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

Jeremy Grantham, we're in one of the greatest bubbles in financial history
Investment strategy

Jeremy Grantham, we're in one of the greatest bubbles in financial history

Merryn talks to Jeremy Grantham of GMO about the current state of the markets and where investors can "hide" from all the craziness, plus inequality, …
5 Aug 2021
The case for nickel – a crucial metal in the Green Energy Revolution
Industrial metals

The case for nickel – a crucial metal in the Green Energy Revolution

Nickel’s use in batteries for electric vehicles makes it a vital metal for the 21st century. Dominic Frisby investigates how to invest.
5 Aug 2021
What Joe Biden's bipartisan infrastructure deal means for cryptocurrency investors
Bitcoin & crypto

What Joe Biden's bipartisan infrastructure deal means for cryptocurrency investors

The US’s $1trn bipartisan infrastructure agreement contains provisions for raising taxes on cryptocurrency investments. Saloni Sardana looks into the …
4 Aug 2021
Bitcoin miners are cleaning up their act, using green energy to drive higher profits
Bitcoin & crypto

Bitcoin miners are cleaning up their act, using green energy to drive higher profits

Bitcoin has been criticised for its vast energy consumption in its pursuit of profit. But that same desire for profit is powering a green energy revol…
4 Aug 2021

Most Popular

Why the UK's 2.5% inflation is a big deal
Inflation

Why the UK's 2.5% inflation is a big deal

After years of inflation being a financial-assets problem, it is now an “ordinary things” problem too, says Merryn Somerset Webb. But central banks st…
16 Jul 2021
The MoneyWeek Podcast: Asia, financial repression and the nature of capitalism
Economy

The MoneyWeek Podcast: Asia, financial repression and the nature of capitalism

Russell Napier talks to Merryn about financial repression – or "stealing money from old people slowly" – plus how Asian capitalism is taking over in t…
16 Jul 2021
Three companies that are reaping the rewards of investment
Share tips

Three companies that are reaping the rewards of investment

Professional investor Edward Wielechowski of the Odyssean Investment Trust highlights three stocks that have have invested well – and are able to deal…
19 Jul 2021