What is ESG Investing and Why Should You Consider it for Your Portfolio?

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Ethical investing has been around for many years, but has not always been considered mainstream. Most investment companies offered one or two ‘ethical’ options, which were generally equity-based rather than covering a range of risk appetites.

Ethical funds were often more expensive than the standard alternative, and performance would usually lag behind.
With such limited choice, these investments often appealed only to committed ethical investors rather than the general public. Investors (and indeed advisers) frequently overlooked ethical investment options in favour of more conventional, diverse investment choices.

But the world is changing. More companies are adapting to fairer, greener and more innovative practices, which makes it easier to include them in a mainstream investment proposition. As awareness increases, so does demand.

Traditional ethical investing has largely been overtaken by Environmental, Social and Governance (ESG) strategies, a more modern and inclusive approach to socially responsible investing.

 

A Brief Guide to ESG

Funds with an ESG mandate aim to invest in companies which have a positive effect on the environment or society in general. The companies selected will have strong credentials in any of the following areas:

Environmental

  • Efficient use of energy and resources
  • Working to reduce pollution
  • Innovation in the areas of waste management or green energy
  • Treating animals humanely
  • Aiding the conservation of natural environments

Social

  • Safe working conditions
  • Regard for employees’ health and welfare
  • Treating staff fairly and avoiding discrimination
  • Upholding consumer rights and dealing ethically with customers
  • Contributing positively to the local community
  • Engaging in charity work
  • Using suppliers who uphold the same values

Governance

  • Transparent leadership
  • A commitment to diversity and equality at senior management levels
  • Reducing conflicts of interest
  • Paying their share of tax
  • Avoiding corruption or illegal activity

Very few companies are perfect in all areas. This means that the fund manager needs to apply judgement and consider whether the positive aspects outweigh the negative.

 

How It Differs from Ethical Investing

Ethical investing tends to focus on screening out negative criteria. For example, companies operating in any of the following areas are likely to be excluded from an ethical portfolio:

  • Weapons
  • Gambling
  • Tobacco
  • Animal testing for cosmetic purposes
  • Any activity causing significant harm to the environment or engaging in human rights violations

Some ethical funds will also exclude the following:

  • Alcohol
  • Oil and gas
  • Meat production
  • Pornography
  • Animal testing for medical purposes

Interpretation of ethical investing can vary between investors. For example, a committed vegan is likely to feel very strongly about animal rights, but may not be so concerned with alcohol or gambling.

Some of the barriers to ethical investing are:

  • Limited choice
  • Generally high costs
  • Negative screening means excluding certain companies, potentially missing out on investment growth
  • A lack of diversification, as most ethical funds hold a high proportion in equities. This is unlikely to suit an investor with a lower risk tolerance.
  • An ethical fund may not meet the investor’s specific ethical criteria. However, a bespoke managed portfolio is likely to be cost-prohibitive and out of the reach of most investors.

ESG investing is slightly different, as it aims to assess companies on a more holistic basis. A company would not necessarily be excluded for one ‘red flag,’ providing their overall contribution to society was positive.

This means that while an ESG portfolio may not suit every investor with strong ethical preferences, the appeal is more widespread.

 

Company Selection

There are several industry sectors which frequently appear in ESG funds:

  • Technology
  • Pharmaceuticals and healthcare
  • Finance and banking

While these areas are not inherently ‘ethical’ or ‘sustainable,’ the companies themselves are found to create more good in the world than harm. For example:

  • Technology companies are usually innovative and may have strong employment benefits in order to attract the best and brightest. The pandemic has demonstrated that technology can help to forge business connections, avoiding the need for travel and reducing carbon emissions.
  • Healthcare companies can produce products which save lives or vastly improve the quality of life of an ageing population. Drugs, medical devices, and healthcare technology can all contribute to a healthier population.
  • Banking is not known for its commitment to ethical practices, however many companies are working hard to change that. A financial company may be selected if it strongly upholds consumer rights, treats staff fairly, and pays its share of tax.

Companies selected for ESG funds are usually internationally recognised global names, such as Tesla and Paypal. They are chosen for their investment potential as well as their business practices.

Consideration must be given to the individual companies, as many of them would not automatically spring to mind as an ethical or sustainable investment. The fund manager would need to weigh up the positive and negative criteria and look at any mitigating factors, for example a commitment to improving in a particular area.

 

A Changing World

The global economy is adapting. ESG investing has moved decisively into the mainstream in recent years. The reasons for this are varied:

Awareness

People are generally more aware of their environment and the damage caused by plastic and carbon emissions. By supporting companies with strong ESG credentials, investors can demonstrate demand for a more sustainable way of doing business.

Influencing

As this demand increases, and certain practices become socially unacceptable, companies can often be persuaded to operate in a more fair, ethical and environmentally friendly manner. Rather than being a hindrance to business progress, it becomes a basic minimum requirement. With a critical mass, investors can also influence company policies from the inside.

Innovation

Innovation has been the driver behind the success of many companies operating in the ESG arena. From technology which renders the daily commute almost obsolete, to healthcare apps and green energy developments, scientific breakthroughs are a major appeal of sustainable investments. The investment potential of ground-breaking technology cannot be ignored.

 

The Post-Pandemic Environment

The Covid-19 crisis has accelerated global change and shone a light on certain practices that were unsustainable. While the end of the pandemic would be most welcome, it has caused society to adapt in ways that are compatible with sustainable investing. For example:

  • Travel has been vastly reduced, from worldwide trips to the daily commute
  • Carbon emissions decreased during lockdown. While this is not necessarily sustainable for the long-term, it suggests that even small changes over a short period of time can have an impact.
  • People have become more reliant on technology and virtual services rather than manufactured goods or city-centric activities.

Of course, there are now new challenges for companies to deal with:

  • Reducing waste as hygiene measures have overtaken concerns about excessive packaging and single use plastics.
  • Efficiently managing the logistics of a society that is increasingly reliant on home deliveries.
  • Creating new jobs in an environment where entire industries have been decimated.
  • Maintaining distance, hygiene, and morale in the workplace.
  • Mental health challenges such as loneliness, anxiety, and depression.
  • Delivering services using increased automation and limited contact. Healthcare is a prime example with more GPs offering video consultations.
  • Managing a remote workforce, or gradually transitioning people back to the office.

Clearly technology and innovation will have a part to play in meeting these challenges in a sustainable way.

 

Why Choose ESG Investments?

In the past, investors would choose ethical investments because they did not want to support companies which caused harm to the environment or society.

But there are many reasons why an investor might opt for an ESG screened portfolio, either as their main investment or as part of a diverse portfolio. For example:

  • The desire to make a positive impact on the world
  • Concerns about climate change or pollution
  • A wish to support and encourage companies acting responsibly, or to influence them to do so
  • A belief that companies operating with fairness and sustainability at the heart of their corporate culture will be more profitable than their competitors
  • An interest in innovation and technology. Science is key in battling climate change and improving medical treatments.

With increased availability of ESG investments, investors have more choice than ever before. Many companies offer a complete range of funds which are multi-asset in nature rather than fully equity-focused. This means that a diverse portfolio can be created to suit any risk level, without overlooking ethical criteria.

Sustainable investments are no longer a niche option. Funds with strong ESG credentials can have a place in any investment strategy.

 

Invitation

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