It can be really challenging ensuring your investment portfolio doesn’t fly in the face of your beliefs, but also delivers the returns you need. Here, we explain the questions you need to ask to dig below the surface in this increasingly popular style of investing.
Several types of investment have boomed during the pandemic, cryptocurrencies and gold leading the charge on the alternatives side. An even bigger and in all likelihood longer-lasting shift has been towards ESG investing.
Selecting investments on Environmental, Social and Governance criteria is nothing particularly new; religious organisations have been investing in this way since the 1970s and momentum has been building for more ethical approaches ever since. But a global crisis that has exposed just how interconnected people, places and systems are has fuelled a veritable stampede towards this investment approach as a desire to put investment capital to good moral use has spread.
The ESG universe is incredibly broad and the nomenclature can be difficult to delineate. Terms like Socially Responsible Investment and impact investing (where environmental or social good is part and parcel of a business model) are often spoken of in the same breath
At the last count, net retail sales for UK responsible investment funds had quadrupled year over year from £1.9bn in 2019 to £7.1bn in 2020, while assets in sustainable funds hit a record £930bn globallyi. The bigger picture is even more convincing. Taking all the various types of strategies and labels into account, an estimated $40trn in assets are now run along ESG lines – a figure which has doubled in just four yearsii.
Therein lies a crucial point. The ESG universe is incredibly broad and the nomenclature can be difficult to delineate. Terms like Socially Responsible Investment and impact investing (where environmental or social good is part and parcel of a business model) are often spoken of in the same breath, for instance.
Alignment on ESG is essential
Aiming to do good while also doing well financially is doubtlessly a laudable aim that more and more of us will pursue wholeheartedly. However, it is vital to guarantee that the investments put into your portfolio really do reflect your values – and that they perform as intended.
If ESG issues are important to you, it is vital to ask some probing questions to ensure you and your adviser arrive at the same view of the world
DIY investors have to be on high alert for “greenwashing”, where ethical labels are slapped onto products that don’t really warrant them. And, even where potential investments are vetted by institutions, there is still significant potential for misalignment on what all this really means. If ESG issues are important to you, it is vital to ask some probing questions to ensure you and your adviser arrive at the same view of the world. The following ones will help you get to the heart of the key issues.
1. Do we really share the same understanding of what ESG means?
The basic principle of looking carefully at how a company is run and performs its business actually results in a multitude of approaches to ESG. Lots of nuance comes into play. Do you want to focus on screening out companies, sectors or markets that you find distasteful, or do you prefer to screen in for investments that make a positive impact? Where do you stand on activist approaches which use shareholder power to improve questionable practices?
These aren’t necessarily binary choices and compromises will typically have to be made in the name of creating a balanced portfolio that still delivers the returns you need. There is a relative lack of fixed income opportunities in ESG, for instance, so you may have to adopt a “good enough” stance in some areas
2. How can we make my investment mandate concrete enough, but not overly proscriptive?
Thinking in any depth about your ESG preferences will reveal that there may be many layers to what your notion of a “good” investment is – particularly when you extend measurements of an investment’s attributes to encompass broader concerns about sectors, countries and even supply chains. One often-cited example is the production of batteries for green vehicles, which can involve conflict minerals such as cobalt in their manufacture. How deep you want to delve is a crucial consideration.
It is important to be clear on things which are anathema to you, yet to also be pragmatic, as being too prescriptive could tie an investment manager’s hands and prevent them from performing as desired
It is important to be clear on things which are anathema to you, yet to also be pragmatic, as being too proscriptive could tie an investment manager’s hands and prevent them from performing as desired. At the same time, being too vague will not help them to narrow down the investment universe to suit your preferences effectively.
3. What impact will my choices have on returns and risk?
It has long been accepted that ESG investing doesn’t necessarily entail compromised returns. On the contrary, they have actually shown significant outperformance during the crisis: over the first three quarters of 2020 stocks with higher ESG ratings had better returns in every month except for Apriliii. It is easy to see how avoiding things like polluting practices and labour disputes can lead to more sustainable profits.
That said, ESG products can have short track records, making it harder to spot which will be true winners. It can also be more difficult to construct a well-diversified portfolio since ESG investing is very much better developed in some countries and sectors. Ensure you really understand how your returns and risk exposure will be affected if ESG is your guiding star.
4. How are we measuring ESG credentials and performance?
This is where things get really tricky. There are lots of vendors of ESG data distilling information into quantitative scores and an investment manager might look at data from one or several to arrive at a consensus view. Further complicating matters, they might look at absolute scores, those relative to the sector, a trend or some combination of all three. A good overall score could obscure poor underlying ones.
There are lots of vendors of ESG data distilling information into quantitative scores and an investment manager might look at data from one or several to arrive at a consensus view
It is vital to have complete transparency on the data collection, aggregation and analysis your wealth manager deploys in its investment due diligence process. An adviser should always be able to explain clearly their house view and process.
5. How will conflicts be resolved, and where do we draw the line?
This is another highly nuanced area. As a starting point, your portfolio manager must have deep insights into the ESG attributes of each asset you hold, how they impact the overall ESG credentials of your portfolio and where any conflicts with your values lie. Clearly, this becomes very much more complex when composite assets like mutual funds are involved, so having sufficient “look-through” capabilities are vital.
More challenging still is deciding just how much is too much. If, for instance, one of the 100 stocks a fund holds is deemed contrary to your preferences, does this make the vehicle unacceptable, even if it only constitutes a tiny fraction of your whole portfolio? You need to have deep discussions on what is statistically significant on each issue you hold dear, and where exactly the line should be drawn – especially since the costs of constantly chopping and changing your portfolio can represent a real drag on returns.
Is ESG a priority for you?
ESG is a booming area, and wealth managers have long been active in addressing clients’ concerns about how their capital can be best put to work. The vast majority have teams focused on this area, and we have boutiques on our panel which specialise in the ethical investment space. However deep you wish to go on ESG, our panel institutions are sure to be able to help.
Let us arrange discussions with your best-matched wealth managers, fast and free today!
iii Fidelity International