Ethical investing: how ethical is your ESG fund?

There’s no doubt that environmental and other issues can have a huge impact on share prices – 2020 has proven that beyond doubt. But how can investors ensure they are backing the right ESG funds?

So pervasive has concern about environmental, social and governance (ESG) issues become that it is hard to find a fund presentation without a slide on it or an annual report without a section explaining how seriously the manager takes the issue. What is less easy to find out is whether what lies behind this is just a box-ticking exercise; the use of an off-the-peg service; or some serious thought about the principles. Yet 2020 has shown how important the issue can be. 

The 80% drop in the oil price earlier this year has hit oil majors BP and Shell hard, forcing them to cut their dividends. Though the oil price has now recovered to be “only” 30% down, both companies’ share prices have fallen by roughly half. Meanwhile, those investors who avoided fossil fuel companies for renewable energy generators have continued to collect dividends on unchanged share prices, despite falling electricity prices and the absence of subsidies on new projects.

Meanwhile, revelations in The Sunday Times in July about terrible working conditions and illegal wages at garment factories in Leicester saw the share price of fashion retailer Boohoo halved. Until then, investors had enjoyed the benefit to the share price of high margins (perhaps as a result of the low wages), but the benefit of profit maximisation has proved illusory, even though a substantial chunk of the fall has since been recovered. This displays the potential advantages of focusing on the “S” and “G” parts of ESG – although it’s also worth noting that several ESG funds were caught out on Boohoo, only selling after the revelations.

Fund managers need to think for themselves

So investors need to think for themselves – but it isn’t easy. Laura Foll, a fund manager at Janus Henderson, notes that “on the system we use, [pharmaceuticals group] AstraZeneca has a worse score than [tobacco makers] BAT and Imperial because the system focuses not on what companies do, but how they do it. We need to understand the reasons behind the scores that are coming out and decide if we think they are correct.” 

Furthermore, coverage of smaller companies is poor and judgements highly subjective (see below). Is nuclear energy an environmental paragon or pariah? Has online betting turned gambling into a toxic business outside regulatory control? How do you draw the line between arms manufacturers and firms, such as Rolls-Royce, that operate more loosely in the defence sector? Governance is particularly tricky to judge. Foll says that, using the Henderson system, Rolls-Royce scores poorly due to the government’s “golden share”, on the grounds that not all shareholders have equal rights – yet this could be a positive in some cases. Non-voting shares were once common in the stockmarket but have almost disappeared; for one survivor in the investment trust sector, Hansa Trust, the non-voting shares are actually priced higher than the voting ones. In the US, the tech giants have often restricted voting rights for the public shares so that the founder shareholders could retain control, but few complain or boycott the shares. 

The risks of taking the ethical stance

And of course, sometimes taking the moral high road simply won’t pay off – at least, not at first. Asian investors with high ESG scruples, such as Stewart Investors, are highly wary of Chinese companies due to their reputation for poor corporate governance, but Stewart Investors’ performance has suffered as a result. 

There’s also the risk that consensus views on ESG issues could change. The replacement of fossil fuels with renewables is an unstoppable trend – resource wealth has not generally been a source of political stability and wealth; extracting energy from the weather is surely preferable. But today’s focus on carbon footprint, for example, may come to be seen as excessive. 

Investment managers who are thinking deeply about ESG include Stewart Investors (Pacific Assets, Scottish Oriental and Scotgems) and Impax (Impax Environmental Markets). A number of mainly younger managers, such as Foll, go much further than simply using their company’s systems and are well worth following. Unfortunately, though, private investors have to do their own ESG research to ensure their investments comply with what are often personal views. Equally though, those concerned solely about returns need to remember that ESG is having an increasing impact on share prices – regardless of their own views on the issues involved.

No simple screening solution

As the troubles at Boohoo suggest, there is no easy, purely quantitative way to screen companies for ESG factors. As Joseph Mariathasan, a director of ESG consultants GIST, puts it: “You can’t simply add together separate scores for E, S and G.”

 The variations between systems make this clear. For example, the GIST team notes that the ESG scores of Japanese stocks show no correlation between MSCI and FTSE. And while electric car manufacturer  Tesla scores highly with MSCI, it does badly with FTSE. GIST believes it is possible to devise a reliable system, but describes its process as “E, S and some G”. 

In short, as Kate Allen of the Financial Times wrote recently, “there are lies, damned lies and ESG rating methodologies”.  And as an investor, that means you need to be prepared to do more research yourself.

Recommended

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

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

ESG investing – investing with a focus on environmental, social and governance issues – is the latest incarnation of ethical investing. Here's what it…
23 Sep 2020
ESG investing
Glossary

ESG investing

ESG stands for environmental, social and corporate governance, the areas in which good behaviour is particularly sought.
19 Jun 2020
Luciano Diana: ESG investing and a welcome dose of optimism amid the gloom
Investment strategy

Luciano Diana: ESG investing and a welcome dose of optimism amid the gloom

Pictet's Luciano Diana talks about ESG investing, climate change and the challenges of Covid-19 and how, while things are tough in the short term, the…
28 Apr 2020
ESG and “ethical” investing: where should you start?
ESG investing

ESG and “ethical” investing: where should you start?

“Ethical”, or ESG investing (environmental, social and governance) is all the rage. But what exactly does it mean? And where should you start? Merryn …
9 Mar 2020

Most Popular

The Bank of England should create a "Bitpound" digital currency and take the world by storm
Bitcoin

The Bank of England should create a "Bitpound" digital currency and take the world by storm

The Bank of England could win the race to create a respectable digital currency if it moves quickly, says Matthew Lynn.
18 Oct 2020
Negative interest rates and the end of free bank accounts
Bank accounts

Negative interest rates and the end of free bank accounts

Negative interest rates are likely to mean the introduction of fees for current accounts and other banking products. But that might make the UK bankin…
19 Oct 2020
What would negative interest rates mean for your money?
UK Economy

What would negative interest rates mean for your money?

There has been much talk of the Bank of England introducing negative interest rates. John Stepek explains why they might do that, and what it would me…
15 Oct 2020