What you need to know about sustainable investing
As sustainable and ethical investing enters the mainstream, there are various approaches for clients to take
In the past, investing in a sustainable or ethically managed fund has been for the few. But now these types of funds and investments are gaining wider appeal among a range of clients.
In its Schroders Global Investor Study 2018, the asset management group found only a quarter of UK investors are concerned that investing sustainably would hinder investment outcomes.
This type of investment approach has, more often than not, been associated with sacrificing returns.
Jessica Ground, global head of stewardship at Schroders, says: "This survey underlines the rapid growth of interest in sustainable investing. The fact that 56 per cent of investors have increased their allocation to sustainable investments in the past five years tells you how important this is for so many people.
“Specifically, it’s encouraging to see that investors no longer appear to be held back from investing sustainably by concerns that this approach may hamper returns."
Ms Ground acknowledges there remain "barriers" preventing investors from taking this approach.
Read on to find out more about how advisers can help clients who want to align their investment portfolios with their lifestyle choices.
Half of advisers talk about SRI with millennials
More than half of advisers are very likely to recommend a sustainable and responsible investing (SRI) fund to millennials, according to the latest FTAdviser Talking Point poll.
The poll asked how likely are advisers to recommend an SRI fund to a millennial.
A total of 52 per cent said they were very likely to recommend an SRI fund, while 20 per cent said they were unlikely to.
A total of 16 per cent said they would never recommend an SRI fund to millennial clients.
Julia Dreblow, founder of sriServices and fund hub Fund EcoMarket, said the result was not surprising.
She said: "Advisers know this area is ‘very now’ and understand that younger investors have a better grasp of issues like sustainability, human rights and climate change than older investors."
SRI investing has become a popular theme across the industry and is also known as impact, responsible or ethical investing.
As more low cost, well diversified SRI funds gain traction and move into the mainstream, we will see an increasing number of advisers begin to recommend them.
Ms Dreblow said: "The big topic is definitely climate change - particularly major oil and gas companies versus renewables.
"Younger investors typically focus on positive stock selection and investing in ways that help deliver positive impacts."
Jason Witcombe, a chartered financial planner at Progeny Wealth, said while he is not surprised by the results, SRI funds are popular for all investors, not just millennials
Mr Witcombe said: “As more low cost, well diversified SRI funds gain traction and move into the mainstream, we will see an increasing number of advisers begin to recommend them.”
CPD: How to help clients approach sustainable investing
Words: Melanie Tringham
Sustainable and ethical investing has moved on from simply applying a negative screening process
Ethical, or sustainable investing, has become much more popular in recent years, especially with the adoption of the Paris Agreement on CO2 emissions three years ago.
Sovereign wealth funds’ subsequent focus in this area, as well as general raised awareness of human impact on the environment, is making many investors much more mindful about whether sustainable or ethical investing features on their radar.
This approach has become much more mainstream, with over 190 funds qualifying for inclusion in a sustainable portfolio, although this very much depends on exactly what the investor, and adviser is defining as sustainable.
Ultimately, the concept of having to make financial sacrifices in order to adhere to one's principles has largely gone out the window, except in the most extreme circumstances, when strict criteria limit one's investment choices, and hence diversification.
Lifting the lid
Jamie Jenkins, lead manager of the F&C Responsible Global Equity Strategy, says: "The whole space is not helped by the number of different labels around this space.
"The main labels are: ESG [environmental, social, governance]; 'responsible' and 'sustainable'. SRI [sustainable or socially responsible investing] has fallen by the wayside.
"When you lift the lid on most of these products, they're all trying to achieve the core objective: it's trying to invest in companies - through equities or bonds - that are trying to make a more positive contribution to society and the environment, and not to direct capital to companies which have damaging or unsustainable business practices ."
He goes on: "I would say there’s an increasing requirement or expectation that all equity funds integrate ESG into their investment process. There are many traditional funds that are putting themselves in this ESG model.
“We do integrate ESG across all our funds, but the process I’m running is one of our active ESG funds.”
Arguably the most common and traditional process used by ethical and sustainable funds is screening, which can come in both positive and negative forms.
ESG factors are also spreading out across the corporate universe, so that as awareness of companies’ environmental impact is becoming a more significant factor for shareholders, so companies are being forced - and for financial reasons too - to move ESG factors further up their agenda.
This means that ESG investing can take a number of forms; for example, one investor might be interested in investing in BP if it has made efforts to restrict the environmental impact of its business.
But for another investor, BP is completely off limits because it transacts in fossil fuels.
So some funds allocate capital where environmentally-friendly policies make commercial sense, such as cutting down on waste, whereas others do so as a specialist environmental policy, investing in companies that are contributing to sustainable development.
Mr Jenkins explains: "For example, our fund is fossil fuel free - we are a low carbon strategy.
"But it’s very important to understand that we’re not expecting our investors to compromise on the return they get by investing responsibly. This is designed to be a high performance product, but we believe in investing responsibly."
Picking the right approach
There are a number of difference approaches that a client will take to ethical investing, in terms of what they mean by ‘ethical’.
According to Bestinvest, the most common way of adopting an ethical approach is screening out undesirable stocks.
In a research note on ethical investment funds, its senior research analyst Louie French says: “Arguably the most common and traditional process used by ethical and sustainable funds is screening, which can come in both positive and negative forms.
“Typically, a fund manager will take a benchmark, such as the FTSE All-Share or MSCI World, and screen out all the companies that are deemed unethical or unsustainable.”
The common type of stocks that an investor will screen out tend to be involved in the arms industry or tobacco.
Alternatively, stocks can be screened for the positive impact they are making on society or the environment.
Another way to invest ethically is to look at 'best in class'.
Mr French says: "The best in class approach is when a fund selects a company that has better ethical and sustainable policies than industry peers.
“For example, if the ethical criteria in an investment strategy allows a fund manager to invest in the banking sector or the oil and gas sector, the fund manager would be expected to select the oil and gas company with the best environmental record, or the bank with the best ethical policies.”
“Engagement” is another approach, he says, which uses shareholder influence to actively pressure companies to employ better policies.
I think people have always been interested in things that have a positive social and environmental benefit.
Many funds, he adds, have outside experts to help monitor their progress in sticking to their principles.
Certainly, when a client comes to an adviser wanting to set up an ethical portfolio, then there are certain procedures that the adviser must go through, and practices vary among the specialist ethical advisers.
But the typical investors do not tend to be millennials.
John Ditchfield, partner at Castlefield Advisory Partners, explains: “The industry wants that to be the case but, if you ask young people if they had any money where would they invest their money, it would be in sustainable investment, but I don’t think it’s been tested.”
The main problem with this notion is that most millennials do not have much money to invest in the first place.
Mr Ditchfield adds: "I think people have always been interested in things that have a positive social and environmental benefit.
"We say: Option A will give you a good financial return but will hold tobacco companies that are trying as hard as they can to ensure young people in the developing world take up smoking.
"Or you can have option B, which can deliver a broadly similar financial return, you’ll be investing in some other interesting [ethical] sectors -and most people will say that they will have option B.”
Some will say they’re concerned about everything and we have to exclude everything.
Andy Hockaday, is a chartered financial planner at another ethical investment firm, Investing Ethically.
When a client comes to him asking for an ethical portfolio, he says that he goes through the usual initial stages, such as attitude to risk, and what they are investing for, to determine the asset allocation.
He says: "The difference is, ethical gets taken into account, and the starting point of that is to complete an ethical questionnaire, to find out what’s important for the client.
“There’s a lot of areas a client might be concerned about, but with the questionnaire they give an idea of how important these areas are.”
For example, they may be interested in supporting different activities around renewable energy or social housing; there’s lots of different types of sustainable or ethical investing, it is what’s most important for the client.
"Some will say they’re concerned about everything and we have to exclude everything," Mr Hockaday adds.
The starting point, he says, is that the the client is “fairly inclusive”, with only a few things that he or she wants to support. This means that the client has a wide range of funds to choose from, and it is fairly straightforward to build a diversified portfolio.
He says: “If you say, ‘I don’t want to invest in arms and tobacco', you can pick from 100 funds, and you can be diversified but you won’t lose out financially. You will have periods of underperformance but this will be outweighed by periods of outperformance.”
Amazon is a frequent, more specific request, due to its working conditions, controversial tax policy and impact on other retailers, and in this case Mr Hockaday says only about a third do not allow investment in this stock.
Investors against animal testing are reducing their options even further, with just a choice of three funds, and the scope for diversification and managing risk are severely limited.
But it is not always a case of banning all stocks that fall into a particular sector.
Data or no data?
So the question for financial advisers encountering this area for the first time is: how to make the right choice?
With 190 funds to choose from, what kind of data is available to help an advisers make a selection?
The answer is: very little. The problem is that the industry relies on quantitative data - performance over five years, for example - and Investment Association classifications to make its analysis.
Clearly the biggest, most important news story of the past five years is the potential result arising out of global warming.
Ethical investing, by its nature is not easily quantifiable in terms of numbers, and there is no IA sector for this type of investing.
The platforms do not provide research in this sector, and only some of the ratings agencies offer information.
Morningstar provides a service, but Mr Ditchfield says this is not particularly satisfactory.
He says: “They screen on the level of reporting rather than what the company is doing. The company might produce a really lengthy report talking about what they’re doing (despite manufacturing unethical goods), but Morningstar decides based on the reporting rather than what they’re doing.
“It’s quite problematic. [I know of] a family that was investing £8.5m, and asked for a sustainable portfolio, and they got nothing of the sort. The adviser in this area wasn’t competent.”
The most obvious option is to seek the advice of experts: the Ethical Investment Association offers information for financial advisers about how to go about advising in this area, and will offer a list of members, and expert financial advisers, who non-experts can call on or outsource to.
The UK Sustainable Investment and Finance Association also offers help and resources for advisers looking for support.
Mr Ditchfield has one clear message about sustainable investing: "Many in the financial industry have decided it’s peripheral, when clearly the biggest, most important news story of the past five years is the potential result arising out of global warming."
Melanie Tringham is deputy features editor of FTAdviser and Financial Adviser
House View: How to build a sustainable portfolio
Addressing sustainability issues has become increasingly important to investors. Our own research shows this clearly, especially among millennials.
The Schroders Global Investor Study found that 75 per cent of young investors (aged 25 to 34) had increased their exposure to sustainable investments over the past five years. This compared to 43 per cent of those aged 65 or over.
It is no wonder sustainability is on investors’ minds. Social and environmental change is happening faster than ever. Global warming, shifting demographics and the technology revolution are reshaping our planet. Against this backdrop the gap between investment winners and losers is set to widen and conventional financial analysis is likely to fall short.
Business models are being challenged at an accelerating pace and quite often this is due to sustainability issues and issues related to environmental and social risks.
Take climate change. Whether you believe in it or not, many policymakers now do and their actions are having an impact on the environment in which companies operate.
From an investment perspective, addressing sustainability is about developing deeper insights that have the potential to help identify opportunities and manage risks and, ultimately, deliver long-term outperformance. To understand the true long-term value and impact of an investment you need to look beyond a company’s business model.
You need to consider the full environmental and social impact of their activities and their relationships with customers, suppliers and employees. This helps you to understand which companies are navigating change better and are likely to survive and prosper over time.
The first step in addressing sustainability when investing is to establish your objectives. Many funds that state that they focus on sustainability do so primarily on the basis of excluding companies in specific industries.
There are encouraging signs that investors are developing a more sophisticated understanding of sustainable investing, which goes beyond exclusions.
However, whether it is focusing on exclusions or other sustainability factors, there is no more consensus among fund managers about what defines a sustainable investment than there is among investors more broadly.
Aligning investment with your values
There are a wide variety of exclusion based funds, which can vary widely in terms of performance. Some of the more extreme examples in the UK provide an opportunity set limited to 25 per cent of the FTSE All Share index. In these types of situations, what drives performance is what you’re excluding rather than stock picking.
Recognising that individuals will have different views of what to exclude, if you are going to incorporate exclusions within your portfolio, there is a case for taking a ‘light green’ rather than a ‘dark green’ approach, for example taking account of concerns around coal, arms, alcohol and tobacco, which make up around 10 per cent of the UK market and 5 per cent of the global market.
Thinking beyond exclusions
There are encouraging signs that investors are developing a more sophisticated understanding of sustainable investing, which goes beyond exclusions.
In a recent survey of 20,000 investors around the world carried out by Schroders the most popular definition chosen for sustainable investing was ‘investing in companies that are proactive in making sure their businesses are well prepared for environmental and social change’.
This suggests that the appetite for investment funds that seek to address sustainability in a more nuanced way is only going to grow.
Taking an active approach
One way that investors might attempt to address sustainability issues is through a passive approach. A number of the major global index providers have developed indices that incorporate sustainability factors. These include FTSE4Good Global, the Dow Jones Sustainable World and the MSCI World ESG. This has enabled the creation of strategies that integrate ‘off-the-shelf’ sustainability scoring systems on a passive basis.
There are two main problems with this. The first problem is that you’re more likely to get a better score if you’re a big company and if you’re a European company.
The second problem is that, unsurprisingly, a lot of these approaches tend to be quite tick box and they tend to be quite backward looking. They were never designed to generate outperformance.
It’s not enough to say we want to create a better world, we need to realise that companies play a crucial role in determining the direction the world is heading in.
It’s quite similar if you took the same approach to buying AAA bonds into the credit crisis and all of a sudden you found that you were holding a lot of exotic credit default swap spreads. You need to engage your brain when you’re assessing credit worthiness and you need to engage your brain when you’re assessing the ESG worthiness of funds.
The second way to address sustainability is to actively integrate it within your investment process. This is the core approach that we take at Schroders.
Fundamentally we seek to develop an in-depth understanding of the sustainability challenges facing companies and to value these on a forward looking basis.
Our dedicated Sustainable Investment team seeks to identify emerging sustainability trends and help our investors understand the investment implications of those trends.
Reducing risk and promoting more sustainable business practices via engagement
It is important not to peddle the myth that we can completely eliminate sustainability risk or deliver portfolios that are perfect. However, what we can do is use engagement to reduce sustainability risk, by encouraging companies to adopt better policies and practices.
At Schroders, we’ve done some quite ground breaking work on sugar, for example, where we’ve encouraged companies to adopt meaningful targets for sugar reduction and more transparency around their ingredients.
Sustainability: the new normal
It’s not enough to say we want to create a better world, we need to realise that companies play a crucial role in determining the direction the world is heading in. This has become clear to many investors who want to understand how their investment decisions can affect the world around them.
Many historic approaches to sustainability have failed to deliver because they haven’t really been linked to investment, however a robust active approach that integrates sustainability has the potential to deliver value to investors and society more generally, so we would expect it to increasingly be seen as the new normal.
Jessica Ground is global head of stewardship at Schroders