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An ethical minefield

Would you invest in tobacco? How about alcohol, or gambling? And how green are “green” investments anyway? We take a look at the ins, outs and moral maybes of ethical investing

31 August 2017 / Investing

The ethical, sustainability and governance (ESG) investment sector is growing rapidly, and experts predict it could become mainstream within a few years. Surveys of investors have shown that most people now want their money to positively impact society and the environment.

Paul Palmer, Associate Dean for ethics, sustainability and engagement at Cass Business School, says most funds in the future will have ESG criteria. One reason for this is that more wealth, whether earned or inherited, will be passing into the hands of the millennial generation.

“Millennials, anyone born after around 1980, are much more clued up about ESG than previous generations,” says Palmer. “As wealth comes to them, they are asking much more searching questions than investors have in the past. Institutional investors such as pension schemes are reflecting these concerns in their asset and fund choices, and wealth managers are responding by increasing the number of ESG funds available.”
Contrary to what critics have maintained in the past, ESG investments have performed well against non-ESG peers. Palmer says the consensus of more than 10,000 studies into ESG investments shows that using them does not mean missing out on performance.

Safety in numbers

Another historic criticism of ESG funds was that there were too few of them available to create a diversified portfolio of assets. Palmer says that has also changed and there are now ample products available. “I wrote about this ten years ago, saying it would only take a few huge wealth managers to start offering ESG funds to see sufficient diversity emerge,” he says. “Now, some of the biggest private banks, such as UBS, offer them. This adds robustness to the market.”

But investors still face substantial challenges when making ESG investments. One of the most important is whether the funds they choose reflect their ethical aims accurately. There is a risk of falling for “greenwashing”: labelling an investment green even though it has little genuine environmental impact, or its issuer still has a net negative impact due to its other business activities. But how much does that matter if a company is taking a “positive action” approach through shareholder activism? But in that case, do shareholders still have to invest in so-called sin stocks to be able to vote at AGMs and make a difference?

An example of this is an energy company releasing a green bond to invest in a renewable energy project, even though its main profits still come from mining oil. This is important as some of the main ESG indices, such as the FTSE4Good, still include large oil and pharmaceutical companies, as well as organisations that have committed a variety of corporate misdeeds.

Buyer beware

Palmer says: “The answer to these dilemmas is to spend time analysing your investments. Some products are robust and others are more greenwash. There are various standard-setters to help you – some have robust methodology and analysis, some don’t, so you must decide which you trust.

“For example, we know that in human rights, Transparency International is robust; and in marine conservation, the Marine Stewardship Council has a good track record. Other such organisations are funded by industry, in which case you are always more circumspect.”

Georgios Ercan, Head of Sales at Dolfin, says that because of these challenges, it takes thorough research to find investments that meet the right ethical criteria and expected performance goals – and that a degree of moral compromise may be required.

“A company that performs well on environmental issues might not perform well on social issues,” he says. “For example, organic sugar cane might be good for the environment, but will it contribute to obesity levels? Is a defence company an investment into war, peace or fighting terrorism?”

Navigating the maze

“To start investing ethically, investors must first set their priorities,” Ercan says. “Depending on the size of your investment and your needs, you might choose a fund or a bespoke discretionary approach. A bespoke discretionary team, such as ours, can screen securities individually to understand their characteristics.

“Depending on what you classify as ethical and your priorities, we would generate recommendations with an analysis of how socially responsible each is. Then we would ensure it meets other selection criteria such as expected performance and volatility, and provide an asset allocation breakdown.”

Another challenge is that ESG requires active management, so costs will be higher than pure index investments, adds Ercan.

But, apart from the feel-good factor of aligning with ethical beliefs, there are many other benefits too. For example, organisations managed according to sustainability criteria should themselves be more sustainable and increase their value over the long term compared to a company with a shorter-term focus.

One thing is certain: the investment landscape has shifted. Asset classes that were regarded as mainstream 50 years ago are considered toxic – both morally and literally – by many investors today, and new investment products are emerging that meet the needs of a generation that seeks to do less harm to the planet and its people.

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