Ditch a broad ESG approach to funds for these two focused investment trusts

The last few years have seen a surge of interest in environmental, social and governance (ESG)-focused funds. These assess potential investments’ success in cutting carbon emissions and improving racial or social diversity and governance.

Two subcategories of the ESG strategy are socially responsible investing (SRI) and impact investing. When it comes to SRI, investors actively favour sectors such as healthcare or renewable energy and avoid businesses such as tobacco firms.

By contrast, a broader ESG strategy might hold Royal Dutch Shell in its portfolio because on some screens it scores well for reducing its emissions (not least by being focused on natural gas). Impact investing, meanwhile, focuses on a particular area to achieve positive, measurable outcomes.

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Running the numbers

ESG investing relies heavily on numbers-led screening based on data sets frequently provided by established market-data firms, such as MSCI or IHS Markit.

There is some debate about how these are constructed, where the data is sourced from (usually the reporting firms) and why it varies so significantly.

The self-reporting of data has prompted experts’ calls for uniform, perhaps even legislated, accounting standards. Other critics point to the relative lack of data on social statistics. Very few screens look at CEOs’ pay, wage differentials or labour representation.

Many ESG strategies lean heavily towards equities with a growth bias that favours technology companies. This has helped many ESG funds to outperform “conventional” equities in the last few years.

But as Vincent Deluard of US-based investment house StoneX observes, the trend has created a skew towards companies that overpay CEOs, employ fewer staff than their old-economy counterparts, invest less in capital expenditure and pay less tax. Tens of billions of pounds are flowing into ESG funds, partly due to their eco-friendly selling point. But there is a strong chance that both the energy complex and old-world cyclical industrial companies will significantly outperform the new world of ESG stocks in the coming months and years.

This could undermine ESG funds’ appeal, especially if the clean-energy stocks – which look overpriced on several measures – start to depreciate sharply. London-based fintech Util argues that ESG is a broken model and that we need to replace it with something else. Cue SRI and impact investing.

Finding alternatives

UK-listed investment trust Menhaden Resource Efficiency (LSE: MHN) launched in 2015 with a broad sustainability strategy. It made mistakes and its share price languished before the board narrowed its focus to profiting from the efficient use of energy and resources. This is a much more interesting remit and the fund is trading at an unreasonable 25% discount to its net asset value (NAV).

Impact investing carries risks, because many of the businesses likely to have an impact may not be very well established. But an excellent example is Home Reit (LSE: HOME), which generates an income by renting out property to the homeless and those struggling with addiction problems, thereby achieving a direct, quantifiable, social outcome.

Combined, these could constitute a socially responsible part of your portfolio. Forget the all-encompassing ESG approach and set a few objectives. Identify the impact outcomes you’d like to help achieve, then find funds that focus on this. Schroders and Big Society Capital are already backing specialist funds such as their joint Social Impact Trust. Concentrating on a few impacts might mean you don’t tick every box: a business that focuses on emissions reductions may not have a great record in other areas. But you can help make a discernible difference.