs and impact outcomes such as clean water, waste, health and wellbeing, and sustainable food.

A personal ESG checklist

For many people, deciding which funds they want to own will be a personal choice. So it’s helpful to have some sort of checklist based on your personal preferences you can use to help filter funds.

For a start, I want to invest alongside managers that engage with portfolio companies on ESG-related issues. A datadriven, box-ticking approach just won’t do it.

Many fund managers lazily rely on the leading ESG ratings and research services. The real skill in ESG is looking beyond these measures. Take the “S” in “ESG” for instance – how is the social impact measured?

Smart managers are now beginning to dig around and examine workplace accident records, or Glassdoor ratings looking at employee satisfaction.

Some funds also take an exclusionary approach – ie, they exclude whole sectors such as all oil companies or arms manufacturers. This has its own issues.

Take nuclear power: a controversial area, but many think – me included – we won’t make the energy transition work without nuclear power. The same is true of the defence industry.

Personally, I think backing the sector is crucial for supporting our democracies and defending our way of life. Still, many ESG funds exclude these businesses as that ticks the right boxes.

Considering all of these issues, I would contend ESG is difficult, though not impossible, to operate within an ETF framework. It requires decisions that might be better done by an active fund manager.

Finding a shortlist of ESG funds

So, how does this translate into some funds to put on a shortlist? There’s only one real candidate for me in the investment trust space: the very experienced team behind Impax Environmental Markets (LSE: IEM), who have a great record.

There’s obviously a much longer list of renewable energy and energy storage listed investment funds.

Options range from The Renewables Infrastructure Group (LSE: TRIG) through to SDCL Energy Efficiency Income Trust (LSE: SEIT), but that’s a whole different subject.

With ETFs, I’d focus on funds that peg their targets to the Paris-aligned benchmarks (PAB). Amundi is especially strong in that space, with funds such as the Amundi MSCI UK IMI SRI ETF (LSE: FT1K).

I also think that JPMorgan does a thorough job adding its own research data via its “research enhanced” range of ESG ETFs.

Last, but by no means least, renewables focused ETFs such as the huge iShares Global Clean Energy ETF (LSE: INRG) or the much smaller Invesco Solar Energy ETF (LSE: RAYS) are worth investigating.

If you are a new graduate, you should not work for “climate wrecking companies”, says António Guterres, the UN secretary general.

In particular, you should not work for any companies that finance fossil fuel development. Instead, you should “use your talents to drive us towards a renewable future”. Sounds nice, doesn’t it? It fits with the environmental, social and governance (ESG) vibe of the last five years or so – and with the apparent requirements of the tsunami of money that has poured into ESG investment vehicles. ESG is now the “fastest-growing corner of the asset management industry”, says the Financial Times. But there’s a problem. Look at it like this, said Kiril Sokoloff of 13D Research & Strategy at the Market Mind Hypothesis symposium last week.

There are 1.3 billion cars in the world. Almost all of them use liquid fuel – transport accounts for around 60%-65% of global oil demand. Electric cars might be a nice thing to have, but they are a nice thing not many people have. When one panel chair at Davos asked last week how many of her (well-off) audience had electric cars, four people put their hands up. In total, says Sokoloff, there are 15 million electric cars in the world. That is a number that might not rise very fast from here given today’s environment. Putting aside the rolling factory closures in the US, the key factor here is the sharply rising prices of the metals you need to make these cars (and their batteries). As prices rise, who – in a global cost of living crisis – will buy them? And who will instead look at the $8trn-odd of value embedded in their existing cars and keep them a while longer.

Unintended consequences

Should we ramp up mining capacity – raising supply to meet demand and bring prices down? Sure, of course we should. But thanks to the well-meaning global elites telling the young to stay away from grubby stuff there is a shortage of mining engineers. This is the same law of unintended consequences that is playing out in the fossil fuel sector. Yes, we want to cut fossil fuel use where we can. But we (perfectly obviously) will be needing fossil fuels for many years to come – so refusing to finance it and calling on all the smart kids to boycott it doesn’t seem like a madly good idea. If all the clever kids are working in renewables, who is keeping the energy show on the road while we wait for all their solutions? It also gives those who aren’t much bothered by ESG more power than perhaps we would like.

Oil-cartel Opec is back to having “huge clout”, notes Sokoloff. Is that what we wanted? We asked here last week if ESG might be causing inflation. The answer is yes (listen to my podcast from a few weeks ago with Barry Norris for more on this and read last week’s story again on moneyweek.com). And that matters for the energy transition too. Perhaps it will happen too slowly because we tried to make it too fast.

For investors, it all adds up to one of many good reasons to look at the energyand resources-heavy UK market notwithstanding the knee-jerk populism of the oil and gas windfall tax. But it also suggests some obvious advice for those graduating this year. Maybe you should ignore Guterres for now and think about applying for jobs in mining and oil. Supply and demand are on your side.

For more on this topic, see:

ESG investing is important, but lots of other things matter too

The world still needs fossil fuels – here's how to invest

Ethical investing has been around for decades. But its latest incarnation, signified by the acronym “ESG” (investing with an eye to a company’s approach to environmental and social issues, and corporate governance) only really began to gain traction in around 2018, according to search-engine queries, as measured by Google Trends. ESG investing is rather more explicit about the idea that there need not be a trade-off between “good” behaviour and attractive investment returns. Indeed, ESG investing argues that high-quality corporate governance, environmentally friendly practices and good corporate citizenship are material to the performance of financial assets.

Defining ESG investing is not easy

There is a logic to this and there has even been some discussion of whether it might be possible to calculate an ESG “factor” (ie, a set of characteristics – similar to “growth” or “value” – which tend to lead companies to outperform over the long run). However, these attempts are hindered by a lack of agreement on definitions. Indeed, there is only a faint correlation between ESG scores from major ratings agencies, indicating the lack of consensus over standards.

Of the three, “governance” is perhaps the easiest to define: it comes down to strategy, accountability and alignment. The idea that well-run companies with a record of strong capital deployment and well-established shareholders’ rights tend to perform better over the long run is neither controversial nor especially difficult to measure – so there is generally more agreement on what good governance looks like.

The “social” component is the hardest to quantify. The scope is wide, and while working conditions, staff diversity, relationships with employees and local communities, and approaches to health and safety, for example, are all important, their precise financial impact is hard to measure. Finally, “environmental” is fairly easy to understand – it involves assessing the negative environmental impact of a company’s actions. But in practice it is hard to measure this either fully or accurately based on the information we have available from companies today. That’s a pity, as it is also the area likely to have the most material wider economic impact in the longer term.

Transition could be stagflationary

That’s because, for all the definitional difficulties, one thing is increasingly clear – the achievement of higher global ESG standards will be inflationary, and may even prove to be stagflationary (ie, slowing growth while pushing up prices). This may be the price we have to pay for more sustainable long-term economic growth – but it’s something investors need to be aware of when putting together their portfolios.

Right now, we are in the midst of a generational burst of higher inflation. There are several causes, including monetary policy, the war in Ukraine and pandemic-related disruption. One crucial fragility that the surge in prices has highlighted is the chronic underinvestment in the development of new sources of oil and other key commodities in recent years. A major driver of this has been the rise in ESG-related scrutiny, which has left companies reluctant to make the long-term investments required to exploit new oil resources (for example), for fear of being left with “stranded assets” if the law, sentiment or technology changes.

Not only are we facing higher prices, but we are at a very unusual juncture in human history in that we are exchanging one technology for a less-efficient version as we move towards the goal of “net-zero” carbon emissions. The discovery of fossil fuels and the harnessing of the high levels of energy stored therein led to an acceleration in economic growth. It stands to reason that the reverse may be true as we shift to renewables, unless further meaningful advances in technology can be achieved in a cost-effective manner. There is a close relationship between GDP growth and energy consumed, which in turn has meant a historically close relationship between GDP growth and carbon emissions (though to be fair, the data suggests that this relationship is no longer as close as it used to be).

We aren’t investing enough

Not everyone agrees with this gloomy prognosis. The “net-zero” transition is not inherently stagflationary, argues Brian Davidson, head of climate economics at Fathom Consulting. He notes that the significant levels of investment needed to make the transition should boost growth, and that renewable electricity is generally cheaper than fossil-fuel powered electricity, which could help alleviate inflationary pressures.

There’s a catch, however – this transition, says Davidson, needs to be well-managed by both policymakers and the private sector. Unfortunately, that’s not what we’re getting. Instead, on the one hand the focus on ESG has meant that investment in fossil fuels has been lower than it would otherwise have been, reducing our energy supply from these traditional sources. But “at the same time investment in renewable sources of energy and infrastructure has not been what it needs to have been to replace it”. In turn this has contributed to inflationary pressure and reduced economic growth.

ESG investing – or just growth stocks?

A global rethink of “net zero” seems unlikely at this stage. So let’s assume this is the direction of travel – a stagflationary transition away from fossil fuels that involves slightly slower growth and higher prices. How should you position your portfolio for this scenario?

You might assume that ESG investing is the way to go. After all, it has proved very popular in recent years, with an explosion of ESG-labelled products hitting the market, and for many years this approach has delivered superior investment returns. However, that’s because the low-growth, low-inflation world we’ve been stuck in since the 2008 financial crisis favoured technology and “longer-duration” (that is, assets that will only generate the majority of their cash flows further into the future) growth stocks over the more economically sensitive, heavy industrial and commodity-related names. This has favoured ESG portfolios simply because they included more of the former and very few of the latter.

More recently though, the surge in inflation and interest-rate expectations has resulted in sharp sell-offs in growth stocks and other long-duration assets, which in turn has hit the performance of once high-flying ESG funds. Meanwhile, in the same way that one could argue that US Treasuries are too expensive due to excess demand from central banks, the same argument might be made that many non-ESG-compliant assets are underpriced due to artificially reduced demand.

It’s hard to pick winners

In the long run, some renewable energy companies and others involved in the energy transition are likely to do very well. But many will fail to make the grade, as was the case during the dotcom bubble. As with many new trends, companies seem to find it easier in the early days to generate revenue than to create value.

This is one reason why some asset managers are taking a wider view of ESG. It’s not all about companies that are already making the grade – it’s also about engaging with companies that are improving. For example, Waverton Investment Management takes what it describes as “a pragmatic approach”, aiming to “identify businesses allocating capital in a responsible manner, ensuring resilience in their business model and long-term financial sustainability”.

Importantly, the approach “includes not only those companies already operating to high ESG standards, but also those on an improving trajectory and/or part of the transition solution. It is often the improvers and enablers that offer investors most value and the prospect of superior returns over time”.

Buy food, fuel and defence stocks

Disruption of supply chains will also interact with ESG investing aims to push more investment to certain sectors. As economist Peter Warburton of Economic Perspectives notes: “The ‘health and safety’ aspect of social investing has undergone a significant reinterpretation, to embrace physical, food and energy security”. Securing reliable supplies of food and fuel in a world where the old certainties of globalisation can no longer be taken for granted implies “a massive reallocation of resources to agricultural food production and global transportation. Higher food prices will be necessary to create an incentive for the cultivation of additional crops and remedy the structural damage to global food-supply chains. Investments in agricultural land, food production and transportation should be handsomely rewarded”, says Warburton. “Go with the grain!”

Perhaps ironically, some of the companies that seem best placed to benefit from a stagflationary ESG-driven transition to renewables are the oil and gas companies, where supply constraints after years of underinvestment in production capacity have been made worse by the situation in Ukraine. The recent run up in energy prices has made these companies very profitable investments, but in the longer run the well-managed ones, with strong governance standards and plans in place to manage the transition to higher environmental standards (including navigating the politics of such a transition) are likely to be the best investments.

Defence stocks have also done well in recent months, but have often been omitted in the past from ESG portfolios. For many people a well-managed defence stock is an acceptable investment and the war in Ukraine has led to something of an ethical re-evaluation of the defence sector (which again indicates how tricky it is to define exactly what is ESG investing and what isn’t).

Despite the many criticisms, ESG investment, under whatever guise it adopts in the future, seems set to stay. But for now, investing in companies that are part of the energy transition seems to be a better course of action than blindly buying companies based on nothing more than a strong ESG rating. Likewise, companies with inflation-linked income or real assets (such as farmland, for example) seem worth being exposed to if we are to see a period of prolonged stagflation.

Edinburgh has a new Library of Mistakes – a financial library devoted to helping us all learn from the disasters of the past. Over the past week it has been running a series of events designed to discuss those disasters; Wednesday was devoted to the mistakes of fund managers. There have been a few.

Some brave managers told us of their awful stock picks (Northern Rock loomed large), but the real mistakes were ones of wider groupthink and the over-enthusiastic embrace of shifts in investment thinking – believing in the ability of the internet to support any valuation going in the late 1990s, or in the new paradigms on offer just before the financial crisis, for example.

What was not discussed was the huge mistake today’s fund managers are making: the fervent embrace of the idea that investing according to environmental, social and governance (ESG) principles is both a good thing and something that guarantees long-term outperformance.

ESG investing has been adopted with enormous speed and zeal

One of the most extraordinary things about this is the speed and zeal with which it has been adopted – despite the data being too short-term for any reliable conclusions (money only started to flow into ESG strategies in real volume in 2015), and the definitions of what counts as ESG being simultaneously so fluid (there is much regulatory movement, but still no set of universal standards) and so rigid (everyone creates their own standards and adheres to them via a strict box-ticking regime) as to be verging on nonsensical.

Take Twitter as an example. You can look up most companies online and see an ESG rating for them with Sustainalytics. Twitter is rated 19.4. This means it ticks a lot of boxes and is therefore a “good” investment. No surprise, then, that it turns up in most ESG exchange-traded funds.

But stop to think about this, just for a second. The fuss around Elon Musk’s takeover of the company centres in large part on free speech concerns – and his apparent full embrace of it. This should be a reminder that Twitter hasn’t been much of a supporter of free speech over the past few years – just ask anyone who deviates from what its moderators consider acceptable views on, say, vaccine efficacy or gender ideology, or indeed Donald Trump.

It might also be a reminder that free speech is not just a good thing in theory but an essential driver of equality, democracy and, perhaps, of successful capitalism. Let’s not forget, writes Jacob Mchangama in his book Free Speech, that in allowing everyone to challenge the elite, “free speech may well be the most powerful engine of equality ever devised by humankind”. If you really believe in democracy and equality – and the S in ESG – do you want to be invested in a company that messes with that? Of course you don’t.

You might even ask why there isn’t an H for human rights in the whole thing (EHSG, anyone?). You can pull out a good percentage of the companies in the average ESG portfolio and make a similar argument.

ESG is fine if it makes you money

Still, maybe you don’t mind pretend do-goodery if your box-ticking is sure to make you money. But it isn’t. The average ESG fund has not had a pleasant 2022 so far, thanks to the underperformance of the growth stocks that make box-ticking easy against the oil and mining firms that definitely do not.

Meanwhile, a recent paper from researchers at the University of Chicago was unable to find any evidence that “high sustainability funds” outperform low sustainability funds. Indeed, perhaps the opposite is the case: there is some evidence that companies focus on ESG to cover for poor business performance.

The strategy has also proved itself to be fairly worthless as a risk indicator (one of its great selling points is supposed to be that, if done correctly, it at least highlights the future risks to a company). Yves Bonzon, group chief investment officer at Julius Baer, who I suspect is something of an ESG apostate, notes that “prior to the outbreak [of war] average ESG ratings for companies with extensive operations in Russia were higher than those of their peers without such exposure”.

Even in March this year, says Amati Global Investors, Refinitiv, a representative ESG scoring provider, was giving Rosneft, the Russian oil group, a significantly higher ESG rating than Serica – a North Sea company providing 5% of the UK’s gas supply. Lots of boxes ticked; no value gained. Whoops.

But it can be a useful tool

Perhaps, says Bonzon, it is time for investors to “grasp that ESG is not about achieving systematic outperformance”. Its merits lie elsewhere, he notes. “It can be a useful tool for investors to express their values in portfolios and hence derive additional non-monetary benefits from investment activity.”

Thoughtful observers will not be convinced by this bit either (think back to the problem of figuring out what and how to measure). But in any case, what 2022 has brought so far is some pretty strong hints that the idea that ESG is some kind of investing win is dead.

Continuing to invest as though it were a big win is going to create the need for many new bookshelves in the Library of Mistakes. It is time for investors to stop ticking and start thinking.

• This article was first published in the Financial Times

• See also:

Too embarrassed to ask: what is ESG investing?

ESG investing: defence stocks as an ethical investment

The road to hell is paved with good intentions. Fears of global warming have created massive enthusiasm for “green investing” over the past few years. Industries that furthered the goal of cutting emissions – such as renewable energy – have found it easier to raise capital. Financial institutions have allocated more money to environmental, social and governance (ESG) strategies in general. Funds claiming to follow ESG principles now manage $6.1trn, representing 10% of worldwide fund assets, mostly in Europe.

Asset managers have shown that they are willing to use their power to structurally shift our economies. The five largest investment managers – BlackRock, Vanguard, UBS, State Street and Fidelity – hold a combined $22.5trn in assets, giving them an enormous amount of clout if they act together.

Last year we saw an example of them doing so, when several backed an activist hedge fund in voting three directors off the board of oil major Exxon Mobil. Meanwhile, banks and insurance companies are making “net zero” commitments not just at company level but also at the portfolio level – which is affecting where they are willing to invest and lend.

There is an obvious problem with this. Many of the industries being shunned by ESG-conscious investors and lenders remain crucial to the way the world works. Sectors that emit large amounts of carbon dioxide (directly or indirectly) include energy, mining, heavy industries such as metals and chemicals, farming and transport. We may not like this, but we can’t immediately replace them: 80% of the energy consumed in the world is still generated from fossil fuels.

The consequence of several years of lower investment in these out-of-favour sectors was already becoming apparent in the second half of 2021: the Bloomberg Commodity Spot index hit an all-time high in October as rising demand collided with tight supply. The Russian invasion of Ukraine brought matters to a head.

We need affordable, secure energy

Investment in oil and gas has been depressed over the past six years and discoveries are at the lowest for the last 75 years, according to Rystad Energy, a Norwegian energy-intelligence firm. Surging oil and gas prices have huge consequences financially – Citigroup estimates the primary energy bill for Europe will reach $1trn this year, close to the record levels of 2007 and 2011. It also has both energy security and environmental implications.

The UK and Europe have to import liquefied natural gas (LNG) from the US – gas that was produced using highly polluting fracking techniques. Reducing European reliance on Russian oil and gas will require intensive capital expenditure in other geographies, not least because all types of oil are not the same and supplies need to be matched to refinery capacity – light, sweet (low-sulphur) crude is easier to refine than heavy, sour (high-sulphur) oil.

Despite the obvious need for more investment and the likelihood that oil prices will remain elevated, the shares of European oil majors have remained flat since the beginning of the year, unlike their American counterparts. That may reflect their exposure to Russia, but also probably, at least in part, the fact that oil is now a taboo sector for some increasingly ESG-conscious investors – ie, today’s equivalent of tobacco.

Firms such as BP and Total offer interesting value in a world where energy is more scarce. However, the most risk-seeking investor may look at the extremely cyclical offshore oil drilling sector, where consolidation is under way and major companies such as Odfjell Drilling and Maersk Drilling should emerge stronger. Canada’s oil sands produce some of the world’s most carbon-intensive crude, but shares of Imperial Oil and Canadian Natural Resources are rising, reflecting renewed interest from investors in the sector.

Of course, it’s not just oil. The transition to die Energiewende (a long-term renewable energy and climate strategy) favoured by Germany has been close to a disaster this winter. Back in October, several European countries warned of potential blackouts and electricity prices shot up due to low wind power generation.

Prices of natural gas for gas-fired power stations – the back-up for wind – soared as well, and stocks fell to all-time lows. The uncertainty of whether Russia (which supplies 40% of Europe’s gas) could turn off the tap at any moment has really demonstrated the fatal flaws in European energy policy.

On the European continent, some factories had to stop or limit production – compounding supply-chain issues – while others began acquiring their own fuel generators to get off the grid immediately. Poland took a different approach.

The government decided that it would continue to exploit the Turow coal mine near the border with the Czech Republic – and would ignore a €50,000 daily fine levied by the European Union to do so. Coal and cheap but highly polluting lignite (brown coal) generates 75% of Poland’s electricity, and the transition to nuclear energy will take some years.

Poland is not the only country deciding that it would rather increase pollution than run short of energy. China, which has tripled its production of coal since 2000, announced a ban on coal exports and is increasing investments in mining to ensure energy security. The reality is that annual world coal consumption still stands at 8.5 billion tons and has not declined much in recent years.

That is why miner Glencore is betting that coal will still be relevant. Its share price is up by 50% year on year as investors come round to the same view. The other big winner may be nuclear energy, which provides about 30% of the world’s low-carbon electricity. France and the UK are both now planning to expand their nuclear capacity to produce carbon-free electricity and meet climate objectives.

This will benefit uranium miners such as Cameco and Energy Fuels. In contrast to coal – which is hard to greenwash – nuclear is undergoing a makeover. The EU now plans to label some nuclear projects – and even some gas ones – as green. You can argue about whether any power that leaves toxic waste to be stored for thousands of years can really be environmentally friendly, but this decision illustrates both the limits of ESG semantics and the risks to our economies of running out of affordable energy.

An electric economy

still needs metals Meanwhile, metals such as aluminium, copper and zinc have all reached elevated levels. Some of this is due to speculation and more recently to sanctions on Russia, and these levels may not be fully sustainable, but there is a real lack of supply. This has been exacerbated by rising demand for some metals caused by the electrification of the economy – another key green theme where the impact on raw materials has been underestimated.

Large miners such as Rio Tinto, BHP and Glencore offer exposure to various metals. Other peers look even cheaper. Anglo American trades on an enterprise value (EV – market capitalisation plus debt) of only 4.1 times earnings before interest, tax depreciation and amortisation (Ebitda) and carries nearly no debt. It regrettably spun off its coal business, Thungela Resources, under ESG pressure last year.

Thungela’s share price has shot up fivefold since its initial public offering in June. Glencore shareholders should probably hope that their company can resist any similar pressure to get rid of its coal operations. Many other miners are also trading at depressed valuations – for example, Nexa Resources, which extracts zinc in Latin America, is on an EV/Ebitda ratio of three and generates 28% Ebitda margins.

Though gold and silver pulled back last year because markets expect a series of increases in interest rates, prices are now resilient and gold miners are priced extremely cheaply. Many are poorly managed and operate in difficult geographies (such as Mali, Peru and Russia), but some generate healthy and steady cash flows. I favour Barrick Gold.

Makers of metals such as steel, aluminium or zinc have different dynamics to miners or energy – their fortunes depend on whether demand and prices for their finished products outstrip raw material costs (metal ores and energy). If we start to see shortages in output here at the moment, it’s not – broadly speaking – about a shortfall in capacity, but rather a shortage of affordable inputs (specifically energy, which is hurting many producers in Europe).

Nonetheless, the market value of steel companies is historically broadly correlated to commodity prices, according to consultancy McKinsey, albeit to a lesser extent than primary producers (there’s a 64% correlation for the steel sector, compared with 84% for oil and gas, and 93% for miners). Steel makers such as ArcelorMittal and Ternium are seeing their shares rally, yet trade at EV/Ebitda ratios of less than two, while generating strong profit margins. This is a notoriously cyclical industry and investors are right to treat it with caution – but today’s aversion to energy-intensive, carbon-spewing sectors may still leave it cheaper than fundamentals would suggest.

Conditions are hurting aluminium producers more: aluminium smelting is extremely energy intensive (and carbon intensive) and so rising energy prices have slashed margins. Unable to fully pass on prices, producers have been shutting down some capacity, which was already leading to tighter supply. The war in Ukraine has now upended matters: Russia is the second largest producer of aluminium outside China, with around 6% of global production, and this may be taken out of the market due to sanctions. Thus shares of efficient producers such as Alcoa, which had been steadily recovering from its 2020 lows, are holding up despite the headwinds.

How gas prices caused a fertiliser crisis

Refineries and petrochemical plants are not the ESG investor’s best friend, either: they take in oil or gas and produce a range of often polluting products. These sectors are often ignored, in part because they are complex. As with metals, returns depend on input costs (eg, oil or gas feedstock) and demand for the products they produce. Prices and margins on some products tend to be fairly closely linked to oil or gas prices; for others, the connection is looser. Local conditions can play a big role: US refiners such as Marathon Petroleum and Valero Energy are doing well now, because the Ukraine crisis has pushed up global prices for products such as diesel (which can be traded internationally), even while US prices for natural gas – a key cost – remain much lower than for European refineries. Petrochemical producers tend to suffer more from high oil and gas prices: the shares of European firms such as BASF and Evonik are now holding up noticeably worse than US firms such as Dow and Dupont, because the latter again enjoy lower feedstock costs. In general, companies producing complex and specialised chemical products generate higher margins (and are more attractive to investors), which explains last week’s move by Belgian firm Solvay to split into two companies: one focused on basic chemicals considered as commodities and the other focusing on speciality chemicals.

There are opportunities for knowledgeable investors to take advantage of input and output price trends, but one product stands out as more crucial than others right now. The rising price of ammonia – made from natural gas and hence hit by higher gas prices – has led to quintupling of fertiliser prices. That will affect food production. Food prices have already increased by 22% in 2021 according to the World Bank, and they are not likely to fall back this year given prices of fertiliser and seeds. Crops such as wheat and maize require regular fertilisation – too much, in many cases. The UK, for example, consumes 100kg of fertiliser per acre, according to the United Nations Food and Agriculture Office – 60% more than in the EU. The efforts made in Europe to reduce usage of fertiliser to preserve the environment and protect aquifers from run off have been considerable, but farmers do not have much room to cut consumption further, especially if they are trying to keep crop yields up.

Indeed, farming is surprisingly a major source of pollution: it is responsible for 17% of global carbon emissions. In Europe, the sector has been hit by heavy environmental regulation, and two years ago the EU agreed to reform farm practices further as part of its drive to hit net zero by 2050. The changes would have led to a further cut in production. Soaring food prices and geopolitical threats will reportedly cause those plans to be reassessed, with greater focus on food security. If so, it will be yet another example of how hard it is now proving to square going green with continuing to meet the world’s essential needs

I have been invited to a seminar titled “How does ESG continue to evolve?” I don’t need to go – I already know the answer: it will continue to evolve until one way or another it encompasses everything. Then, like everything that has tried to be all things to all men before, it will mean nothing.

I’ve written here before about the idiocy of exclusionary investment – refusing to invest in fossil fuels and mining, for example, because they are dirty – but relying on both to drive the global economy and the energy transition.

ESG investors (people following environmental, social and governance criteria) tend to focus so much on the environment that they forget the social – the wellbeing of our communities and the maintenance of our living standards.

The past week has made that point pretty clearly – we are seeing the results of structural under-investment in efficient energy in oil and gas prices – there is talk of the average UK household energy bill hitting a terrifying £3,000. We have also seen it in share prices and in the way people want to invest.

In Europe in February, notes Deutsche Bank Research, companies with “lower ESG ratings . . . fared better”. And carbon prices? No one was much interested – as gas soared, carbon saw “high single-digit declines”.

At the same time, flows into ESG-focused exchange-traded funds (ETFs) weakened and investors turned to “more diversified instruments”.

As I think you would expect, those who thought investors would be happy to lose money for their principles might have another think; prepare to hear less about green transition and more about energy security.

Surely, defending democracy is ethical?

So what do you do if you run an ESG fund? You think about how things that are going up could perhaps be reclassified from a bit iffy to completely fine.

Take defence: this has long been a no-no for full-on ESG funds. It’s also been a bit of a “no” for most funds with a bit of an ESG overlay – after all, jets and tanks have something of a significant carbon footprint and anything designed to frighten and kill is surely impossible to classify as a good thing.

But it isn’t so simple. Sure, if you are only selling goods to nasty dictators it’s hard to see how you could fit under E, S or G. And we wouldn’t want to buy your shares anyway, as we would worry about the G issues in your client base meaning you’d never get paid.

War is nasty, the weapons that facilitate war are nasty and buyers of those weapons aren’t always particularly steady clients. But if you supply weapons to the invaded underdog in an unprovoked fight, or to the countries backing said underdog to pass along, could we not file your activity under S as a social good? Surely.

As the Latvian deputy prime minister said this year: “Is national defence not ethical?”

The problem is that most defence companies serve both the dictators and the underdogs – and so end up in the “too hard” bucket for a lot of managers.

The sector stayed cheap – and by the end of last year European defence stocks in particular were trading at a pretty hefty discount to the MSCI index of global shares as a whole. This dynamic has changed.

One example is Sweden’s Skandinaviska Enskilda Banken. A year ago it decided that none of the funds it runs would be allowed to touch defence stocks; last week, the Wall Street Journal reported, it changed its mind. Now six of its 100 funds can – although they will perhaps have missed the 30% rise in Saab in the past few days. Saab makes fighter jets.

You could say, it’s only six. But you could also say the principle is dead, now we are just arguing about quantum.

A few months ago there was no way that, when the EU got around to completing its social taxonomy criteria for sustainable finance, defence would have had a hope of being considered aligned with its aims – that it makes a “substantial ESG contribution” or does “no significant harm” for example. Today it’s almost a certainty.

Here are analysts from Citi on the matter: “Defence is likely to be increasingly seen as a necessity that facilitates ESG as an enterprise as well as maintaining peace stability and other social goods.” If something is obviously vital to maintaining peace how can it also cause social harm?

You can also go vague – this is generally a killer strategy in the ESG world.

ESG investing is almost impossible to define clearly

A press release for a new fund just crossed my desk. It’s got all the buzzwords in its name – the Climate Transition Equity fund (check the double meaning in equity… very good) – and it focuses neatly on the idea that you can divide good firms into mitigators and enablers. The former work to reduce their own emissions and the latter “provide products and services that support other companies and activities on their decarbonisation path”.

Those launching this fund mean well, I assume, and it is perfectly clear that at launch they have in mind producers of renewable energy and carbon capture technology when they talk about enablers. But if a wind turbine manufacturer is an enabler, surely so too are the producers of rare earth metals and (whisper it quietly) coal miners (steelmaking mostly needs coal).

See how easy it is to shuffle the goalposts out a little, should you be so minded? And how easy it is for close-to-pariah stocks to move to hero status in times of crisis?

The key point here is that the idea that nobody – yes, even the EU – can provide a static ESG framework that both excludes some sectors or companies and works. They can’t; there is good in most listed companies (that’s how they got listed in the first place) and pretty much the only sector you can argue has no upside of any kind is tobacco (although that might not be what those living off the dividends will say).

So if you want to invest sustainably for the long term in companies that offer something to society you don’t actually need an ESG fund manager. In fact, you probably don’t want an ESG fund manager; they’ll either be too inflexible or too concerned about how to communicate their unexpected flexibility.

You also don’t want to be in passive investments to the extent you have been in the past – as Research Affilliates’ Vitali Kalesnik points out in the latest MoneyWeek Podcast.

In a world in which we have just been reminded that G can stand for governance at a state as well as a corporate level, you don’t want a little bit of everything (most global portfolios will have a had a small weighting to Russian equities) you just want an unconstrained, active, focused, and thoughtful fund manager – possibly one who recognises that his clients want to be good to the planet and to the people on it, but who also remembers the 1970s and buys you a hefty position in real assets to be getting on with.

• This article was first published in the Financial Times

The Power of Capitalism – that’s the title that Larry Fink, CEO of Blackrock, has given to his latest letter to the CEOs of the companies in which his firm invests.

Fink’s letters matter. Blackrock is the largest money management company in the world – the most recent numbers suggest that it has over $10trn under management.

That’s not just real money in absolute terms, but also the kind of money that gives him stunning power.

The most powerful shareholders in the world

Along with Vanguard and State Street (the world’s other fund management giants), Blackrock controls some one third of all assets managed worldwide.

In the US, one of the big three is the top shareholder in 495 of the companies in the S&P 500. In the UK, Blackrock and Vanguard between them control over 10% of more than two-thirds of the 100 largest listed companies. Last year Blackrock was the number one shareholder in 41 of those firms.

I could go on – there are endless stats on this. But you get the idea: Fink controls a vast mountain of money invested in the world’s stockmarkets in such a way that, given how dispersed other shareholders are, gives him enough votes and enough clout to demand that an awful lot of companies do pretty much anything he fancies.

And, as he makes clear in his letters (which, by the way, aren’t really just for the CEOs – if they were, I’d get fewer press releases about them) he fancies quite a lot of stuff.

For the last few years it’s been CEOs being more into ESG (environmental, social and governance issues) – presumably because that is what Fink figured his clients were increasingly into. So we have had a good few letters explaining that the old way of running a listed company – making stuff or creating a service, selling it as efficiently as possible, and using the profits to the benefit of shareholders, is wrong, wrong, wrong.

Instead, said the world’s self appointed hectorer-in-chief, shareholder capitalism must give way to “stakeholder capitalism” and each company should also “show how it makes a positive contribution to society.”

You might say that the very act of creating a service or product that is in demand and legal is in itself proof of a positive contribution to society. Not so: companies must benefit “all their stakeholders including shareholders, employees, customers and the communities in which they operate”.

Note that “neutral” is not an option – there must be “benefit” (oh, and there must be net zero – in 2021, Fink announced that all companies should be net-zero carbon emitters by 2030). It’s all quite a lot for one unelected do-gooder to demand from pretty much every company in the world isn’t it? Less shareholder capitalism than money manager capitalism, perhaps.

A backlash is building

No surprise, then, that there’s a sense of a little backlash building. One example: last week JD Wetherspoon released a trading update. In it, the company noted that Blackrock (which holds some 3.5% of Wetherspoon shares) had voted against all Wetherspoon non-executive directors “for alleged shortfalls in corporate governance standards at our November AGM”.

Quite right, you might say. But I’m not so sure. Blackrock’s corporate governance executives had, said the update, never previously mentioned concerns and had given no warning of their voting intentions.

Worse, “Blackrock itself infringes UK corporate governance guidelines since its chairman is also CEO and it does not appear to observe the nine-year maximum tenure guideline for non-executive directors.” Glasshouses. Stones. Not easy living up to your own standards is it?

Still, Fink is nothing if not market aware. So this year’s letter contains some careful backtracking. Turns out that “stakeholder capitalism is not about politics. It is not a social or ideological agenda. It is not ‘woke’. It is capitalism, driven by mutually beneficial relationships between you and the employees, customers, suppliers, and communities your company relies on to prosper.”

Fink continues: “This is the power of capitalism. In today’s globally interconnected world, a company must create value for and be valued by its full range of stakeholders in order to deliver long-term value for its shareholders. It is through effective stakeholder capitalism that capital is efficiently allocated, companies achieve durable profitability, and value is created and sustained over the long-term.

“Make no mistake, the fair pursuit of profit is still what animates markets; and long-term profitability is the measure by which markets will ultimately determine your company’s success.”

So stakeholder capitalism is actually shareholder capitalism? Or something – Fink fudges it a bit at the end. When different groups of stakeholders want different things, he says, companies must “stay true” to their company’s “purpose”.

This is meaningless guff, of course (unless everyone agrees that a company’s purpose is to make money – in which case it means “please get on with making money”). Backtracking is never simple.

Is Larry Fink seeing the light on individual shareholder power?

Much more interesting, however, is that there is a hint in this letter that there will be a time when how Larry Fink defines capitalism – or the guff he uses to disguise the fact that there is a conflict between how he’d like to be perceived and the way his day job conflicts with that – doesn’t matter so much any more.

One of my long-term gripes about the fund management industry is the way in which it has appropriated our shareholder rights. All shares come with a vote. But if we invest via funds we don’t get those votes – the fund managers do. Sometimes they use them, sometimes they don’t – but one thing they never do is ask us how we would like to use them.

This is not a good thing – it undermines the very foundations of shareholder capitalism and divorces us from the corporate world (and capitalism itself, for that matter). If we are the end owners of companies (we are), should it be us or Fink who tells them what to do? I’d say us.

Fink might be beginning to agree – or at least to understand that, as he can’t please all the people all the time, he might as well let them please themselves. I say “might” because we are at the “sounds good” stage – and he could easily change his mind on it, if it gets to the “adversely affecting his business/influence” stage.

Still, here’s what he says: “Many people are rethinking their relationships with companies as shareholders. We see a growing interest among shareholders in the corporate governance of public companies. That is why we are pursuing an initiative to use technology to give more of our clients the option to have a say in how proxy votes are cast at companies their money is invested in.”

For now, this is limited to a few institutional clients (fund manager gives vote to fund manager) but “we are committed to a future where every investor – even individual investors – can have the option to participate in the proxy voting process if they choose.”

I’m not holding my breath (it’s the “even” in “even individual investors” that suggests we aren’t top of his list), but this is still so much a part of my idea of what shareholder capitalism should be that it is the subject of my new book Share Power (more on this here).

Unusually, I seem to have timed its release rather well – and even more unusually, I seem to have found a point of agreement with the CEO of BlackRock.

MoneyWeek readers can get a discount using the below details, but you can also order it on Amazon here.

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Poor Liontrust. You’d think you could sell pretty much anything these days if you labelled it “green”, “responsible,” “sustainable”, or anything else ESG-related (“environmental, social and governance”, if you didn’t know already). But last week the fund manager had to scrap the launch of its first investment trust – the ESG Trust.

You can blame the difficulty of raising money from UK investors (a few other trusts have failed to launch recently). It may also have been lack of ambition: the trust was looking to raise just £100m – not enough to make it investible for wealth managers.

But these explanations don’t hold enough water. UK investors, notes Numis Securities, invested a net £3.5bn in markets in May. The AIC (which represents investment companies) notes that overall, fund raisings in the sector have been hitting record after record.

What, then, is the problem? Perhaps, as Patrick Hosking puts it in The Times, “the ESG blancmange is starting to wobble”. One key issue is the definition of sustainable, ESG, or whatever you want to call any one firm’s version of do-goodery. There are hordes of thoughts on this (Hosking mentions 14 different “frameworks”), but no set standards.

The first consequence is that pretty much anything bar fags, oil and gas can be labelled sustainable if you can just find the right framework. The second is that most ESG fund managers tend to make finding the framework easy by going for techy stuff (just seems cleaner, doesn’t it?).

Consider the top holdings of Liontrust’s existing Sustainable Future Global Growth Fund: think Visa, Alphabet, PayPal, Autodesk (a software firm) and Iqvia (a health tech company). You get the picture. All too often ESG just means techy growth stuff. But you can get that kind of portfolio almost anywhere.

Note too that (partly as a result of the recent flood of money into ESG) anything you can easily (for which read “lazily”) shoehorn into your ESG definitions is expensive. Anything you can’t (without having to embrace the grubby nuances of real life) is not.

This brings me neatly to the UK market. Wm Morrison has not often featured in ESG portfolios. It might have been winning awards for sustainable business practices for years. It might have been known for its social responsibility. It might have been cheap – so cheap that US private-equity firms are now fighting over it. But I still don’t know of a single ESG fund that owned it (email me if you do).

UK fund managers are now muttering about it being sold too cheap. But it’s a bit late for that. They should have bought more of it sooner – then it wouldn’t have been cheap in the first place.

There’s more on Morrisons in this week's magazine. But it is time for UK investors (who, despite pouring money into markets as a whole, pulled a net £572m out of the UK in May) to take the huge hints private equity is dropping. This market is cheap; its stocks might not be the fun, fashionable, superficially clean tech stocks the modern fund manager fancies, but they aren’t bad either.

Is Alphabet really morally superior to a good supermarket? I pointed this out on Twitter. Simon French of Panmure Gordon (more from him on the podcast here) responded “Rio Tinto. Yield of 5.5%. P/e of 6. Wrong price.” You won’t find cheap Rio in most ESG funds. But you will find expensive electric car companies that can’t survive without the copper it mines. How does that make sense?

Last week, Eiji Hirano, former chair of the board of governors at Japan’s Government Pension Investment Fund (GPIF) – the world’s largest such fund – told Bloomberg that he sees signs of a “bubble” in ESG investing (that is, investing with environmental, social and governance issues in mind). The GPIF was an ESG pioneer in Japan, but now “needs to go back to its roots, and think about how to analyse if ESG is really profitable”.

It’s not the only one. Investors once took it for granted that ethical investing (ESG’s predecessor) would deliver worse returns than the market as a whole. The mere fact that ESG investing means buying from a more limited universe of stocks implies that in the long run, you’ll lose out, because there will be times when the stocks you not allowed to buy outperform the ones you are.

Yet these days, ESG is often presented as a “factor” in and of itself – an investment strategy, similar to value or momentum investing, that will result in long-term outperformance due to some fundamental attribute of the stocks concerned. Robert Armstrong, in his Unhedged newsletter in the Financial Times, looks at two research papers, both by US professors Lubos Pastor, Robert Stambaugh and Lucian Taylor, which try to shed light on the matter. In theory, ESG aims to cut the “cost of capital” for “good” companies, and raise it for “bad” ones, incentivising “good” behaviours and cutting off funding to “bad” ones.

You can argue over how effective this is (if you raise the cost of capital too much, then “bad” companies will simply go private). But even if it works, it means the ESG investor must underperform in the long run. Why? Because for a company to have a lower cost of capital, an investor must pay a higher share price or accept a lower bond yield than they otherwise would. Yet the same team found that shares with high ESG ratings beat their less ESG-friendly peers by 35% in total between 2012 and 2020.

Why? Some argue it’s because so many ESG stocks also fit the criteria for the “quality” factor (whereby profitable stocks with strong balance sheets outperform) – the ESG label has nothing to do with it. But Pastor, Stambaugh and Taylor note that ESG outperformance is correlated with rising concerns about climate change. They argue that as a result, demand for ESG-badged products has surged faster than markets expected, driving the outperformance. In short, Hirano’s fears of a bubble look justified. In turn, as Armstrong notes, anyone investing in ESG now in the hope it will keep outperforming is betting that “the market still systematically underestimates consumers’ and investors’ taste for green products and assets – despite the fact that ESG products and funds have been very heavily promoted”. Not a bet I’d feel confident making.

Fund management company Liontrust has announced its intention to launch the Liontrust ESG Trust PLC (ESGT). The portfolio of ESGT will comprise 25-35 holdings in sustainable companies around the world that Liontrust has awarded the highest sustainability scores.

In 2015, the United Nations laid out 17 Sustainable Development Goals (SDGs). These ambitious, global goals aim to achieve a more sustainable future by 2030. These include improving education, tackling poverty and gender inequality and creating more sustainable and responsible industry and infrastructure.

With its goal of offering sustainable investments, ESGT is seeking to align itself with the UN’s SDGs. But some fit more easily into an investment framework than others. Peter Michaelis, head of the Liontrust Sustainable Investment team, explains the process of working with the team to try to find ways to support those more challenging targets through investing:

“One of several ways our team highlights the impact of our investments is to show how our themes are aligned with the United Nations’ 17 Sustainable Development Goals. Each theme is limited to one main SDG. In reality however, there are overlaps. Most companies in our portfolios are exposed to areas helping to meet more than one SDG.

“However, we have found gaps where our themes do not have significant exposure to certain SDGs. This is unsurprising. We designed the themes specifically for investment, whereas the SDGs involve civil society, governments and other aspects of human endeavour. Nevertheless, we believe it is important to examine whether investment could have a positive impact on these areas and will donate a portion of the management fee from ESGT – an investment trust whose stock market listing is planned for early July – to projects that explore potential for instruments relating to four SDGs in particular:

• SDG 1: End Poverty – via provision of access to loans at fair rates for those in poverty
• SDG 2: End Hunger – via investment in food production and distribution in developing regions
• SDG 14: Life Below Water – via development of bonds in blue carbon (marine sequestration of carbon dioxide) or to back marine protected areas
• SDG 15: Life on Land – via bonds to back biodiversity or carbon and biodiversity enhancement through reforestation

“Liontrust’s Sustainable Investment team has been engaging on biodiversity-related issues for 20 years, focusing on areas including palm oil, timber and plastics. But while we can be sure our clients have avoided the worst-polluting and damage-causing companies, palm oil has caused 39% of forest loss in Borneo since 2000. Deforestation elsewhere is still rampant and there are over five trillion pieces of plastic in oceans.

“Through conversations with expert organisations such as ZSL (Zoological Society of London), we can get a better grasp of complex issues, make more targeted requests for change and continue to drive better treatment for one of the planet’s greatest natural resources.”

Learn more about ESGT

Key Risks

Past performance is not a guide to future performance. Do remember that the value of an investment and the income generated from them can fall as well as rise and is not guaranteed, therefore, you may not get back the amount originally invested and potentially risk total loss of capital.

Disclaimer

The information and opinions provided should not be construed as advice for investment in any product or security mentioned, an offer to buy or sell units/shares of Funds mentioned, or a solicitation to purchase securities in any company or investment product.

Fund management company Liontrust has announced its intention to launch the Liontrust ESG Trust PLC (ESGT), with a portfolio of between 25 and 35 holdings in sustainable companies around the world that it has judged to have the highest sustainability scores.

Peter Michaelis, head of the Liontrust Sustainable Investment team, reveals the trends he expects to shape ESGT between today and 2041:

“Over the last 20 years, we have experienced huge transformation across so many facets of life, and Covid-19 has shown this change will likely accelerate as we move past the pandemic. The changes we can expect over the next two decades will be reflected in ESGT, for which the IPO is planned for early July.

“Increasing urbanisation looks set to continue, with more than two-thirds of the global population likely to be city dwellers by the early 2040s. Currently cities emit 50% to 60% of greenhouse gases and will therefore have to invest in retrofitting to mitigate environmental impacts.

“Healthcare is a huge part of a more sustainable future, as people need to be around to enjoy a better world. Looking beyond the pandemic, our view is that we will see significant advances across areas such as gene editing and DNA sequencing, and these will revolutionise how we think about treatment.

“By 2041, our hope is that the electricity we consume will primarily come from renewable sources and be delivered through a hugely upgraded and more intelligent grid that includes demand-side management. Many things that currently consume fossil fuels will have switched, such as electric vehicles and heat pumps to heat and cool buildings.

“Electric cars should be 2041’s dominant form of passenger vehicles, and the combustion engine is likely to be an antique as quiet, clean cities become the norm. Cars will be charged from solar panels connected to houses and battery technology so developed that refuelling is a thing of the past. We anticipate autonomous vehicles as the norm for deliveries of food and parcels; while driving your own car is unlikely to be fully autonomous, safety systems should take control of braking and manoeuvring.

“The digital economy is increasingly central to a properly functioning global economy and this will continue. We predict ongoing shifts in the future of networking, systems, applications and services. While the internet will continue to play a vital role in how we communicate, artificial intelligence could personalise our experiences within platforms and quantum technologies and computing make networks faster and more available.”

Learn more about ESGT

Key Risks

Past performance is not a guide to future performance. Do remember that the value of an investment and the income generated from them can fall as well as rise and is not guaranteed, therefore, you may not get back the amount originally invested and potentially risk total loss of capital.

Disclaimer

The information and opinions provided should not be construed as advice for investment in any product or security mentioned, an offer to buy or sell units/shares of Funds mentioned, or a solicitation to purchase securities in any company or investment product.

Last year was the year ESG investing (finding homes for your money while looking out for environmental, social and governance concerns) really took off –in 2020, $152bn of new money poured into ESG-labelled products and the total global assets in these products hit more than $1.6trn.

The young are all over it. A new survey from Montfort Communications, a PR company, and Boring Money, a financial news website, makes the point: in a poll of retail investors, some 63% of 18-34-year-olds say they would choose a new fund manager based on their approach to ESG. That number falls to 17% for the 55-plus group. In the younger group, 78% of respondents say ESG affects their investment choices. That falls to 67% among the 35-54 age group and about a third of the 55-plus group.

The 2021 ESG Investor Insights Report from Natixis, the French banking group, reports that 68% of savers surveyed say they want their investments to consider the impact on people and the planet, with the young more enthusiastic than the old.

These numbers will tally with many you may have seen before. Ask anyone if they’d like to be nice – or seen to be nice – and mostly they will say yes, with the young saying yes a bit more often (either because they are more interested in ESG or because they are more interested in optics – we can’t know). Lovely.

The problem with ESG investing is that it is hard work – you have to do actual research if you want to find a fund to suit your preferences. That might be one reason ESG action doesn’t seem to match ESG survey-answering.

In a recent Aegon poll, 77% of those surveyed said that they think climate change is an important risk to consider when investing. But only 15% of the same people say they are following that thought up with active ESG investing. And the many people who say they want their investments to align with personal values? It isn’t clear they’re following their thoughts either: UK financial professionals say that only 42% of their clients asked about ESG in 2020.

ESG investing may actually be the default now

Good news then: it might not be necessary for you to do anything at all. If your ESG feelings are of only average intensity it might already have been done for you. In 2019, 39% of investing institutions said they did not implement specific ESG policies. In 2021, only 28% said the same, says the Natixis report. So, more than 70% of institutions are now ESG a-go-go. The number saying they integrate it into their processes was up from 19% to 48%, with various impact/active ownership/best in class strategies making up the rest (ESG is marketing buzzword heaven).

You may say that these definitions appear to cover pretty much any activity (I’d agree), that, while regulators are working on the standardisations, the definitions of all these are in many cases so blurred as to be meaningless; and that everyone’s criteria are completely different (one investor’s green dream is very often another’s sin stock).

You might also say, if you were so inclined, that this divergence of measurement makes a nonsense of the idea (held by 53% of institutional investors) that companies with better ESG records generally post better investment returns on their stock. Perhaps those returns are not a function of corporate performance but, at least in part, a function of the demand for their shares generated in the scramble for ESG-friendly portfolios?

Nonetheless, it is very clear that the mood music has changed. Everyone is ESG investing, partly, it would seem, because that’s what the young say they want – and they’re the ones now financing the greatest industry bonanza of all time (auto-enrolled pensions). As Nick Bastin of Montfort says: “These long-term potential revenue streams represent a massive opportunity that asset managers ignore at their peril.”

However, it might also be that the shift is about more than what the kids want. Fund managers have to follow the regulations, and regulation is getting to the point that it pretty much mandates attention to ESG issues.

Around the world, for example, ESG reporting is being made mandatory for asset managers – and the idea that all managers have ESG responsibilities is now standard. Here’s Sir Jon Thompson, chief executive of the UK’s Financial Reporting Council, on our new Stewardship Code for asset managers: “There is a clear and consistent expectation that environmental, social and governance issues, including climate impact, are included in stewardship and investment decision-making.”

If you want to be a well-regarded brand in the asset management market place, you’ll at least want to look like you are living up to those expectations. Talk to any of the big-name fund managers and they’ll tell you about their ESG overlay and their stewardship department. That department will be operating throughout the business. The upshot is this, whatever the labels say, whether you buy an ESG fund or a non-ESG fund from a big-brand fund manager, you will still be buying one with some kind of an ESG overlay –there isn’t really any other kind any more.

The difference, for what it’s worth, will be in the portfolio. There are lots of niche do-good funds of course (related to renewable energy and the like), but in general, if you buy an ESG-labelled fund, the odds are you’ll get a quality growth fund probably with a bias to tech with a lot of blurb in the marketing about ESG. If you buy a non-labelled fund you’ll get whatever else it says on the tin (income, growth, global, whatever) with a lot of blurb in the marketing about sustainability.

So you could see the way in which survey respondents fail to follow through with action as a problem –their fine words butter no parsnips. Or you could note that an ESG fund will mostly have much the same effect on the world in which we live as a well-run non-ESG fund. In this sense, everyone, apart from those who actively want a “sin” fund jammed full of companies regularly behaving badly, is already mostly getting what they say they want, whether they know it or not.

•This article was first published in the Financial Times

If you are a nice person you won’t hold shares in any companies involved in fossil fuels or mining; their activities are dirty, environmentally unsound and that’s that. You can’t believe the planet is in trouble and also hold businesses involved in creating that trouble. End of.

This is certainly the view of Friends of the Earth. The group has recently produced research showing that British local government pension funds have almost £10bn invested in “climate wrecking companies” – even though many councils have expressed fears of a “climate emergency.”

Shocking. Or is it? Might – just might – there be another way of looking at this, one that is just a bit hard to hear over the cacophony of ostentatious do-goodery?

The first question to ask is exactly what divesting – selling shares in “bad” companies of this sort – achieves. I’d venture nothing good. Sure, it makes it harder for firms that might want to raise new money via the equity markets and, if the generalised disapproval makes banks wary too, it might raise the cost of debt too. But for firms already chucking out cash, it makes no difference at all – and certainly none to current oil and gas production.

When you sell the shares, someone else buys them and the business just carries on. The transition to cleaner energy is under way, but it’s going to take several decades. In the meantime we need traditional sources of energy and shouting at oil doesn’t change that. You could even call it, as the UK pensions minister did this week, “reverse greenwashing” – something that might make you look good but that does nothing to fix the real problem.

You can argue this even more forcefully when it comes to the miners. If you want to get rid of the combustion engine – and find me someone who will say they don’t – you will need copper, as copper wire is one of the best ways to move electricity around. You will need mountains of rare earth metals too, for the magnets in electric motors and lithium for batteries. A medium-sized electric car currently contains two to three times as much copper as a comparable conventional car. Net zero might be a grubbier business than some like to think. What we want, then, is not no oil, no tin and no copper, but more carefully produced oil, tin and copper. How do you get that? Probably not by making a show of flouncing off in a huff.

Impact investing

Enter impact investing, the idea that instead of divesting, big investors should stay invested and encourage better behaviour. This is much harder than flouncing. But it works. Big energy companies, especially the European majors, are spending huge amounts on wind and solar and “committing vast sums for development areas such as green hydrogen and carbon capture”, says John Teahan of investment group RWC Partners.

Shell, Total and BP are all aiming for net zero by 2050 – partly as a result of pressure from the more hardworking of their large shareholders. It is the job of those shareholders now not to abandon them, but to make sure they stay on track and to “encourage them to go faster and further where possible”.

Paul Jourdan, of Amati, the investment house, says something similar about miners. Here the long-term environmental, social and governance (ESG) issues are endless – think everything from bribery to water pollution and worker safety. But again, regulation and engagement work: the past 15 years have seen “huge change”, with most miners offering “meaningful information” on all ESG aspects, he says. (John recently talked to Paul about this at length in the MoneyWeek Podcast – listen to what he has to say here.)

There’s something else the divesting cheerleaders need to bear in mind. Selling shares might not make any difference to a business, but it makes a difference to who owns the business. If you make a big institutional holder who really cares about, say, the climate, sell to a private holder who really doesn’t, what exactly have you achieved?

Take that a little further and imagine Friends of the Earth persuading all UK funds to sell fossil fuel firms. Those sales push the share prices down and down again. They become cheap – very cheap. But those who invest in listed companies are too media-aware to buy them back. The result? The companies are taken private by someone, maybe in the UK, maybe abroad, who doesn’t care what Friends of the Earth thinks. Now not only are its assets held by someone who might be, as Total’s chief executive puts it, less “mindful” of ESG matters than the original holders, but also by someone who doesn’t have to bother with the transparency and stewardship obligations that come with a public listing. Is that really what we want? Note that, according to data from Dealogic, five British companies have been taken private this year already, including power equipment firm Aggreko, on top of 34 in the past two calendar years.

Don’t forget the point of investing

There’s one more thing you need to think about. The money. The UK’s pension funds – and indeed the big retail facing funds – serve an important social purpose. They are there to finance your future. The core part of their job (for all the grandstanding about other stuff) is to compensate you for the years you put into boring Zoom calls with the capital and income required for a pleasant retirement.

So if renewable energy stocks are ridiculously expensive – there’s a bubble under way – and old energy stocks are cheap, do pension funds have a responsibility to sell the former and buy the latter? And if Exxon provides an income of more than 5% a year and that income is handy, why should they let someone else have it? Not for us, thanks; our pensioners have morals – let those nice chaps in private equity have the money instead. Hmm. And I’ll add another hmm to that on the basis that most pension funds hold private equity too. Let them take a dirty company over and odds are you will find you still own it – you’ll just be paying higher fees to less accountable management for the privilege.

So what should you do? Investing with an eye to sustainability is full of nuance. But if you care about the planet I’d say there is a case to be made for holding not fewer but more fossil fuel and mining stocks. Better they are in the right than the wrong hands. With that in mind you might look to UK value and income funds (they mostly hold this stuff).

Two investment trusts I have mentioned here before, the revamped Temple Bar (LSE: TMPL) (which I own) and BlackRock Energy and Resources Income (LSE: BERI) are good places to start. And if you are one of the seven million people with cash in the UK’s local authority pension funds maybe drop them a line explaining that maybe, just maybe, holding fossil fuel firms is one of the most socially responsible things an engaged and financially-aware investor can do now.

Quick thing before I get started this morning – MoneyWeek is hiring! We’re looking for a writer to join our web team. You can find out more about it here. But long story short, if you’re a journalist or you work in the City, and you enjoy Money Morning and would like to write something similar, you should definitely take a look.

Back to this morning. ESG funds are having a moment. Funds that invest with environmental, social and corporate governance (ESG) issues in mind had a very good 2020, according to Attracta Mooney and Patrick Mathurin in the Financial Times.

Total assets in these funds rose to nearly $1.7trn last year, up a whopping 50% on the previous year. Given what happened to markets in 2020, that’s extraordinary.

So what’s going on? And what do you need to know about ESG?

The trouble with active management

Let’s start with a bit of background here. It’s been a rough few years for active fund managers. Before passive funds became such a big deal, being a mediocre fund manager was a cushy job: you found a hot sector or company; you bought stocks that roughly reflected the underlying index; you watched the money roll in from punters, or from the people who advised the punters; and you took a percentage fee from that big pile of money.

As long as your performance wasn’t ridiculously bad – and as long as you quietly did nothing more radical than tracking the index, it wouldn’t be – then you could sit on your big pile of money, and not do very much more than run the occasional ad campaign around Isa season to make sure the cash kept defaulting into your big lazy fund.

Those days are gone. Investors are still saving money – that’s not the issue – the problem is that most of it has been going into passive funds. Investors have realised that by using passive funds (which just track an underlying market, rather than trying to beat it), they can get exposure to markets at a much lower cost than by using active funds.

If active funds compensated for their higher charges with consistently better performance, then this wouldn’t be a problem. It would still make more sense to pay for the added performance. However, finding an active fund that can beat the market consistently is extremely hard. So if you opt for active over passive, you risk not only paying more, but getting a worse performance too. That has turned active funds from being something of the default option to being a much harder sell. In turn, that means the bloated “asset gathering” model is endangered.

What are the options? Reducing fees is one option. Fees generally have gone down – a bit – over time. And we’ve also seen the occasional genuinely innovative fee structure which at least attempt to align the manager’s interests with those of their customers. But you can only cut fees so far. When it comes down to it, an actively-run fund is going to struggle to compete with passive funds that, in some cases, charge absolutely nothing at all.

Another option is just to be better. Some managers are doing this very successfully right now. The investment trust sector has always been nimbler and arguably more accountable to its investors than the unit trust/open-ended funds, and they are having their time in the spotlight right now.

For example, investment trust and growth stock specialist Baillie Gifford is one of the best known active success stories today. Meanwhile, in the US, Cathie Wood’s ARK Investment is doing well by capitalising on thematic investing. Both have stellar records of trouncing any passive tracker and, as a result, attracted a lot of investors’ money.

So a record of genuine outperformance is another way to stay successful. But it’s not easy to get on top, and it’s even harder to stay on top – even the best fund managers endure tough periods, during which investors’ affections can prove fickle.

Other managers demonstrate a commitment to genuine active investing – having small, concentrated portfolios of their “best ideas” (typically between 20 and 35 stocks). They may also stick very explicitly to a style (such as “value”, for example). Even if they’re out of fashion for a time, at least investors know what they’re getting – no one knows what the future holds, so diversifying your portfolio by style can be as sensible as diversifying by geography and asset class.

But what if being better, cheaper, or more disciplined than everyone else is not for you? What if you just want to attract investor money the old-fashioned way? You know, via a combination of hype and apathy? That’s where ESG funds come in.

ESG is a cynical branding exercise for some

This is going to sound cynical, so let me begin by saying that there are some very dedicated ethical/ESG/sustainable investment groups out there who have been doing this for decades. Ethical investing is not new. Nor is concern about the climate or working conditions or whether you should buy tobacco stocks or not, and all the other issues surrounding ESG investment.

Indeed, interest in ESG investing isn’t particularly new either; it’s not something that millennials invented. So what explains the upsurge in the industry getting interested in it? There are a lot of factors, but at least one big factor is that active managers see an opportunity to fight back against passive that doesn’t involve a) being cheaper or b) being better.

Passive has made inroads into the ESG area too. But it’s a harder sell. The whole point of ESG is that there’s meant to be someone making judgements about the companies involved. An index tracker might be able to do simple ESG screens but it’s never going to be able to “engage” with company managements to the same level.

Also the biggest passive players will always struggle to go “pure ESG” – you can’t claim the moral high ground by launching a carbon-neutral ETF when you’re running a massive S&P 500 tracker on the side with full exposure to all those horrible fossil fuel companies.

So active companies suddenly have a new battleground where they can give investors a reason to use them again. They’ll tackle managements and make sure that they keep the nasty stuff out of your portfolio. And they’ll be able to charge you for it and if performance isn’t up to scratch, then never mind, at least your money is “doing good”.

Think I’m being overly twisted here? I don’t. In Europe last year, more than 2,500 existing active funds rebranded to “ESG”, rather than starting new funds from scratch. I’m sorry, but that’s not a change of strategy or a Damascene conversion – that’s a marketing decision.

ESG will continue to be a force in investing – we’re going to be seeing ever more promises regarding carbon neutrality from governments and from companies, and we’ll keep seeing new reports about how ESG has outperformed (it’s amazing how good you can look when you avoided energy stocks in an energy bear market and stuck all your money in the FAANGs instead – be interesting to see what happens when the turn comes).

I’m just warning you to take it all with a pinch of salt. “Greenwashing” is endemic to this part of the business. If you care about investing in accordance with your ethical beliefs, then you need to do your homework. Understand where your own boundaries are, then find a fund that respects those specific boundaries (remember that some ESG funds hold Exxon Mobil, for example).

If you can’t be bothered doing the homework, then do yourself a favour – don’t stick it in any old ESG fund that you see being marketed to you. Use a cheap passive fund instead. At least you know what’s in it.

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Is it the job of a company to attempt to mitigate climate change? Milton Friedman would have said “No”. Back in 1970, he popularised the idea that the primary aim of executives should be to maximise the value created for their shareholders in a (still) brilliant essay. Companies should make stuff or create a service within the appropriate regulatory boundaries, he wrote; then sell it, and pay the proceeds to the providers of its capital. Aiming for anything else, he said, is to spend “someone else’s money for a general social interest”. And why would you want to do that?

It was compelling stuff — and its logic held firm in the corporate world for nearly 50 years. But today Friedman is old news. In 2019, the US Business Roundtable decided to redefine “the purpose of a corporation to promote an economy that serves all Americans ”. It comes with five commitments — to customers, employees, suppliers, communities and shareholders. This was soon followed by the Davos Manifesto 2020, where lots of people who have benefited from shareholder capitalism laid down their thinking on getting rid of it. Shareholders are mentioned last again, behind “society at large”.

Pretty much everyone has now jumped on this bandwagon. In July, Joe Biden announced his aim to bring “an end” to the “farce” that is shareholder capitalism, while the pandemic has given renewed energy to the conversation about the purpose of a corporation. The upshot is a long list of organisations asking companies to step back from what used to be their core purpose and to focus on a lot of other things.

Are all these new responsibilities too much?

Climate change is top of the list. In Australia, a new “Climate League 2030” is calling for companies to slash carbon emissions beyond government forecasts. In the US, the “We Mean Business” coalition is pushing for the same thing. There has long been pressure for companies to do something about gender issues. Then there is social justice in general, with the kickback against shareholder primacy opening the floodgates to pressure groups demanding that companies enter the culture wars. There is barely a brand left that isn’t running an inclusive campaign of some sort. See Coca-Cola’s hosting of the Together We Must series of virtual dinners to discuss social justice topics, or Uber’s anti-racist campaign (“If you tolerate racism, delete Uber”). In the UK, scores of companies support footballer Marcus Rashford in his free school meals campaign.

But it isn’t just the planet and their clients that these newly stakeholder-focused companies feel they must help. Even before the pandemic, there was a new corporate paternalism at work. But now companies feel both an opportunity to tie-in nervous employees with benefits, and a responsibility for their physical and mental welfare. All thinking firms have a wellness programme; most are at least considering hiring one of the new unconscious bias training firms. Workers also have new, high standards for their employers: in a recent survey, over 70% said their CEO should speak out on climate change, diversity and inequality.

The modern company then, has to save the planet (it “acts as a steward of the environmental and material universe for future generations”, says the Davos manifesto); enhance diversity; guarantee the correctness of every link in its supply chain; eliminate the gender pay gap and child poverty; and, at least for now, watch out for its employees’ mental, financial and physical health. A good company “fulfils human and societal aspirations”. Oh, and somewhere amid the paternalism and political grandstanding, it has to find the time and energy to sell stuff and make profits through a series of rolling lockdowns. Welcome to stakeholder capitalism in the Covid age.

It is not necessarily a bad thing. Most of what is being demanded of companies is good in its own right. But are we asking too much of the company?

Stick to the company’s core purpose

It might be fine for established companies that don’t need capital to say that they aren’t going to humour its providers any more. That might not work so well for new companies seeking capital. The genius of capitalism also lies in specialisation and comparative advantage. So expecting companies to have a purpose that goes beyond their obvious stakeholders to all of society may be asking managers to juggle too many balls. If multiple layers of expectation are piled on top of a firm’s core purpose, you end up burying it, or at least heavily distract from it.

That’s particularly the case if not all your managers are on the same side in the culture wars. What if over-reach inside stakeholder capitalism turns it into conflict capitalism? In the end, surely the social welfare of individuals is more a matter for their families, friends and state-funded community services than their employers. By the same token, the physical health of the population is a matter for public health services, while issues such as climate change are a matter for governments to rule on. Let’s not forget that companies pay taxes specifically so that others do such stuff. Earlier this week, Australia’s assistant superannuation minister pointed out that it was not the job of the private pension sector to “change the earth’s temperature” but to create retirement incomes. It didn’t go down well. But she made a good point.

• This article was first published in the Financial Times

With several terms associated with investments that prioritise the planet and society as much as they do financial performance, it’s worth a closer look at the sector and how it can help your investment strategy.

Investors are no longer focused solely on long-term financial returns – they’re increasingly considering the wider impact of their capital on the world and society. Terms like sustainable, responsible and ethical investing are often used to describe this shift, though they’re not always interchangeable.

There’s arguably been a perfect storm of political and economic forces affecting the sector. Between 2018 and 2022, demand surged as the Paris Agreement aligned global climate policies, regulatory support improved and investment flooded into sustainable strategies. By 2022, 86% of asset owners surveyed by the London Stock Exchange Group (LSEG) said they were “evaluating or implementing” sustainable investing practices, up from 53% in 2018.

Since then conditions have shifted. Russia’s invasion of Ukraine drove up energy prices and turned attention towards energy security and defence, while inflation and economic uncertainty have overshadowed long-term sustainability goals in some markets.

At the same time, rising costs and more complex regulations have made ESG funds more expensive to run. This, alongside changing investor preferences that favour short-term trends and market cycles, has contributed to outflows, according to Julia Dreblow, founder of SRI Services and Fund EcoMarket.

What does ‘ESG’ stand for?

‘ESG’ has evolved from a niche concept to a mainstream investment consideration since the term was coined in the United Nations’ (UN’s) 2004 report ‘Who Cares Wins’.

Once viewed as a trade-off between values and returns, many investors now recognise the relationship between sustainable objectives and performance is more nuanced.

Companies have placed greater emphasis on corporate social responsibility (CSR), embedding ESG considerations more firmly into the investment landscape and potentially supporting greater resilience against long-term risks like climate change.

Performance, however, depends heavily on timeframes and sector dynamics. Sustainable funds outperformed traditional peers over the five-year period to 2024, but many have lagged more recently given higher interest rates and exclusions to sectors such as fossil fuels. That said, opportunities within energy and defence may warrant a more selective approach at company level.

While enthusiasm has tempered, Robeco argues ESG is not 'dead', as some commentators have suggested, but has instead corrected, with investor sentiment remaining broadly stable despite geopolitical pressure and shifting priorities around areas like cybersecurity and infrastructure.

What type of investments does ESG cover?

It’s a broad and complex area, with many variables and definitions.

‘E’ – or environmental element – look at companies’ climate and sustainability implications. This includes carbon footprints, resource use, waste management and progress towards net zero.

The ‘S’ – social – typically spans issues affecting stakeholders including employees, suppliers, customers and local communities. This can include human rights, fair wages, diversity and working conditions.

The ‘G’ – or governance – covers company leadership, transparency, accountability, board composition and executive pay.

There is no single way to apply ESG criteria to a portfolio but most fund managers use a combination of three approaches.

Negative screening excludes certain sectors or companies, such as tobacco, defence stocks or fossil fuels while positive screening seeks businesses that perform well on ESG measures or contribute positively to sustainability goals.

Stewardship takes a more active approach, with investors using their influence as shareholders to encourage better practices through voting, dialogue and monitoring progress against targets. Advocates argue it’s hard to influence a company if you don’t have a ‘seat at the table’.

Impact investing goes a step further by targeting measurable social or environmental outcomes alongside financial returns, such as renewable energy projects or businesses addressing social challenges.

ESG is not limited to equities. Fixed income also plays a role, typically through green or ethical bonds, which fund projects or issuers meeting certain sustainability criteria.

How to invest in ESG or sustainable funds

Investors have several routes into ESG or sustainable investments.

If direct shares are your thing, it might be worth using an independent research tool like MSCI ESG Ratings or Sustainalytics from Morningstar to check how they rank certain companies.

Consider your screening criteria in light of the above – negative or positive screens, or impact, for example. Cross reference this with the company’s individual ESG or sustainability reports – often published alongside or referenced in their annual report, found in the investor relations section of company websites. You may also find additional ESG-related information on your chosen trading platform.

Explore funds and model portfolios that integrate ESG considerations (sustainable options are often offered alongside platforms’ main ranges).

On the equity income side, one actively managed constituent of Hargreaves Lansdown’s Wealth Shortlist is Janus Henderson UK Responsible Income Fund, with an ongoing charge figure (OCF) of 0.85%.

If you’re looking for actively managed bond funds, some options include Aegon Ethical Corporate Bond, Columbia Threadneedle UK Social Bond, Rathbone Ethical Bond or Royal London Ethical Bond.

Each will focus its support in a different direction but these typically back targeted projects, companies or government initiatives that are local or national in reach.

If you prefer passive funds, Legal & General offer several with different regional tilts – Legal & General Future World ESG Tilted & Optimised UK, World and Emerging Markets portfolios. Each tracks its respective Solactive L&G Enhanced ESG Index and combines stewardship, ESG integration and exclusions.

A couple of more concentrated, thematic ETFs are Wisdom Tree Renewable Energy UCITS ETF or the Invesco Hydrogen Economy UCITS ETF, while a broader index fund is the Vanguard ESG Developed World All Cap Equity Index Fund. In fixed income one highly regarded tracker is iShares ESG Screened Overseas Corporate Bond.

Elsewhere, government-backed options like National Savings and Investments (NS&I) offer green savings bonds – fixed rate bonds that allow you to lend money to the government to fund green projects like wind power or zero-emission buses.

How have ESG funds performed?

Performance remains one of the most debated aspects of ESG investing. According to Morningstar, global sustainable funds recorded net outflows of around $27 billion in the fourth quarter of 2025, following nearly $55 billion of outflows in the previous quarter, with large UK institutional clients accountable for a “substantial” share.

But Morningstar this did not necessarily indicate declining interest, with money moving from pooled ESG funds to bespoke mandates.

Returns have also been uneven. Using UK indices as a proxy, ESG-focused stocks have lagged the broader market in recent periods. Over five years, Morningstar shows the UK Target Market Exposure index returned 78.2%, compared with 32.2% for its UK Sustainability index.

But short-term performance and fund flows don’t always tell the full story. Broader asset allocation trends often have a significant impact, particularly as ESG funds are often concentrated in specific sectors or styles.

Dreblow said investors remain concerned about environmental and climate issues but broader market shifts disproportionately affect ESG strategies.

“This isn’t people necessarily turning against sustainability. People don’t want sea levels to rise, see fires everywhere and other extreme weather events. People care. But if there’s a shift away from equities and a shift away from the UK, that will make a difference,” she said.

”These things swing and they will swing back again.”

What’s the regulator’s position on ESG?

In recent years, the Financial Conduct Authority (FCA) introduced Sustainability Disclosure Requirements (SDR) to help consumers better understand and compare ESG investments, while tackling concerns around greenwashing – where ESG-related claims cannot be substantiated.

Dreblow said SDR was well-intended but challenging in practice, arguing the level of granularity required around fund labels meant compliance was difficult for many managers, especially when portfolios change over time.

The FCA has also consulted on its future approach to regulating ESG ratings, with findings expected later this year, and a new ESG ratings regime due to come into effect in 2028.

Dreblow said during the boom into sustainable investing a few years ago, many ratings agencies had limited access to environmental and social data, meaning assessments were skewed towards the ‘G’ because governance intelligence was easier to access due to previous legislation.

The roots of ESG stretch back much further. Ethical investing principles can be traced to religious movements that avoided so-called ‘sin stocks’ linked to weapons, alcohol or gambling.

In 1984, Friends Provident launched the UK’s first ethical fund, marking the first overt opportunity for investors to align moral values with investment objectives.

Ethical investing is becoming increasingly popular, and there is now a wide range of green and ethical investment options.

It’s also possible to invest in an ethical pension, so saving for your future doesn’t mean you have to compromise on your principles.

In fact, while you may already be taking steps in your personal life to protect the planet - such as cutting down on the amount of meat you eat, trying to take trains rather than planes, and switching to a green energy tariff - making your pension more ethical could be the most effective thing you do.

According to the campaign group Make My Money Matter - which has now closed - “greening” your pension is 21 times more effective at reducing your carbon footprint than going veggie, giving up flying or switching your energy provider.

It claimed that £88 billion of UK pensions are invested in fossil fuel companies, working out as an average of £3,000 per pension saver.

There are encouraging signs that younger people want to save for retirement in an ethical way, whether it’s a workplace pension or personal pension. According to research by digital wealth manager, Moneyfarm, 86% of Gen Z (18 – 29 year olds) and 73% of Millennials (30 – 44 year olds) say they would rather accept lower returns on their pension savings and work past the standard retirement age to make up the shortfall, than fund what they perceive to be socially or environmentally damaging industries.

Across all ages, the tobacco industry topped the list of sectors that 44% of Brits do not want their pension money invested in. This was followed by alcohol (31%), defence and ammunition (25%), fast fashion (22%) and oil and gas (21%).

However, few savers have yet to fully embrace a green pension. A 2023 study by Scottish Widows found that only 10% of pension savers have switched to a green pension, due to a lack of information and access to them.

So, how can you make your pension ethical and ensure it’s having a positive - not negative - impact on the planet?

What is an ethical pension?

An ethical pension means ensuring that the money you save for retirement is doing good, and not investing in anything that you deem to be harmful.

The question of ethics is different for everyone, of course. But many people would agree that investing in companies involved in fossil fuels, tobacco or gambling is unethical. Conversely, investing in renewable energy businesses is regarded as ethical. You might also add companies that take business ethics seriously (such as paying workers a fair wage) and have a robust environmental policy (such as recycling, preventing waste and striving to be “net zero”).

The result is you may wish to “screen out” companies that do not fit your ethical criteria, or go further and only invest in companies that are actively striving to do good.

How do I make my pension ethical?

If you are in a workplace pension, you will be limited to investing in the fund range that is on offer from your pension provider. There is likely to be an ethical fund option, which will typically filter out companies that don’t meet ESG criteria (ESG stands for environmental, social and governance).

There may be more than one ethical fund. Look out for ESG or SRI (socially responsible investment) in the fund names, as well as “ethical” or terms like clean water or renewable energy.

You can decide which fund is the right fit for you (be sure to check the fees too, and also the risk level - some ethical funds are considered to be higher risk), and whether you want to put your whole pension in the fund, split it across several ethical funds, or perhaps put a percentage into an ethical fund and the rest in mainstream funds.

If you have a DIY pension on an online investment platform, such as a self-invested personal pension (Sipp), there is likely to be a much wider range of ethical investment funds.

These may include active and passive funds, those that focus on a particular area like renewable energy, those that invest only in the UK and those that invest globally.

Look carefully at the factsheets to see exactly which companies they invest in. For example, a company making meat substitutes may be applauded for helping tackle climate change, but it could also have terrible (or non-existent) diversity and inclusion policies. It’s up to you where you draw the line in terms of what an ethical pension should invest in.

With a Sipp, you can also buy shares in companies that you believe to be ethical, as well as funds.

Can I build an ethical pension with a robo-adviser?

Yes, some robo-advisers offer the chance to opt for an entirely ethical or socially responsible portfolio, whether you’re investing via an ISA, pension or general investment account.

These include Nutmeg, Moneyfarm and Wealthify, as well as personal pension provider PensionBee.

Nutmeg offers portfolios built from exchange traded funds that lean towards companies and bond issuers that have high ESG standards.

Wealthify has five ethical plans allowing pension savers to invest in organisations committed to having a positive impact on society and the environment.

If you’re looking for a bit more hand-holding, and require a financial adviser or wealth manager to give you some expert help on building an ethical pension, the UK Sustainable Investment and Finance Association’s find an adviser tool is a good place to start.

Which are the most ethical pension providers?

If you’re looking for an ethical pension provider, a good place to start is The Good Shopping Guide’s list of the best and worst providers.

It names Aviva as the most ethical pension provider, giving it a score of 92. Interactive Investor and PensionBee come joint second, with 83. This is followed by Royal London, Wesleyan, LV= (Liverpool Victoria), NEST and Penfold.

At the other end of the spectrum, the list highlights Bestinvest, Vanguard and Nutmeg as the least ethical pension providers.

The Good Shopping Guide’s criteria includes looking at pension providers’ environmental reporting, including their impact and goals; if they are committed to reducing carbon emissions; if they have unethical lending practices; and, political donations.

Meanwhile, the Good with Money website names what it considers to be the best ethical pension funds. These include:

• NEST ethical fund
• PensionBee Impact Plan
• Penfold Sustainable Plan
• Liontrust Sustainable Future fund range
• Henderson Global Sustainable Equity fund

If you’re looking to make your Sipp ethical, investment platforms often have lists of ethical or sustainable funds that they rate highly (both for their green credentials as well as investment performance). Interactive Investor has ACE 40, which it says is the UK’s first rated list of sustainable investments.

Sipp providers may also offer ready-made ethical portfolios. For example, AJ Bell has a Responsible Screened Growth Fund.

Questions to ask when choosing an ethical pension

It can be tricky building an ethical pension. For example, you want to make sure the investments match up to your idea of ethical (and not become a victim of “green-washing”), while also ensuring you don’t pay too much in fees, and of course still get good investment performance. These are your life savings after all.

Here are some things to consider:

• Beware of “greenwashing”. Check the fund factsheet to view its objectives and top 10 holdings, to ensure it aligns with your principles. If you’re unsure, do extra research to double-check (for example, does it feature in lists of highly rated ethical funds?).
• Make sure your portfolio is diversified. Investing in renewable energy might be your number one priority, but if your nest egg is solely focused on these types of companies, you could be exposed in the event that they suddenly fall in value (for example, due to a change in government policy). Try and aim for a range of different companies, in a number of countries, across multiple asset classes, to protect yourself.
• Do you want to focus on screening out or are you committed to only investing in ethical firms? In other words, you may be happy to simply avoid fossil fuel firms and other sectors you believe to be unethical, while other pension savers may want to invest only in companies that they perceive to be doing good, whether it’s for society or the planet.
• Check the fees. This is one of the golden rules of investing, and it’s no different when it comes to ethical pensions. Always find out what the fees are (the annual charge, and any other extra fees) before you invest.
• Check the risk profile. Ethical funds can have higher risk profiles than mainstream funds. This may be due to them focusing on a niche area and a lack of diversification, or because the companies themselves are risky - perhaps they’re start-ups in a fledgling sector. Always make sure you’re happy with the risk level and that you understand your money can go down in value as well as up.
• If your pension does not offer decent ethical investment options, consider transferring to one that does. For a personal pension or Sipp, it’s fairly straightforward to move to a competitor. With a workplace pension, speak to your pension provider about your options. You could also try lobbying your employer to provide a pension scheme with better ethical investment choices.

Stockmarkets’ stumble last week fuelled fears of another sharp setback. So it’s perhaps worth revisiting the initial outbreak of turbulence in March to gauge what type of fund managed to provide some downside protection. The short answer is: not much at all bar some technology-focused funds. Pretty much every asset class plummeted.

Nonetheless, interestingly, one strategy does appear to have provided some comfort: investing in environmental, social and governance (ESG, see page 15 for a full definition) funds. They slipped during the sell-off, but their relative outperformance was striking.

The evidence piles up

MSCI runs a hugely popular index of world stocks, the MSCI ACWI index, which also features a variation called the ESG Leaders index. This has been outperforming the main index for years, but by 16 March that outperformance had hit record levels. Another index and research outfit, Morningstar, has compared 26 ESG index funds’ returns between 13 February and 13 March 2020 with those of their conventional peers. Returns were higher for 85% of ESG ETFs in the US market and for 100% in the context of non-US developed-market stocks.

One key measure looks at fund-flow data. French investment bank Societe Generale says that “ESG was the only equity strategy showing positive flows in the market downturn in March and... positive flows in April”. Anne Richards, the CEO of mega-fund manager Fidelity, says that the price of a share in companies with a “high (A or B) Fidelity International sustainability rating dropped on average less than the S&P 500 from its 19 February peak to 26 March. Those rated C to E fell more.”

On average, among the 2,689 companies rated, each ESG rating level was worth an additional 2.8% of stock performance compared with the index.

Analysts have several explanations for this. Many ESG funds were bullish on growth stocks, quality stocks, and healthcare-tech stocks, all of which outperformed. But most ESG funds are bearish on capital-intensive industrial and energy stocks, which plunged.

As these stocks become more expensive, they might fall out of favour and cheaper value stocks could catch up. But ESG funds’ longer-term future may still be rosy. Professor Chendi Zhang of the University of Exeter Business School has led a study measuring the performance of US stocks in the first quarter of 2020. In the three weeks between the start of the market decline and the US government’s bail-out package, firms with high ESG ratings outperformed those with low ones by 7.2%.

It seems corporate level ESG policies “are as valuable in creating resilience as cash”, which Professor Zhang described as “extraordinary”. The key may be consumer attitudes: “credible ESG policies tend to attract more loyal customers, [implying] less need to compete on price”.

Building a brand

This sounds credible and reinforces the idea that ESG burnishes brands, which in turn transforms ESG firms into a new form of quality stock – the type of stock that can become overpriced for extensive periods of time.

Analysts at Killik & Co highlight the bigger picture: the regions in China, Italy and the UK worst-afflicted by Covid-19 tend to be areas with high atmospheric road pollution. So climate change and adaptation to a post Covid-19 world become the same concern. More broadly, the push towards a greener, cleaner world will drive the “greatest reallocation of capital of the 21st century”. And of course, gold rushes have a tendency to create their own forward momentum. So if the markets do take another tumble, ESG funds could be a defensive way of playing several trends at once.

I wish I knew what ESG investing was, but I’m too embarrassed to ask

Environmental, social and governance (ESG) investing – and similar approaches such as socially responsible investing (SRI) – aim to make money while avoiding firms viewed as having a negative impact on the world and encouraging those that have a positive impact.

Traditionally, ethical approaches to investing mostly focused on not buying any companies in businesses that the investor dislikes (known as exclusionary screening). This often included vice stocks, such as tobacco, gambling or alcohol. Some investors might aim to invest more in industries that they view as beneficial (such as renewable energy), although this was less common. However, as demand for ethical investing has become greater, this has evolved to include approaches where the investor takes into account whether a firm is trying to follow the highest standards they can within their sector. Hence an oil producer or a miner would not necessarily be ruled out in some funds or portfolios that follow ESG mandates, so long as the firm is attempting to minimise the adverse impacts of what it does. Some ESG investors will also engage with firms to try to pressure them to follow more sustainable practices, rather than simply not investing in them.

Environmental factors are probably the first thing that many investors associate with these kinds of investing strategies – from climate change to air and water pollution to biodiversity. Social issues are perhaps the broadest and the hardest to measure: they can include how the firm deals with customers, labour standards and human rights in its supply chain, or matters of gender, diversity and equal rights in its workforce. Governance is the strand that is most closely associated with traditional investment analysis: it includes issues such as executive pay, fair treatment of minority shareholders and questions of business conduct, such as bribery and corruption.

Investing ethics are a very personal decision. I tend not to invest in tobacco: my view is that smoking is always harmful, and that tobacco firms’ business is based on trying to make us forget that. Still, I write about tobacco in MoneyWeek when it’s relevant, because tobacco users have a choice. But I won’t generally write about private prisons, because prison users don’t get a choice where they serve their sentence and the evidence suggests that giving for-profit companies too much control of the justice system creates all sorts of moral dilemmas and leads to worse outcomes. I have no problem with the idea of investing in countries such as Iran because I think engagement is a better way to bring change than sanctions. However, North Korea would be difficult, because the regime’s control of the economy means that it would be the main beneficiary.

The wages of sin

Most MoneyWeek readers are going to disagree with me on at least one of these points. As that shows, the idea of ethical investing (or ESG – ethical, social and governance investing – as it’s sometimes called more broadly) means something different to all of us. This makes it hard to measure how ethical decisions affect investment performance. But one way to think about this is to look at returns from sin stocks – a list that includes tobacco, alcohol and gambling, as well as niche categories such as sex and pornography (where there tend to be few listed companies), and sometimes weapons.

Studies show that sin stocks tend to beat the market over the long term, which implies that ruling them out might lead to lower returns. Yet that’s not necessarily the case, according to analysis by Elroy Dimson, Paul Marsh and Mike Staunton in the Credit Suisse Global Investment Returns Yearbook 2020. Sin stocks are a small part of the global market: alcohol, tobacco and gambling each make up less than 1% of the FTSE All World index. You could leave them out of a diversified portfolio without much effect. Some of the sectors now under scrutiny are bigger – oil and gas accounts for 5% of the FTSE All World. But surprisingly, the Dimson, Marsh and Staunton data shows that excluding any single sector would have had only a small effect on long-term returns in the US from 1926 to 2019.

That said, the narrower the market, the bigger the effect could be. Tobacco is about 5% of the FTSE 100, while oil and gas is 13%. Leaving some of those out could have a much larger effect. So whether you are picking individual stocks or buying a tracker or an active fund with an ethical angle, the key is to make sure that the universe of stocks is wide enough that you won’t miss the sector you want to exclude.

Everyone’s mad for the fund management industry’s favourite acronym, ESG, short for environmental, social and governance investing. More than $4bn was shovelled into funds claiming to focus on it in the UK last year. New funds based on the idea that investing comes with various levels of governance responsibility are appearing all the time.

You’ll want to be in on this. All portfolios should at least nod to the idea that there’s more to life than short-term profits. But how?

You can make it easy. At the simple and old-fashioned end of the ESG spectrum is the idea that you can exclude the big baddies and be done with it. So perhaps just don’t buy big oil. No Shell and no BP.

Excluding the obvious big polluters is not enough

But think on and you might start to feel that’s not enough. After all, if you aren’t mad for oil, maybe you shouldn’t be mad for the companies that create demand for fossil fuels. You’d better not hold anyone that makes tractors. No Deere & Company. No Caterpillar. Same goes for aerospace firms, airlines and airports.

Following on from that last one, if you can’t hold an airport operator you really should knock out all companies which might exploit the people travelling via airports. Goodbye WHSmith, Ted Baker, CK Hutchinson Holdings (owner of Superdrug) and all luxury goods companies. Oh, and Mondelez International (maker of Toblerone, 25% of which is sold in airport duty-free shops — very often to me).

Think, too, about something such as pornography. I don’t think I much want to invest in porn. But you know what? Porn is really popular — and widely distributed by an awful lot of the companies you think are just fine ESG-wise. If you don’t want to be invested in adult entertainment, do you want to be invested in Google or mobile phone firms (around 80% of porn is watched on mobile devices)? Just asking.

This isn’t easy. Grappling with it means you are either going to have to drive yourself mad with the inconsistencies inherent in your approach (such as owning a car but refusing to own oil companies), hope the state takes on the responsibility for you (the Financial Conduct Authority has just announced proposals to improve climate-related disclosures by listed companies, for example) or outsource your morals to someone you have some trust in.

ESG and the world of fund management

It’s familiar-sounding rhetoric. But look at the industry as a whole on gender diversity. In 2000, 14% of fund managers were women, says Morningstar. Today, 14% of fund managers are women. There are lots of reasons why women might not want to be fund managers but it’s just a little hint at the gap between talk and walk in the fund management sector.

So with that in mind, here’s your ESG choice. You can buy a fund with one of the following buzzwords in its title: ethical, impact, socially responsible or just ESG. Otherwise you can find a fund management company that has an acceptable ESG-process embedded in its systems and buy any of its funds.

Consider a firm that insists on the proper treatment of all stakeholders connected to its investments (employees, customers, taxpayers and suppliers), keeps watch on the sustainability of, say, their water use and also takes an active approach to helping them improve.

In the end, your hope is that there is no obvious distinction between the ordinary funds these firms run and any other fund with an explicit ESG policy embedded in it.

Some ESG funds to consider

If you go for the former you will not be short of options. You can go for an active fund that just tries to be a bit more responsible than most (perhaps Fundsmith Sustainable Equity or Unicorn Ethical Income) or one that tries to invest in firms that will improve the world, maybe Pictet Global Environmental Opportunities or Montanaro Better World (I sit on the board of a Montanaro fund, though not this one).

You can go a step further than this and invest in the super-woke new CPR Invest – Social Impact, a fund as “dedicated to tackling social inequalities” as it is to helping you out with your personal urge to have a bigger Isa pot than everyone else.

Finally, you could take a more passive route and choose one of the many exchange traded funds (ETFs) that exclude various types of sin stocks. Interactive Investor has a useful list of funds with an ESG bent — the ACE 30. On it is one I hold, Impax Environmental Markets, and one that I will get around to holding at some point, the L&G Ethical Trust.

If you go for the latter approach it’s a matter of working out which firms are less awful than the rest of them. This is not a sector that regularly covers itself in ESG glory. Maybe they have signed the UN-backed Principles for Responsible Investment initiative. Or perhaps they just have a convincing ESG policy note on their website and no record of obviously awful behaviour.

Stewart Investors is hugely orientated towards sustainability, so any of its funds would suit. The Pacific Assets trust, which I hold, or GEM Sustainability funds are both good. The same goes for Impax Asset Management. L&G also appears to have a good corporate ethos, as do Baillie Gifford (I sit on the board of a trust it manages), Pictet and Hermes.

Beware the downsides of ethical investing

A few caveats to all this. Do-goodery is compelling. Just like you, I want to have ESG embedded in my Isa portfolio. But there are downsides. First, valuations. Are you prepared to pay extra for explicit ESG? Companies that are very obviously focused on the bandwagon aren’t cheap. Some prices, says Graham Clapp of investment manager RWC, are “echoing the bubble of the late 1990s”.

Second, there could be an exclusion penalty. Whatever you do, you are knocking out part of the market. There is plenty of find-the-answer-you-want research that will tell you that avoiding the dirtier parts of the market will make no difference to your returns. But cutting the diversity of portfolios does make a difference. In 2019, more than 80% of global power consumption was still derived from fossil fuels, for example. That’s quite something to decide you want nothing to do with.

Finally, you might want to worry a little about greenwash overload. Even in the course of writing this column I have read so many smug platitudes I am suffering from an almost overwhelming urge to spend a few hours gambling, smoking, boozing and binge sugar-eating, possibly in the passenger seat of a speed-limit-smashing, diesel-powered Shogun.

• This article was first published in the Financial Times

MoneyWeek has a bit of a hippy feel to it this issue. We’ve got veganism on the cover and houseboats in the property spread. We’re not the only ones. A week after Boris Johnson decided that new petrol and diesel cars will be banned in Britain from 2035, this week transport secretary Grant Shapps suggested it might even start in 2032. The dismayed reaction from car manufacturers tells you all you need to know about why investors need to pay attention to this stuff.

Change is afoot. You might be on board with every “green” sentiment going, or you might think that a lot of it is trendy nonsense – it’s irrelevant. You should certainly approach trends with scepticism, but if you fail to acknowledge genuine shifts in behaviour, often driven by government regulation, then your portfolio could be left high and dry.

For example, a report from the International Energy Agency (IEA) this week revealed that global energy-related emissions of carbon dioxide were unchanged in 2019, even though the economy continued to grow (by 2.9%). How did that happen? It’s mainly due to developed economies cutting back even as emerging emissions keep climbing. Despite the impression given by teen truant and climate crusader Greta Thunberg’s occasional spats with US president Donald Trump, America saw the biggest drop in absolute terms. Significant falls were also seen in the European Union (with the UK particularly strong on this front) and Japan. The main driver is that coal is being displaced by natural gas and renewables (wind in particular). And more than eight years on from Japan’s Fukushima disaster, nuclear generation is growing again.

The question however as always is – how much of this stuff is priced in? I read a fascinating blog from Joachim Klements earlier this week in which he discussed work by researchers from the University of Augsburg and Queen’s University. They looked at more than 10,000 listed companies across the world, and put together a measure of their exposure to changes to regulations around carbon pricing and climate change. Since 2013, he notes, their research finds that companies with the lowest carbon risk exposure (ie, the “greenest” companies) have done better as a whole than the wider market. Now that’s what you’d expect – if climate change vulnerability is a new risk, markets should price that in. However, if it’s been going on for six years, then that’s more than enough time to go from “sensible re-pricing of future prospects” to “mania”. And if you look at recent share-price movements, I think we’re getting to the point where you could argue that a “green bubble” is underway.

There’s electric car group Tesla, whose share price has more than trebled in just four months. But as Eoin Treacy of FullerTreacyMoney notes, it’s not alone. Renewable energy exchange-traded funds (ETF) – tracking everything from battery technology to solar power – have jumped, while hydrogen stocks (you’ll have to wait for the ETF, but I’m sure there’s one coming) have surged too. Now, bubbles can go on for a lot longer than anyone expects. Stuart’s vegan share tip suggestions may be worth a punt, but I’m not sure a houseboat will ever be a good investment.

In a fast-changing world the companies that will survive and thrive are those that make the world a more sustainable place. We look for businesses that improve people’s quality of life through medical, technological or educational advances; drive improvements in the efficiency with which we use increasingly scarce resources; or help build a more stable, resilient and prosperous economy.

We want investors to be able to generate strong returns while benefiting society. This can be done by identifying long-term transformations such as technological and medical advances and investing in companies exposed to powerful trends.

Smurfit Kappa: cutting waste in paper and packaging

Smurfit Kappa (LSE: SKG) is one such business. Paper and packaging companies are at the centre of the waste debate and we see strong financial and environmental opportunities for those that can operate sustainably. Three-quarters of the fibres that Smurfit Kappa uses are from recycled sources and the remaining 25% come directly from its own plantations and third-party suppliers. We see value in Smurfit Kappa’s responsible resource management, operational efficiency and products that help to reduce waste, use fewer resources as well as increase recyclability, reusability and degradability. CEO Anthony Smurfit has said that consumers are increasingly demanding sustainable packaging and with its expertise in paper-based packaging, the company is ideally positioned to take advantage of this mega-trend.

Software might not be the first sector you think of when mulling sustainable stocks. But Autodesk (Nasdaq: ADSK) offers an opportunity. It brings technology to the construction sector, which had previously relied on paper and sketches. Its software reduces errors in construction, saving time and vital resources, and makes the overall construction industry more efficient.

Autodesk has fared well in spite of fears that demand for its technology is vulnerable to a slowing global economy and construction market. While the construction industry remains cyclical, the secular nature of the growth in technology adoption should ensure strong compound growth over many years to come.

A healthy outlook for IQVIA

Finally, I’d point to IQVIA (NYSE: IQV), which has a market value of $30bn. In the UK we spend 9% of GDP on healthcare; in the US the figure is 18%. This spending is expected to grow by 6% a year for the next decade, so we know there is a need for innovation in this sector. This can easily be demonstrated by looking at drug trials. For a pharmaceutical company aiming to distribute a new drug, creating it is just the start of the story. Trials are compulsory and there are usually at least three phases.

Costs can run to $400m per phase, with the expense even greater when trials run over; they are also difficult to recruit for. IQVIA has data on prescriptions, the software to design, plan and monitor drug trials and allows companies to run these important events in a more effective manner. It’s a sustainable company because it enables better patient outcomes via innovation, but it’s also a firm with good revenue growth, good management, and good business fundamentals. There is plenty of upside for this stock.