Ethical investing: how to find an ESG tracker fund

Ethical investing is hot right now, with ever more fund managers offering products focusing on environmental, social and governance (ESG) issues. Research by Morgan Stanley shows that 84% of millennials (today’s 20 to 35-year-olds, roughly), see taking account of ESG impact as a “central goal” when it comes to investing. But it’s not just the younger generation. Apparently, nine out of ten wealth managers (who typically deal with a much older age group) believe that the Covid-19 outbreak has resulted in greater investor interest in ESG investing, according to an FT/Savanta survey.

This interest isn’t just limited to traditional actively-managed funds. Plenty of money is finding its way into various types of ESG exchange traded funds (ETFs). According to industry consultant ETFGI, the sector enjoyed record net inflows of $28.53bn through to May this year, with cumulative inflows of a record $82bn into ETFs globally. Meanwhile, data from Morningstar shows that the number of “sustainable” funds launched in the UK jumped from 98 in 2009 to 396 in 2019 – more than tripling within a decade.

Inevitably, this profusion of funds has created lots of new jargon – see below for a basic guide. But regardless of the type of fund used, ethical investors have enjoyed strong performance in recent years. Funds investing in the socially responsible investing (SRI) or ESG “leaders” of the MSCI All Country World index have beaten the parent index over the year-to-date, three and five years. That persisted even during the pandemic – 80% of global ESG ETFs listed in Europe have beaten the MSCI World index during that time, according to Morningstar.

Subscribe to MoneyWeek

Subscribe to MoneyWeek today and get your first six magazine issues absolutely FREE

Get 6 issues free

Sign up to Money Morning

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Sign up

There are intuitively sensible reasons as to why a focus on ESG issues might make sense for investors. The damaging impact of major environmental or governance scandals on share prices is clear. Big stories in recent memory include oil major BP’s Gulf of Mexico disaster, and car manufacturer Volkswagen’s “Dieselgate” scandal, each of which saw their share prices fall by 20%-plus in a single day. MSCI has also found that “companies with good ESG ratings tend to be more profitable, better quality and lower risk”. The push to cut global carbon emissions has been a prime driver of ESG but since the pandemic many investors have also been focusing on social outcomes – “employee wellness” and accounting practices in particular, according to Deutsche Bank.

The ESG ETFs to invest in now

So if you go down the ESG route, what are your options when it comes to funds? The key is whether you prefer passive index trackers (mostly ETFs) or actively-managed funds. Active funds can take a more focused approach, perhaps targeting only those businesses with an immediate direct impact. The danger with that approach is that fund managers take what are called “idiosyncratic risks” – potentially picking the wrong company, at the wrong price. For instance, many clean energy funds emerged in the last decade, but ended up investing in poorly managed and capitalised businesses that failed to take off. Passive funds by contrast avoid these selection issues, by quantitatively screening the whole universe of stocks and only selecting those businesses which pass a “screen” of key measures.

That said, just to confuse matters Fidelity has recently launched a range of actively-managed ESG ETFs, investing in US stocks (LSE: FUSR), European businesses (LSE: FEUR), and global equities (LSE: FGLR). All have ongoing charges figures (OCFs) ranging between 0.30% and 0.35%. To be included in the ETFs, companies must exhibit a positive fundamental outlook and strong sustainability credentials based on the firm’s sustainable ratings.

One range of ETFs popular with many advisers are those from UBS, working with index provider MSCI. The UBS MSCI ACWI Socially Responsible Hedged to GBP UCITS ETF (LSE: AWSG), for instance, provides access to large and mid-cap equities across 23 developed and 24 emerging markets that have outstanding ESG ratings while excluding companies that have negative social or environmental impacts. It also hedges the effect of foreign currency movements between developed markets and the pound. More broadly the MSCI SRI range looks to invest in the top 25% best-scoring companies across each sector (after some business exclusions).

What’s in your ethical passive fund?

As with many things in the financial industry, ESG funds come with a great deal of jargon. What does it all mean?

ESG-filtered funds: these proactively screen for businesses with a high ESG rating.

Sustainability or SRI funds: these combine both a “positive” screen (businesses you want to own) alongside a “negative” screen (businesses you want to exclude). Many exclude alcohol, tobacco, gaming and weapons businesses, while other variations include fossil-fuel-free (or reduced) funds, which exclude businesses involved in fossil fuel production.

Low carbon/climate change funds: these focus specifically on businesses with a record of generating low carbon emissions.

Thematics: these are sector-based funds which invest in certain global themes such as water, forestry and clean energy.

Equality-based funds: many of these focus on encouraging global gender equality

Green bonds: these are issued by firms and organisations to finance a specific low- or zero-carbon project.

The key distinction for the purposes of most investors is probably the difference between ESG and SRI funds. The former look to screen through a wider market to maximise a return based on various ethical criteria, but profit or capital gain remains the primary objective. The latter, by contrast, look to balance financial and social outcomes, with the financial outcome (in other words, the return to the investor) frequently a secondary consideration.