Reseach Team, 8 September 2017

Giving consideration to more than just the numbers when investing is not a new concept, with socially responsible or ethical investing dating back to the eighteenth century. Today, investors are increasingly aware that taking environmental, social and corporate governance issues into account is not only good for society but it can also have a material impact on a company’s valuation.

Every day, individuals do their bit to make the world a better place, be it adopting good recycling practices, building more environmentally friendly and efficient homes, or opting for a more efficient car or appliance. The rationale that drives us to make these decisions in our everyday lives can also be extended to investment portfolios thanks to the plethora of options available from leading market providers in the responsible investing space.

While the numerous investment options available in this space have, on one hand, made it easier for investors, navigating the responsible investment space remains complex. Socially responsible investing (SRI), ethical, ESG (Environmental, Social, Governance), thematic, best in class, impact, sustainable, responsible, green, negative screen and positive screen exclusions are just a handful of the different terms and approaches used in the responsible investing universe. But terminology is not the only wide ranging feature in this space. The importance of different ethical, social and sustainable issues (e.g. climate change, resource scarcity, labour rights and corporate governance) can differ vastly from one individual to the next and from one fund to another. As such, determining what matters to you when investing is the first step you should take when approaching the responsible investment universe.

While some investors may ponder whether or not a focus on environmental, social and ethical issues has a place in investment markets, the findings from over 2,000 academic studies show a high correlation between sustainable business practices and corporate financial performance. This means an orientation towards long-term responsible investing can be incorporated into a portfolio without sacrificing its return objective, as can be seen in the chart below.

ethical graph

A closer look at some of the factors considered in the ESG space provides some insight into the findings of these studies, and is an aspect we already incorporate into our investment approach (specifically on the governance front). The ethics, vision and integrity of management and the board, and how a company conducts their business (not just what they do) can have a huge impact on the long-term success and performance of a company. Embracing standards for responsible business behaviour encourages closer analysis of a business’s practices and supply chain by management, and the setting of targets that must be measured, reported on and hopefully improved on from year to year.

Adopting an ESG stance can also help to position portfolios to take advantage of opportunities in the market arising from regulatory changes and advancements in technology. Meeting emission reduction targets is a prime example of this, with demand for clean energy, efficient power grids and energy efficient buildings expected to continue to rise. On the flipside, technological advancement and cost declines in areas such as water technology, industrial automation, renewable power and energy storage (e.g. batteries) pose a threat to incumbent industries and demand for such things as fossil fuels.

ethical graph 2

Common strategies in the responsible investment space

Historically, SRI funds have tended to adopt a ‘negative or exclusionary’ methodology where companies or sectors were excluded from a portfolio based on social, ethical or religious criteria – the most common of which relate to areas such as weapons, tobacco, alcohol and gambling. However, like all things, deciding on what to exclude is fraught with challenges. For example, it is easy to exclude companies that manufacture alcohol and cigarettes, but should you also exclude companies that sell them, such as supermarkets? How far one casts this net will clearly be dependent on the importance of such issues to each individual. However, consideration needs to be given to what impact this (i.e. the degree of exclusions) will have on a portfolio’s investable universe, diversification and investment returns.

A further area of contention of this exclusionary strategy is that even if a company is excelling in other areas such as corporate governance, health and safety or waste reduction it could not be considered for investment due to the industry or sector in which it operates.

Today, index providers and portfolio managers are adopting a more dynamic ‘positive or best in class’ approach to investing, focussing on a broader range of environmental, governance and social factors. This involves digging deeper into each investment to determine factors such as whether the company is considered to be making a positive social contribution, is seeking to minimise adverse environmental effects from their operations, has strong governance practices, and ethical standards in place.

Companies are scored on these and other factors, with those scoring above a pre-determined threshold being eligible for inclusion in an index/fund. Controversial sectors may, or may not be, specifically excluded using this approach. However, if they do not meet the best in class minimum standards they will not be eligible for inclusion. In some instances, companies with an exposure to controversial sectors may be included in an index or portfolio where the manager believes engagement with the company can improve their ESG related policies and practices, or where the less than desirable activities only make up a small part of a company’s operations. This is why understanding the methodology adopted by the index provider or fund manager is of utmost importance when investing in this space.

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Some examples of key environmental, social and governance criteria assessed and scored by market providers and managers are shown in the table above.

Sustainability themed investing’ is another approach to responsible  investing and tends to be focussed on specific environmental issues such as clean energy, green technology or sustainable agriculture. However, investors need to be aware that the significantly more concentrated nature of this approach has historically resulted in a higher level of volatility and a greater variance in returns versus the broader market.

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Market Players

The task of assessing a company’s principles in relation to social, environmental and governance factors has been made easier over the years by the growing number of indices, rating agencies (RobecoSAM, Ethisphere, Bloomberg and Sustainalytics) and providers (BlackRock, iShares, SPDR, Guggenheim, PowerShares) operating in this space.

The three large index providers (MSCI, FTSE and Dow Jones) have developed a number of indices that cross the spectrum of the responsible investing space (see the table above). While some providers, such as MSCI, have their own in-house global ESG research team who score companies based on the team’s own proprietary analysis, others such as Dow Jones collaborate with specialists in sustainability investing (RobecoSAM) to create their sustainability index family. However, as noted earlier, the methodology adopted by each index provider can differ substantially, even across their own suite of indices. As such, while the plethora of options available that has taken a lot of the leg work out of assessing companies, investors still need to give consideration to the methodology adopted by the index providers or fund manager to ensure they align with their requirements.

Not all the indices available in the responsible investment space are easy to invest in. For example, there are no listed ETFs (Exchange Traded Funds) that track the performance of the FTSE4Good family of indices. However, these indices and the lists produced by the different rating agencies can be used as a guide for investors wishing to build an exposure to individual company names.

The growing number of options in this space is a clear indicator that the integration of environmental, social and governance considerations into mainstream business practice and everyday investing decisions has become increasingly prevalent as individuals ascribe more value to not only financial performance but also companies that are contributing to making the world a better place.

Please note: This article was first published in the August 2017 edition of News & Views under the title “Doing good – the case for ethical investing”. Craigs Investment Partners clients can view the latest edition of News & Views, which includes the full version of this article, by logging in to the Client Portal.