WHY IT PAYS TO BE GOOD

It feels nice to know your cash is being invested in ethical companies – and data shows
that the returns are equally virtuous

BY DAVID PROSSER 

Should investors worry about the way companies behave? For increasing numbers of us, the
answer is definitely yes. Not only because many people want to put their money to work with
organisations whose values they share, but also in light of the mounting evidence that companies
with responsible and sustainable business practices deliver superior investment returns.

This is why the use of environmental, social and governance (ESG) data is now so important to
many investment funds. In a world where we face threats such as Covid-19, climate change and
income inequality, and with growing recognition of the damage that poor corporate stewardship
can do to businesses in the age of social media, this data can help investors manage risk.

Investors might be promised that their funds will never

invest in oil, gas or defence
Indeed, there is a growing body of research suggesting that investing in this way can protect
investors. Data from Morningstar, for example, reveals that ESG led funds provided much more
resilient returns during the market volatility of the Covid-19 pandemic earlier this year.
“We use ESG data as an additional lens in every investment decision we make,” explains
Stephen Metcalf, an associate in global manager research at RBC Wealth Management. “It is a
means with which to make smarter decisions and to drive better financial outcomes.”

Investors often demand nothing less, with money pouringinto ESG focused funds over the past
year. And from 2021 onwards, the European Union will require all investment managers to
publish data on the sustainability impacts of their portfolios, driving even greater scrutiny of the
records and behaviours of the businesses in which they choose to invest.
 
However, for investors exploring these ideas for the first time, it is important to be clear on what
different styles of ESG investment offer. Not all funds are alike.

Some products – often known as responsible investment funds – very deliberately screen out
certain types of company when building a portfolio; investors might be promised, for example,
that their funds will never invest in the oil and gas sector, or in defence companies.

Other funds focus on sustainable investment; rather than making moral judgements, managers
use ESG data as part of their investment process on the basis that sustainable businesses will
deliver stronger long term performance. That might be because, say, a renewable energy
business looks to have strong prospects in the transition away from the carbon based economy,
or because a clothing retailer faces potentially adverse effects from problems in its supply chain.

Different approaches suit different types of investor, depending on their views and investment
goals. But given companies with strong ESG data have this year outperformed their non ESG
counterparts, just another example of their resilience – along with the growing awareness of
investors of all ages – this type of investment looks set to continue growing in popularity.

ESG JARGON EXPLAINED

ESG: an initialism that stands for environmental, social and governance; this is a way to describe
the issues that investors may take into account when seeking to invest responsibly or sustainably.
Responsible investment: an investment style in which the fund manager deliberately avoids
businesses involved in certain activities or industry sectors. A range of different types of screen
are available, with focuses on issues such as environmental change, tobacco, alcohol, gambling,
and arms manufacturing and defence.
Sustainable investment: an investment approach in which the fund manager takes into account
ESG factors alongside traditional financial metrics when making investment decisions. Such
funds work on the basis that businesses with higher ESG scores are likely to deliver more
resilient performance over the longer term.
Impact investment: an approach where investors look for a measurable social or environmental
return on their investment. Impact investment is not outright philanthropy, as investors typically
look for a financial return too.
DO ESG INVESTMENTS REALLY OUTPERFORM?
A growing body of research suggests that funds taking ESG data into account deliver superior
long term investment returns. For example, a study published earlier this year by Morningstar,
looking at 745 such funds based in Europe, found that the majority of strategies had
outperformed their non ESG counterparts over the previous one, three and five years.
Another recent study reached similar conclusions about more short term performance. It looked
at the performance of ESG funds during the market downturn earlier this year and concluded that
more than 60 per cent had managed to beat global stock market indices. In other words, funds
using ESG investment criteria had provided investors with crucial protection from the worst of
the volatility.
There are good reasons to think this outperformance will continue – and even accelerate. ESG
funds are effectively reducing their exposure to companies carrying environmental and social
risk – carbon intensive businesses likely to suffer in the move to carbon neutral economies, for
example, or businesses at risk of reputational damage because of the way they treat employers,
suppliers or other groups.
As scrutiny of businesses involved in these more risky practices continues to increase – boosted
by social media, the growth of advocacy and protest groups, and the rise of ideas such as
responsible capitalism – the risk of being invested in them is likely to grow even higher.