22 Sep 2019
I hope to shed some light on the many different areas of ethical investing; its historical context, what some of the terms mean, the implication for investment risk and return and the universe of investment options now evolving in the UK. This first article outlines what sustainable investing is and puts it into a historical context. The second will cover the different approaches available to investors and how the market is developing.
It seems that you can’t turn the page of any financial publication without seeing that we should be investing more ethically. Socially Responsible Investing (SRI for short) is the new hot topic for advisers and ESG factors are now a serious consideration when appraising investment options.
In the UK, funds with a specific ethical mandate now have assets of £18bn invested, but that figure is many multiples higher if you also count those funds which include some ESG or sustainable screening in the investment process. This can be confusing for advisors and even more so for clients as everyone seems to have a different interpretation of what ethical investing means to them. Understanding that point, or at least clarifying that question, means that you are on the first step to guiding the client through the myriad of investment options.
Ethical investing is not a new concept and has a rich history dating back many hundreds, if not thousands of years. The Jewish concept of tzedek, which means righteousness, justice and equity, is enshrined in the Torah and puts down laws which govern, amongst other things, redressing imbalances in economic life. The Islamic faith has a number of rules, or sharia, which govern all that is forbidden or haram.
The root of modern, ethical and socially responsible investing can be pinpointed as the period during the 18th century when the Quakers in the US were prohibited from participating in the slave trade and in England, the founder of the Methodist church, John Wesley, gave a sermon entitled ‘the Use of Money’. In the sermon, Wesley outlined three tenets or rules detailing how people should use their money: “Gain all you can, Save all you can, Give all you can”, but he does put limits on these. He stated that you should not gain at the expense of your life or health or of those of your neighbour. In 1798, Malthus penned ‘Essay on the principles of population’, a warning that the growth in population could outstrip the Earth’s resources’ ability to support them.
The first public UK ethical funds were marketed in the UK in the early 1980s. These funds followed the path of the early US ethical mutual funds from the late 1960s and early 1970s. Exclusionary screens were applied, preventing investment in weapons manufacturers during the period of the Vietnam war and in South African companies, during the apartheid regime in South Africa. There had previously been a tradition of managing investment funds on behalf of religious organisations and charities using their own philosophies to determine their investment policies. Friends Provident, which has been a Quaker organisation until fairly recently, launched the Stewardship fund in 1987. The fund used strict screening to exclude a range of companies whose businesses operated in industries such as tobacco and arms manufacturing. Many found that this strategy restricted the investable universe too much, increasing the risk of the investment.
Today, many investment firms have taken the screening principle and refined it, making it more nuanced in its application. Previously a big oil firm would be excluded from a portfolio but investment is now considered in energy companies that strive to produce products that are more environmentally friendly, or who are looking to diversify their product portfolio towards cleaner energy technology.
The lexicon of ethical investment terms is expanding as fast as the assets under management, with sustainability and ESG being two of the most common terms. However, there is often confusion as to what these terms mean. To some, sustainability means signing up to the U.N’s Sustainable Development Goals (SDGs). This objective was adopted by all United Nations Member States in 2015 and provides a blueprint for future peace and prosperity. There are 17 goals in the form of an urgent call to action for all countries covering a range of issues such as the elimination of poverty, promotion of peaceful and inclusive societies, conservation and sustainability of the oceans, through to ensuring access to safe and affordable sources of power. The aim is to achieve each of these goals by 2030. Although these objectives are aimed at nation states, companies can use the framework and apply it to their investment philosophy. The ‘Brundtland Report’ of 1987 outlined the definition of sustainable development as follows: “development that meets the needs of the present without compromising the ability of future generations to meet their own needs”. In essence it asks if the way in which a company operates means that it will be around in the future.
Investors are not only using financial analysis to appraise potential companies to invest in but are also integrating environmental, social and governance consideration (ESG) into the analysis process. These three risk factors, which fall under the sustainability umbrella, are becoming increasingly important and can mean that it takes ethical investing away from its religious roots and places it on a more scientific footing. Companies are scored on how they address issues at a corporate level, or how their internal policies relate to issues such as corporate governance, workers’ rights and health and safety. Executive pay is also coming under greater scrutiny. In the environmental sphere, how are companies dealing with environmental concerns such as corporate waste disposal and pollution? These are seen as risk mitigation factors and will give an indication of how engaged the senior management is in adapting to the changing risks in the world and highlights whether the companies that they run have a sustainable business model. This is seen as essential, particularly when companies operate in less developed countries that may not have high environmental standards, or countries where corruption is a part of everyday life. An example would be a mining firm operating in Africa; does the firm have up to date policies on health and safety, transparent governance and tight environmental procedures? If it does, it is likely to be more sustainable than a mining firm that is highly polluting, where work-associated deaths are common place and the long-term viability of the company is unknown.
All of these factors will have long term financial implications for companies. A Credit Suisse report suggests that firms with higher ESG scores tend to have lower cost of capital, leading to higher profits and valuations and benefitting the investor. This was echoed by a 2017 report from Hermes Investment Management which highlighted a significant relationship between ESG factors and credit spreads, or to put it another way, bond issuers with stronger ESG performance benefit from lower credit defaults.
Fund managers are increasingly citing ESG considerations in their stock or bond selection process but they must avoid ‘greenwashing’ or putting on a thin veneer of ethical gloss on their funds. Fund managers who do not truly integrate ESG as a way of assessing potential stocks may face criticism and are potentially hampering their future returns.
Robin Ghosh, Investment Research Manager, RSMR
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This information is for UK Professional Advisers only and should not be given to retail clients.The value of investments and the income from them may go down as well as up and investors may not get back the amounts originally invested.
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