Is it time to consider ESG investing?

The coronavirus pandemic is confining many of us to our homes and shutting down industrial activity across the globe. Not only is the pandemic causing a devastating impact on our health, but concerns about the economy have caused a drag on stock and bond markets too.

But there might be one small silver lining. Satellite imagery shows our inactivity is temporarily limiting air pollution levels.

In recent years environmental, social and governance (ESG) funds have proven popular and thinking about ESG when building a portfolio has become increasingly important for investors.

But you don’t have to be an environmentalist to consider ESG factors when you invest. Issues related to the way a company is managed, or its effect on the environment and society can cause reputational damage, impact profits and drag down a company’s share price.

This matters today more than ever. In a world dominated by social media, a company's misdeeds appear on the news feeds of millions in a matter of hours, potentially sparking outrage, backlash and boycott.

With pollution levels down and societal issues high on the agenda, we’ve taken a look at ESG in more detail. In this article, we look at the evidence behind ESG and give you some practical tips on how you could add ESG into your portfolio.

This article isn’t personal advice. If you're not sure what’s right for your circumstances, please ask for advice. All investments and their income fall as well as rise in value, so you could get back less than you invest. Past performance is not a guide to the future.

ESG – what's the evidence?

There's ever increasing research that suggests a link between companies taking ESG seriously and their corporate financial performance.

A 2012 Deutsche Bank study combined the results of over 160 academic studies, research papers and literature reviews. All of the papers they looked at suggested that companies taking ESG seriously tend to benefit from a lower cost of capital – i.e. investors perceive them as lower risk. 85% of the papers they looked at suggested good management of ESG issues leads to better corporate financial performance. 89% of the papers demonstrated a positive link between ESG and stock market performance. However the study also noted that investors weren’t always good at capturing that outperformance.

Other more recent studies have suggested that the stock market is now better at pricing in ESG information into share prices. This makes it harder for investors to use ESG analysis to gain an advantage over others. It's still important to carry out ESG research though. If you don’t it could lead to investors undervaluing companies with strong ESG credentials, and overvaluing those that take ESG less seriously.

There's also evidence that engaging with companies on ESG issues adds value. For example, a study of investor activity in the extractive sector showed a 4.4% additional return from companies that engaged with shareholders. They also tended to be less volatile than their peers.

It's tough for individual investors to engage with companies. But when you invest in a fund, you leave that responsibility to a fund manager. They often have a pretty big stake in companies which means they can make sure their voices are heard on issues they think will benefit investors.

How can you mix in ESG into your share portfolio?

ESG is just good risk management. Just as an investor should be aware of a company's competitors, amongst other things, they should also understand environmental, social and governance risks that could impact a business. There are a number of ESG factors that investors could consider. We’ve listed some of them below.

Environmental

• What are the company's direct carbon emissions?
• Does the company create other toxic emissions?
• What's the carbon footprint of its products?
• How vulnerable is the company to climate change?
• What packaging does the company use for its products? Is it recyclable?
• How does the company manage its water use responsibly? How does it dispose of wastewater? Would it suffer if water use was restricted?
• How does the company manage its impact on biodiversity?
• How does the company manage its energy and fuel requirements?
• Is the company at risk of increased media focus on the environment?

Social

• Does the company treat its staff, customers and suppliers well?
• How does the company approach diversity? Do they have a policy on diversity and inclusion?
• Does the company have measures to prevent bribery and corruption? Is there a bribery and corruption policy?
• How does the company ensure data security and customer privacy?
• Are the company's marketing and advertising practices fair?
• How does the company ensure product safety and quality?
• Does the company ensure high labour standards throughout its supply chain?
• Can the company benefit from social opportunities (is it providing access to healthcare, finance or communications, for example)

Governance

• Are company managers paid appropriately and in line with the interests of shareholders? Is there proper disclosure on executive pay?
• Do the managers receive appropriate scrutiny from an independent board? Is there separation of the Chairman and CEO roles? How many independent directors are there on the board?
• Does the company use fair accounting practices? Is it transparent in its approach to taxation?
• Does the auditor have a positive opinion of the accounts?
• Do all shareholders have equal voting rights?

You can get this information from a number of sources, including the ESG disclosures in a company's financial reports and its website.

You might not be able to answer every one of the questions for every company you think about investing in, and very few companies will score 'full marks'. Just because a company falls short on a couple of measures though, it isn't necessarily a bad investment. But it’s something to consider when building your investment case.

It's also worth remembering that the importance of these questions depends on which sector a given company operates in. For example, water restrictions would have a much greater impact on companies that need clean water to make their products, like those in the food and drinks industry. On the flipside, water restrictions wouldn’t have much impact on a company involved in financial services. For these companies, fair marketing and advertising practices are a greater concern.

More about ESG investing

What if I want to invest in funds?

When you invest in a fund, you leave the responsibility of company research to a fund manager.

Fund managers are increasingly recognising the value of ESG and most mainstream managers are integrating ESG into their investment processes in one way or another.

If you want to find out how a fund manager approaches ESG, you can start by checking the fund documents, such as the factsheet. A fund manager's website can also be a useful resource for ESG-related information.

But if you want to be more proactive in your approach, you could go a step further and consider investing a portion of your portfolio in a responsible investment fund. There are a number of approaches responsible investment funds can take. To find out more about the various approaches, read our guide.

We look at three ESG funds below. All of them engage with the companies they invest in to push positive change, in the interests of investors. This is not personal advice or a recommendation to invest. If you’re not sure if an investment is right for you, please seek advice. Remember, that each of the following funds take a different approach to responsible investing. You should carry out your own research to make sure responsible funds invest in a way that's in line with your attitude to risk and personal ethics. These should be held as part of a diversified portfolio and they won’t be suitable for all investors. For more information, please refer to the Key Investor Information for each fund.

Kames Ethical Equity

Kames is a fund management company focused on responsible investing. They aim to identify and understand the key environmental, social and governance risks of each company, industry and sector they invest in. They believe companies that lead the way in governance and sustainability tend to outperform over the long run.

The Kames Ethical Equity Fund has been managed by Audrey Ryan for more than two decades. She's a passionate ethical investor with a good track record.

Ryan uses a strict approach and excludes certain areas completely. She won’t invest in companies involved in activities deemed unethical, from tobacco and alcohol producers, to munitions manufacturers and companies that use animal testing.

More than two thirds of the UK’s largest companies are excluded from the fund's investment universe for ethical reasons. This means there’s a focus on higher-risk small and medium-sized companies. Our analysis suggests this has helped the fund deliver stronger performance than the broader UK stock market over the long term. Remember though past performance isn't a guide to future returns.

We think Ryan has the potential to deliver good returns for ethical investors over the long run, although there are no guarantees.

This fund currently holds shares in Hargreaves Lansdown plc.

Past performance is not a guide to the future. Source: Lipper IM to 30/04/2020.

Find out more about Kames Ethical Equity including charges

Kames Ethical Equity Key investor information

Legal & General Future World ESG Developed Index

We think the Legal & General Future World ESG Developed Index is a good option for broad exposure to global stock markets, while being mindful of ESG issues. It invests in almost 1300 companies across the globe and aims to track the Solactive L&G ESG Developed Markets Index.

The index increases investments in companies that score well on a variety of ESG criteria – from the level of carbon emissions generated, to the number of women on the board and the quality of disclosure on executive pay. It also reduces exposure to companies that score poorly on these measures.

The fund won't invest in tobacco companies, pure coal producers, makers of controversial weapons (such as cluster munitions, anti-personnel mines and chemical and biological weapons) or persistent violators of the UN Global Compact Principles (a UN pact on human rights, labour, the environment and anti-corruption).

Legal & General has been managing tracker funds for more than three decades and is home to the biggest index tracker team in the UK. That means it's got the resources and expertise to track indices as closely as possible. The managers' flexibility to invest in derivatives adds risk though.

Since launch in April 2019, the fund's tracked its index well, although this is a relatively short period of time and past performance isn't a guide to the future.

Past performance is not a guide to the future. Source: Lipper IM to 30/04/2020.

N/A - Full year data before 2019 is unavailable.

Find out more about Legal & General Future World ESG Developed Index including charges

Legal & General Future World ESG Developed Index Key investor information

BNY Mellon Sustainable Real Return

The BNY Mellon Sustainable Real Return Fund is a more conservative option for investing responsibly. Launched in April 2018, the fund follows the same robust investment process, implemented by the same team, as the BNY Mellon Real Return Fund – which has been on the Wealth 50 (and formerly the Wealth 150) since December 2010.

The team aims to make money in a variety of market conditions. The fund's 'return-seeking core' accounts for around 60% and invests mainly in the shares and bonds of well-run, financially secure companies. They think these companies have a unique set of advantages over their competitors. They also consider how well those companies manage their impact on the environment and society. The rest of the portfolio is invested in government bonds, commodities and cash, with the aim to dampen volatility.

The fund's sustainable 'red lines' ensure companies that violate the UN Global Compact Principles and those incompatible with the aim of limiting global warming to 2°C aren’t considered. It also won't invest in any company that makes more than 10% of its revenues from tobacco.

The fund's performed better than its peers in the IA Targeted Absolute Return sector since launch, but is slightly behind its official benchmark, LIBOR +4%. It's early days though and we think the combination of an established, robust process, with an experienced team could mean this fund has the potential to do well over the long run. Although remember there are no guarantees and past performance is not a guide to the future.

The managers' flexibility to invest in high-yield bonds, emerging markets and derivatives adds risk.

Past performance is not a guide to the future. Source: Lipper IM to 30/04/2020.

N/A - Full year data before 2018 is unavailable.

Find out more about BNY Mellon Sustainable Real Return Fund including charges

BNY Mellon Sustainable Real Return Fund Key investor information

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