Sustainable team Handelsbanken Wealth & Asset Management
28 Nov 2019 8
Investors looking to invest their money sustainably can be faced with a dizzying array of terminology to decipher. Indeed, labels in the sustainable investment space are many, varied and overlapping.
While this can seem overwhelming, we think that keeping five key points in mind when approaching sustainably-branded investment options can help to clear the fog:
A clear mission statement
What are sustainable managers aiming to achieve? What is the intent of the investment portfolio?
Evolution
Sustainable investing is changing rapidly. The next iteration of sustainable money will not go to the same places as the last. The labels discussed below will no doubt shift, merge, grow and disappear in the coming years.
Authenticity
Due diligence will show up which funds are acting in the spirit of sustainable investing and which are merely adopting the label.
Relationship
Investment managers and advisors can now add two sources of value to clients: financial and non-financial. It is increasingly important for managers to select and explain investments simply and accurately.
Disclosure
Transparency is key. Investments need to demonstrate their sustainable credentials, and a fund must do what it says.
But while these points are crucial in understanding the spirit and intent of investment products, investors also need to know how to interpret product existing labels. Our explanations below describe some of the terms investors may come across.
1. Exclusion/negative screening
What is it?
Excluding assets from an investable universe on ethical or sustainability grounds (e.g. investing in the UK stock market, but excluding tobacco, alcohol, gambling and defence stocks).
Developed as a style by religious groups who wanted bespoke portfolios to align with their religious beliefs.
The good
This is a good way of expressing views in a simple, pure way.
It is easy to understand, so investors know what their portfolio is doing.
The bad
This approach does not involve any engagement with or incentivisation for excluded companies or sectors to improve their behaviour or environmental, social, and governance (ESG) impact.
The other (grey areas)
Some argue that depriving a sector of investment means that those remaining invested will enjoy higher returns (though this is not necessarily evidenced in practice).
Approaches like this require limits. For example, tobacco producers are excluded, but what about tobacco distributors, or companies in the supply chain? What about an industrial company that derives some of its revenue by selling to the defence sector? Usually this is addressed via a revenue limit – e.g. not more than 5% of revenues from involvement in defence.
2. Impact investing
What is it?
Investing with a non-financial goal alongside a financial goal (e.g. investing in renewable energy cannot only deliver strong risk-adjusted returns, but also clean energy).
The good
Investors are able to potentially achieve two goals simultaneously.
Impact investing can be highly targeted, such as aiming at very specific social or environmental problems.
The bad
The range of impact investments on offer tend to be less well diversified than traditional investing.
The other (grey areas)
Investors must be disciplined in not accepting projects with poor financial potential and strong non-financial potential – impact investing is not philanthropy.
Due to a general desire to ‘do good’, some would say that impact investing attracts too much capital, leading to lower returns, but evidence varies on this point.
3. Sustainable Development Goals-linked investing
What is it?
Investors try to link their portfolios to the UN’s 17 Sustainable Development Goals (SDGs).
This is not a mutually exclusive style of investing – impact, thematic, ESG integrated approaches all aim to achieve variations on this theme.
The good
The SDGs are internationally recognised and accepted, and easy to understand.
The bad
A loose alignment with SDGs can mislead investors into believing a product is more sustainably-focused than it really is (see below).
The other (grey areas)
A company with a minority of its work aligned with an SDG might be labelled as ‘SDG-linked’, despite the majority of its business not falling into this category (this is known as ‘greenwashing’). This can be helped through clear disclosures (from companies) and clear limits (from investors) on acceptable minimums for SDG-oriented business activity.
4. Best-in-class investing/ positive screening
What is it?
Each company is scored on ESG criteria, and only the highest ESG scorers in each sector are invested in (e.g. invest in BP, but not Shell).
The good
The more investors choose this approach, the more a company is incentivised to improve its ESG impact, because better companies receive more funding (implying a lower cost of capital for the business).
The bad
This approach incorporates substantial grey areas (see below).
The other (grey areas)
Much depends on the ESG scores, but different score providers have different methodologies and output.
Scores are also inherently lagged (backward-looking), and disclosure from businesses is not consistent.
This approach does not necessarily take into account the industry a business is in (e.g. investing in BP instead of Shell is not helpful if you don’t want any exposure to fossil fuels in your portfolio).
The cut-off for ‘best’ can be arbitrary – for example, the index-provider MSCI tends to use the best scoring 25% or 50% of businesses.
5. ESG (environmental, social and governance) integration
What is it?
ESG factors are explicitly included in the investment process.
Like SDG-linked investing, this is not a mutually exclusive style, as ‘best-in-class’ investing would also be a form of ESG integration.
The good
Many would say it is part of an asset manager’s day job to consider ESG, and by accurately assessing ESG risks and opportunities one can build a portfolio that delivers superior risk-adjusted returns when compared to a portfolio that does not consider ESG factors.
The bad
Inconsistency (see below).
The other (grey areas)
Each manager integrates ESG in a different way - the responsibility may fall on the managers themselves, or fall to a specialist ESG team.
There is again the potential for an asset manager to say they are integrating ESG whilst providing little evidence of this. This is particularly true for managers trying to invest in low scoring companies in the belief that they will improve their ESG impact. A fund taking this approach could therefore, on the surface, have ‘worse’ ESG characteristics than a non-ESG-integrated fund!
6. Thematic investing
What is it?
Picking a theme or societal trend and investing in companies involved in that space, or set to benefit from that trend.
Water stress could be a theme, and a thematic fund could then invest in water companies that are involved in water supply/efficiency/technology.
The good
Easy to understand for investors.
Inherently forward-looking. Far from relying on historic data, thematic investing is about predicting what will be important in the future.
The bad
The strength of thematic investing is also its weakness: investors have limited historical evidence/data to work with when considering new trends.
The other (grey areas)
As with SDG-linked investing, thematic managers can over-emphasise a small percentage of a company’s business operations in order to justify a place in the portfolio. Again, this can be helped through limits on acceptable minimums for thematic business activity.
7. Engagement investing
What is it?
In the same way that asset owners can engage with a company to improve business/financial performance, investors are increasingly engaging with companies to improve their ESG impact. This could be via voting, management meetings, disclosure requests, or proposals to the Board.
The good
Active ownership makes for good and proper stewardship of client assets.
The bad
The role/capability of ‘passive managers’ (who invest according to the stock or sector weightings of an index, also referred to as ‘indexing’ or ‘tracking’) in engagement activities is unclear.
The other (grey areas)
Investors intending to take on engagement activities must first ask themselves which elements of ESG are important to the businesses they invest in.
They must also decide whether or not to co-ordinate with other investors to take action.
8. Socially responsible/sustainable investing/blended approach
What is it?
Usually used as a high-level title for investment strategies that incorporate one or more of the other investment strategies outlined in this article.
For example, MSCI have SRI indices which incorporate both negative screening and a best-in-class approach.
Another example, Heartwood’s sustainable funds include negative screening, best-in-class, ESG integration, thematic and impact investing!
The good
Can draw on the strengths of multiple approaches.
The bad
Inconsistency (see below).
The other (grey areas)
As these funds are high-level in title, they often require more explaining than other types of investing.
Remember: perfection can be the enemy of good
While there are complexities, grey areas and ambiguity involved in sustainable investing, this must not dissuade people from investing sustainably. When it comes to sustainable investing, we believe perfection can be the enemy of good.