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What is sustainable and ethical investing?

Sustainable and ethical investing is about investing in those companies and sectors that are at the heart of the transition to a more sustainable world and that are positioned to grow and benefit from this transition. As well as providing a way for people to invest in line with their values, sustainable and ethical investing creates exciting investment opportunities.

The growth of sustainable and ethical investing

The global sustainable fund universe includes open-end funds and exchange-traded funds globally that claim to have a sustainability objective and/or use binding ESG criteria for their investment selection.

  • According to Morningstar, ESG fund assets reached US$1.65 trillion at the end of 2020.
  • There were more than 300 fund launches in Morningstar’s European sustainable fund universe taking the total to more than 3,000 by the end of 2020.
  • Data from Calastone estimates that ESG funds have taken US$84 out of every net US$100 flowing into equity funds in the last two years, a total of US$15.1 billion out of US$18.1 billion

Different sustainable and ethical investing styles

When it comes to being ‘green’ with your money, there are a number of different investment approaches and these are evolving all the time. Common approaches include:

Ethical investing

Ethical investing is the oldest form of investing in the sector. With this approach, you invest in line with your ethical principles and exclude companies that you consider unethical, for example tobacco or weapons.

ESG investing

ESG stands for Environmental, Social and Governance. Alongside financial returns, this approach uses ESG factors to evaluate how sustainable companies and countries are.

  • Environmental factors include biodiversity, climate change, raw materials and water scarcity, pollution and waste
  • Social factors include labour policies and community relations, product safety, supply chain sourcing and social impact reporting
  • Governance factors include shareholder rights, diversity, business ethics and transparency

Sustainable and responsible investing

Sustainable and responsible investments are wide-reaching terms that incorporate a range of ESG factors and themes to focus on companies that can grow sustainably over the longer term.  This includes companies that are positioned to benefit from changing trends related to ESG issues and/or have a positive impact.

Impact investing

As the name suggests, impact investing is about making an impact (as well as a financial gain) through investments. The aim is for money invested to generate a measurable, positive impact on the environment or society. 

Accurately measuring impact from a quantitative perspective is an ongoing evolution that requires an improvement in data quality but institutional investors have worked hard to improve environmental disclosures in areas such as carbon and water usage. Social impact in areas such as healthcare is harder to measure and investor focus is more on case-by-case examples. A number of fund groups in the ‘sustainable’ arena have been working hard to measure their investment impact relative to the UN’s 17 Sustainable Development Goals.

How ethical and sustainable funds work

Investment processes for funds in this part of the market differ from conventional funds and they can vary on a fund-by-fund basis. The crucial point is that the approach to ethical and sustainable investing, which is chosen for each individual fund, works alongside standard fund management techniques to form the overall investment strategy. Here are the most commonly used approaches.

Screening

Screening is probably the most common and traditional process used by responsible and sustainable funds. It 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 industries and companies that are screened out can vary, but most tend to be related to health (alcohol or tobacco), the environment (oil and gas or mining), and companies with poor employment practices. Positive screening is when companies are included because they make a positive contribution to society or the environment, such as renewable energy or health. Many funds use both forms of screening when selecting companies.

Best in class

The best-in-class approach is when a fund selects a company that has better ESG policies and profile 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 lending policies.

This is very much a case of weighing up the pros and cons of each company and its individual corporate responsibility.

Engagement

The basic methodology of engagement is to use shareholder influence to actively pressure companies to employ better policies while trying to enhance shareholder value. Engagement is now a core part of sustainable and ethical investing.

Outside influence

While some fund groups have specialist in-house teams to help select sustainable companies, the majority of funds in the sector use outside resources to help implement the fund’s objectives. This can come in the form of independent committees that review the investment decisions of the fund manager. These are often made up of experts from charities, faith-based organisations and non-governmental organisations (NGOs).

In addition, a number of funds use independent research from specialist external ESG data agencies to select companies to invest in. Independent research is a key feature in the screening and best-in-class processes used in stock selection for many funds. Some funds also periodically engage with existing investors by seeking feedback on investment policies via surveys.

Choosing a sustainable or ethical investment to meet your objectives

When it comes to choosing an investment fund it is important to think clearly about your motivation. Does a single issue, such as the environment, matter more than anything else? Or are you looking for a broad-based approach to investing ethically and sustainably?

The next step is to choose a fund that has investment policies in line with your principles. This can be the most difficult part of the process because not all funds have clear guidelines on what an acceptable investment is. Investors with strong views on a number of issues may also need to compromise to find a fund that matches the majority of their beliefs. Debates around whether an industry or a stock should be included in a fund are fairly common, especially in controversial areas such as animal testing, where opinions can differ greatly.

The investment policies of funds in this sector are frequently split into three groups to highlight the strength of the criteria they follow. The scale is helpful when trying to compare funds but, as always investors should review the individual fund policies before investing.

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Can I make money through sustainable and ethical investing?

Yes, you can make money through sustainable and ethical investing. As with all investing, it’s important to remember that the value of investments can go down as well as up but long gone are the days when people accepted that they may have to compromise returns in order to invest in line with their values.

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Please note that some ethical funds may, by definition, have a limited investment universe; this may affect performance.

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