Fifty Shades of Green

The demand for ESG friendly funds and products has hit an all-time high.

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Few can doubt that the idea and concept of responsible investing based off good environmental, social and governance practices is currently gaining momentum. Demand for ESG friendly funds and products continues to hit fresh highs. For instance, according to UK Investment Association, there is now over £20bn in ethical funds compared to the £5bn 10 years ago.

Last year ethical funds saw their best ever net retail sales year raising by £1.2bn (only the second time it was over £1bn, the first being previous year in 2017). This figure was more impressive, despite the whole industry net sales being out over £5bn in 2018. As you would expect with this type of sales momentum, many groups are launching funds and solutions to capture this trend.

However, investors must understand some of the differences between the increasing complex type of shades of ethical funds out in the market place. You can put these funds in multiple classes, but the four broadest and popular groupings are; Negative screening, ESG, Sustainability and Impact. Each one of these groups treat the concept of ethical or responsible investing slightly different and each have their own merits that will appeal to different types of clients.

Negative screening: These tend to be the more tradional ethical funds as some might term them. Negative screening or exclusion strategies involves removing certain companies or whole sectors from the investible universe. 

ESG: This tends to focus around ESG integration into the selection process. Looking at the cost their product or services has on the environment, judging how attune the company is with regards to is social obligations and the standard of governance within the company with regards to honesty, integrity and transparency. Managers will assess these ESG risks and opportunities alongside traditional financial analysis to help make the best investment decision.   

Sustainability: Tends to be focused on certain themes that can cover a wide range of issues based around sustainable consumption or resource management. This can lead to a limited number of industry groups being represented in the portfolio, often with growth characteristics.

Impact: Impact investing is a relatively new concept, having only been coined in 2007 by the Rockefeller Foundation. Impact investing tends to focus on social issues with the aim of the investment to help solve social challenges.

But does ethical/responsible investing limit returns? While there is much debate around this subject there is evidence for numerous studies showing that a focus on ESG can enhance returns. According to research from the University of Hamburg and Deutsche, a positive relationship between ESG ratings and corporate performance was evident in close to half of the 1816 academic studies published since 1970, with a negative correlation being found in just 10% of the time.

The key to most of these studies is on the broader term ESG.  This makes sense, as focusing on these factors is what any good steward of capital (be in a portfolio manager or company management) should do. Any business that over the longer term exploits their customers, stakeholders or environment will eventually be found out and punished.  With this in mind we looked at all our open-ended active funds to see if they consider ESG factors in their selection process despite not being classed as responsible investments.  We have been pleasantly surprised by the results.

Out of the 65 underlying active managers we spoke to:

  • Over 95% of those active managers do look at ESG criteria when it comes to stock selection.
  • We only have 3 managers who did not consider ESG criteria (EMD bond manager, UK Index Linked Bond Manager & a Macro focused Absolute return manager who uses Index’s not direct stocks)
  • Around 40% will rule out stocks purely on ESG factors.
  • 63% have increased the focus on ESG over the last few years with almost 60% now having separate ESG teams.

It is therefore fair to say that there is a growing number of funds and managers that may not first screen as Ethical but are applying some of the tools to everyday stock selection.

Now you need to be aware of funds and managers who are saying they are applying ESG factors to the process but are not (so called ‘green-washing’). Blindly following ESG scores without knowing and understanding what you are following can lead you to very different results. ESG scores can vary on who is doing the scoring. Even independent ESG rating agencies apply different techniques and methodologies to ESG never mind individual companies.

If you look at two of the biggest ESG rating agencies, MSCI, FTSE and use their output you can come up with different answers based off different opinions of what matters and levels of transparency. The well-known example of how different they can be is the treatment of the electric car company Tesla. MSCI ranks it top of ESG within the global automobile sector while the FTSE puts it as the worst carmaker globally on ESG issues. This example does highlight some of the subtle and less subtle differences between rating agencies; for example, MSCI gives Tesla a strong score for the environment as it focuses on the emissions produced by its products, while FTSE gives it a very low score on the environment as it focuses on the emissions produced by Tesla factories. FTSE also gives the company low scores based off lack of data while MSCI assume an average score if it has no data on certain metrics.

If you have a strong negative view on certain sectors, then your universe will always be limited as will be the case if you want funds to help solve a problem. But if you want funds that are aware of the importance of environmental, social issues and good governess then your potential universe is probably wider than you thought and is growing.

As with all investments please remember that capital is at risk and investors may not get back the original amount invested.

Screening out sectors or companies may results in less diversification and hence more volatility in investment values.

Scott Spencer

Fund Manager


Risk Disclaimer 

Views and opinions have been arrived at by BMO Global Asset Management and should not be considered to be a recommendation or solicitation to buy or sell any companies that may be mentioned.

The information, opinions, estimates or forecasts contained in this document were obtained from sources reasonably believed to be reliable and are subject to change at any time.

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