Unwrapping ESG

Unwrapping ESG

ESG investing has received a huge amount of attention this year. The heady combination of high-profile ethical causes in the form of the Extinction Rebellion and Greta Thunberg’s speech at the UN Climate Summit, alongside strong investment returns, has put ESG investing at the forefront of investor’s minds.

Historically ESG, or ethical investing, has been viewed as a rather niche investment style. This was certainly the case when we launched our own ethical portfolio back in 2008, however, it is now very much a part of virtually every fund manager’s investment process. Despite the surge in popularity, ethical investing can be tracked back to the 1800’s, where religious groups would identify and set ethical investment criteria. Things have, of course, come some way since then and the current iteration of ethical investing consists of three parts;

Environmental e.g. Global warming, pollution, energy usage

Social e.g. Employees working rights, health and safety policy, cyber security

Governance e.g. Board structure, accounting policies, shareholder protection and rights

These three parts are now considered to be relevant factors that could contribute to the long-term success of the company or fund, rather than simply limit the investment universe and reduce potential returns. For example, analysts across a wide range of funds now look at pollution levels (E), worker’s rights (S) and shareholder protection (G) as a matter of course; the evidence being that these factors contribute to the longevity and success of the company.  These factors are, however, less tangible than many traditional indicators of a company’s success and cannot be found on a balance sheet. At the very minimum then, the emphasis on the above factors forces analysts to do more work from a qualitative perspective, perhaps giving them an edge relative to more traditional peers.

It is worth noting that ESG investing is far from an exact science. Its subjective nature is evidenced through examples such Tesla’s ESG rating, as provided by two separate ratings agencies;

Rating Agency A – Rates Tesla highly. The company has very strong environmental credentials. Electric cars reduce the amount of petrol cars on the road and therefore reduce pollution/emissions.

Rating agency B – Rates Tesla poorly. The company has very weak governance credentials. Elon Musk has demonstrated a loose approach to company management, dividing opinion.

These ratings are so different to one another because they value the E, S and G components differently, with Agency A prioritising environmental factors and Agency B prioritising governance factors. This ever-widening difference of opinion on companies such as Tesla influences ethical portfolios, whereby certain factors are more heavily considered than others. Governance is perhaps the most popular factor and evidence suggests it is most widely considered by all managers, possibly because it is the easiest to understand and therefore quantify. A positive work culture has an impact on everyone connected to the business and reduces the likelihood of a ‘black swan’ like management event.

As alluded to previously, the success of ethical funds has been widely discussed, however it’s worth mentioning that ESG and ethical screening has vetted out many underperforming areas over the last 5 years e.g. Oil & Gas. Whilst it has been true that a rising ethical tide has, so far, lifted many if not all boats, we still feel it necessary to be selective. For us, from a fund selection perspective, this means blending a selection of ESG/Ethical managers who have performed well, partially due to their screening process but not solely because of it.

As many people are undoubtedly aware, where possible we use multiple funds in a sector when constructing any IBOSS portfolio. The Ethical Portfolio is no different, and it is not only the amount of funds, but the difference in strategies which remains important. In our opinion, this gives the portfolio a more diverse range of broadly ethically responsible funds and managers, potentially providing a more rounded ESG portfolio.

We try to adopt a pragmatic approach, therefore avoiding some of the most rigid criteria and instead selecting funds which are indicated as investing on what the manager believes to be ESG/Ethical lines. The result is a focus on providing a fully diversified portfolio with an ESG/Ethical bias. As ESG/Ethical investing is necessarily subjective, we feel we must ultimately leave it to individual advisers to assess whether they feel an investment is appropriate for their client. We have recently witnessed a plethora of fund launches in this space, with some fund and model providers opting to have very large holdings in a small number of funds; this concentration risk is something we wish to avoid for any client using IBOSS through an adviser.

In summary, we would point out what is widely known and largely accepted by investors and managers alike; namely that the concept and interpretation of ESG/Ethical investing varies considerably. So, whilst the definitions may well evolve over time, the subjectivity of all things relating to ethics will remain.