Investors have piled in to ethical funds in droves after the coronavirus pandemic forced British homes and businesses into lockdown earlier this year.
Between January and September a massive £7billion poured into environmental, social and corporate governance funds, up from £1.9billion over the same period a year earlier, according to the Investment Association.
Experts posit that the combination of raging wildfires, floods and hurricanes along with a global health pandemic has at last stirred investors into action.
An increasingly persuasive financial argument hasn’t hurt either. The best performing fund in Interactive Investor’s top 30 ESG list was the iShares Global Clean Energy UCITS ETF, which returned 62.79 per cent over 12 months to the end of September.
By comparison, the MSCI World Index returned 11.44 per cent in the same time.
FundCalibre: ‘Eventually we think some element of ESG will be part of every fund mandate.’
Interative Investor ran analysis across its ESG list and found 67 per cent of their favoured ethical funds produced a positive return between January and September, with 53 per cent in the first quartile of performers and 17 per cent in the second quartile.
Separate analysis from Fidelity International looked at individual stocks with higher ESG ratings and found they outperformed those with weaker ESG ratings in every month from January to September apart from April.
There is a fair political wind for ESG too. This year has seen government put the bellows under the green growth agenda, with the launch of green government bonds, a £160million fund for new wind farms and a 10 point plan to drive a ‘green industrial revolution’ unveiled last week by Prime Minister Boris Johnson.
Asset managers, alive to the financial opportunity this presents, have spent much of 2020 scrambling to market their – in some cases new-found – green consciences.
With such a frenzy around ESG, investors may be wondering whether it’s all a fad or a structural shift in the investing landscape.
Green bubble or the future of governance?
Backing companies focused on reducing the use of fossil fuels, cutting carbon, improving healthcare and meeting the needs of an ageing society seems a reasonable approach to building long-term financial resilience into any investment portfolio.
Between January and September, a massive £7billion poured into environmental, social and corporate governance funds
But when money floods this fast into any asset class or sector, the question of value is inevitably raised.
‘This massive shift in flows and an improvement in performance has led people to ask if ESG is a bubble,’ says Ryan Lightfoot-Brown, analyst at FundCalibre.
Government’s ‘green revolution’
Earlier this week the government unveiled a £12billion plan to encourage economic recovery and support industries contributing to a reduction in carbon emissions.
Banning new sales of petrol and diesel cars by 2030. Investment in battery technology and the roll-out of electric car charging points.
Installing thousands of offshore turbines to produce enough energy to power every home by 2030.
Working with industry to generate five gigawatts of the low carbon fuel by 2030.
Investing in new technology to develop mini- reactors. Decision still pending on major new power stations like Sizewell, in Suffolk.
Cycling and walking: £5 billion investment in low carbon transport, with cycle lanes to benefit from a share of £2 billion fund.
Supporting the development of the world’s first commercial zero carbon plane.
HOMES AND BUILDINGS
Making homes, schools and hospitals greener and warmer, with improved insulation and heat pumps phased in to replace conventional boilers.
Becoming a world-leader in technology to capture and store harmful emissions.
Protecting and restoring the natural environment, including planting 75,000 acres of trees every year.
INNOVATION & FINANCE
Developing new green technology and making the City the global centre of green finance.
‘I would say it is correlation rather than causation. The counter would be, who is investing any other way?
‘No fund house is likely to launch a “sins” fund today, so it is difficult to see what mandates, certainly as a public vehicle, will be heavily buying into the likes of oil and gas majors and arms companies.’
Lightfoot-Brown subscribes to the logic that good governance of corporate, environmental and social risk is just good governance.
‘Eventually, we think that some element of ESG will be part of every mandate, whether that is screening out certain industries, to scoring corporate governance,’ he says.
‘This will continue to the point that ESG is just another input managers use, just as they do a balance sheet or cash flow statement. Just some will be better at analysing these inputs and their effect than others.’
On that basis, ESG’s burgeoning popularity may simply be long overdue. And if that’s the case, why would any sensible investor accept a fund manager who didn’t factor in ESG risks when choosing companies?
Sophie Kennedy, head of investment at EQ Investors, says: ‘Environmental, social and governance factors relate to the way in which a business manages its operations, which is very much process driven.
‘A business that is managing its financially material ESG risks well along with transparent disclosures, indicates that it is a well-managed, quality company.
‘In times of market volatility and economic downturn, investors are often keen to be exposed to those businesses that are more likely to survive in the long run.
‘That is a key reason why flows have been surging into funds investing in ESG-leading companies within their sectors.’
Rising demand and future growth
Research from investment platform Interactive Investor suggests over a third of those not currently investing ethically would like to be able to, indicating there is still unmet demand for an ESG approach.
Millennials are the keenest on adopting ethical principles, says Myron Jobson, personal finance campaigner at the investment platform, but when it comes to committing funds, baby boomers are currently the most active.
It is not just II seeing this shift. ‘Fund strategies that deliver ESG integration have matched investor interest and are attracting assets from non-ESG integrated peers,’ says EQ’s Kennedy.
‘We see this outperformance as long-term and expect these companies to further benefit from recovery packages announced globally, such as the EU Recovery Fund.
‘About a third of EU recovery grants and loans are earmarked for decarbonisation and digitalisation – themes that ESG leading businesses should be in pole position for.’
ESG’s burgeoning popularity may simply be long overdue as part of basic due diligence.
Assessing value in ESG
ESG funds have generally had a positive year in 2020, with fans attributing this to their focus on companies fit for the future.
This may be partly true, but it’s also worth noting that a lot of ESG funds are heavily weighted towards big technology companies and the US – both of which have had a good year for reasons that have little to do with environmental or social ethics.
A global equities fund excluding oil and gas majors, armaments and tobacco is likely to include hefty stakes in Microsoft, Apple, Amazon and Google.
Romi Savova of Sipp provider Pensionbee says: ‘The collapse in oil prices and increasing digitisation have been the two big trends this year.
‘The compounding of those two things simultaneously is what has caused that huge difference in returns.
‘The question for the future is whether those trends are here to stay? Much of this comes down to the future of the workplace – whether this giant experiment around working from home has worked.
‘For those companies where staff have been able to work from home it’s been a huge success and means the workplace is inevitably going to return to a form where it’s not nine to five in the office every single day; for 90 per cent of people there is going to be more flexibility.’
How do you know if funds or companies are actually delivering on the ESG promise or presenting you with a green smokescreen?
She adds: ‘That will be good because it helps to reinvigorate local economies.
‘When the Covid crisis is over and the vaccine is in place, we may actually see local communities flourishing as a result.
‘That’s also good for the environment because you won’t have the need to travel or commute so much and cause pollution in order to achieve the same outcomes.’
Fund tips: EQ Investors
Rathbone Ethical Bond fund
Bryn Jones and the fixed income team at Rathbones continue to evolve the fund’s ambition, from what was a traditional approach of excluding issuers in the classic controversial sectors to now positively finding impactful bond issuers that contribute to solutions. An example of this is the backing of the recently launched COVID-response bonds issued by the African Development Bank. We continue to have positive engagements with Rathbones which evidences the collaborative nature of our relationship we truly value.
BMO Responsible Global Equity
A global equity fund investing in companies considered to be making a positive contribution to society and the environment. The engagement strategy and reporting by BMO is also market leading, and we encourage peers to adopt their type of reporting transparency.
Royal London Sustainable Leaders
Mike Fox and his team hold substantial sustainable investing experience and a diverse set of skill sets. Although a UK mandate, the fund can invest up to 20 per cent overseas, which they tend to make use of to gain access to positive sustainability stories in sectors underrepresented in the UK.
As with any investing theme that suddenly becomes flavour of the month, making sure you’re getting value for money is fundamental. But how do you know if funds or companies are actually delivering on the ESG promise or presenting you with a green smokescreen?
‘As with any investment, make sure you do your research,’ says Sophie Kennedy, head of research at EQ Investors.
‘There are plenty of funds and ready-made portfolios labelled as ethical, sustainable or ESG but at closer inspection are nothing of the sort.
‘Look under the bonnet – double-check that the companies held match-up with your own personal values. Check-out the top 10 holdings and decide whether those companies are what you are happy to invest in.
‘Make sure the fund has a dual mandate: to deliver attractive long-term returns and to deliver positive change. If not, avoid.’
It’s not easy to recognise when open-ended funds are overvalued as most are notoriously opaque about their holdings.
While it’s no guide to future returns, it is possible to review past performance.
Interactive Investor’s ACE 30 list groups funds it has screened for ethical principles, with Brown Advisory US Sustainable Growth and VT Gravis Clean Energy Income, returning 28.45 per cent and 17.89 per cent over the year to 30 September 2020 respectively.
But being green and ethical is no guarantee of success. Unicorn UK Ethical Income was the worst performer over the period at -14.44 per cent, behind BMO Responsible UK Income at -12.77 per cent and L&G Ethical at-11.88 per cent.
Trust tips: Interactive Investor
Impax Environmental Markets
The UK’s largest environmental investment trust, targeting long-term capital growth by investing in companies offering solutions to environmental challenges. The fund has a particular focus on alternative energy and energy efficiency, water treatment and pollution control, and waste technology and resource management, which includes sustainable food, agriculture and forestry.
Companies involved in significant controversies that it considers violates ‘global norms’ related to human rights, labour, environment and corruption don’t make the cut.
The trust’s investment team actively engages with companies in the portfolio to improve practice and disclosure across their governance and sustainability activities and views proxy voting as a key activity as part of this process.
Having launched in 2002, the trust has an 18-year track record but has seen its performance go from strength to strength since 2016, when investors began to take a closer interest in ESG factors.
Investment trusts are publicly listed, making valuation much more transparent.
Investment companies typically trade at either a premium or discount to net asset value – the valuation put on the underlying holdings held within the trust.
‘When it comes to investment trusts, the discount or premium to a trust’s net asset value demonstrates the level of demand and can provide a measure of how highly valued that trust is,’ says Annabel Brodie-Smith, of the Association of Investment Companies.
She points to investment trusts in the renewable energy infrastructure sector, which invest in a wide range of assets from solar parks to wind farms, helping the transition to a lower carbon future while also being highly prized for their strong and sustainable yields.
Brodie-Smith says: ‘This is part of the reason that the average investment trust in the renewable energy infrastructure sector currently trades at a 15 per cent premium – a marked contrast with the average investment trust which trades at a 5 per cent discount.’
Not all sectors that qualify as environmentally responsible command such a premium however.
Trusts in the environmental sector invest in in areas such as plastic recycling and water treatment. In this sector, valuation follows performance with investment trusts that have performed the strongest trading at a premium or a narrower discount.
Brodie-Smith says: ‘For many investment company managers, backing businesses that operate in a sustainable way is seen as crucial to long-term outperformance.’
The fact that ESG themes are becoming more widespread is clear from looking at recent investment trust launches too.
Home REIT and Triple Point Energy Efficiency Infrastructure, both of which launched last month, invest in high-quality accommodation for the homeless and green infrastructure respectively.
This month also saw the announcement of another prospective launch, Downing Renewables & Infrastructure, which plans to invest in renewable assets such as wind, solar, hydro and geothermal.
iShares Global Clean Energy UCITS ETF
The iShares Global Clean Energy UCITS ETF tracks the 30 largest clean energy stocks, as defined by the S&P Global Clean Energy index, across utilities – electricity generators from hydro, solar and wind – and the manufacturers of equipment to generate that clean power.
The methodology behind the index also incorporates a carbon scoring and screening criteria to ensure the fund delivers on its namesake.
Clean utilities have performed well this year, aided by declining discount rates.
Most importantly, clean utilities have outperformed the overall utilities sector consistently as clean utilities have been benefiting from preferential supply contracts amid declining power needs in 2020, and given lower “stranded asset” risk ie. premature writedowns of their value from future lower-carbon policies.
However, it is the clean energy equipment makers that have led INRG’s stellar performance, driven by expectations of increased long-term demand and looking past the delays in renewable capacity additions in 2020.
This has been reflected in the returns of all sub-segments, from the solar and wind equipment names, to alternative clean energy technology suppliers eg. hydrogen fuel cells.
Can passive ESG deliver?
In Interactive Investor’s ACE 30 list active funds were beaten by a tracker: the iShares Global Clean Energy UCITS ETF, which returned 62.79 per cent over the year to 30 September 2020.
But can a passive approach can really cut it with ESG principles at stake?
Passive funds and trackers traditionally mirror an index, aiming to match its performance and deliver a steady rise in value. With this approach, it’s almost inevitable that some shares in an index won’t measure up to everyone’s idea of ethical.
II’s Jobson says: ‘The inclusion of companies like Shell in the FTSE4Good UK 50 index may raise an eyebrow, but some investors argue that the company boasts “green” credentials because of its renewable energy division.’
Others may not agree that a nominal renewable division counts for much when the same company’s new oil and gas extraction is accelerating along with their carbon footprint.
Hargreaves Lansdown’s Emma Wall says: ‘The key to assessing a passive fund’s ESG credentials is whether the process aligns with the philosophy.
‘For example, specialist ESG passive funds will often track a specialist index which either screens out certain “unethical” stocks, or overweights companies with better ESG credentials according to either a ratings agency, or proprietary research.
‘Some combine both approaches. You can also examine whether a passive fund provider has exercised their voting rights as shareholders on contentious ESG issues, and used their clout for the good of their underlying unit holders.’
Asset managers are launching new passive funds that exclude sectors such as fossil fuels
‘Smart’ passives fiddle around with the weightings of stocks in this way, buying less of some and more of others, in a bid to outperform the benchmark index they track and take account of investors’ ethical preferences.
EQ Investors’ Kennedy says: ‘Understandably, the focus in the passive space has been on driving down costs.
‘What you’re now seeing is increasing demand from investors with a real emphasis on sustainable considerations but with a low-cost passive mindset.
‘In reaction to this, asset managers are launching new passive funds that allow you to remove companies involved in sectors such as fossil fuels. We think this is essential to improve the climate change scenario alignment of investment portfolios.’
Pensionbee is in the process of raising funds to enable it to launch its new fossil free plan, a passive fund that tracks an index compiled to order by Legal & General named the FTSE TPI Global (ex Fossil Fuels) Equity Index Fund.
Chief executive Savova says: ‘If people have a view that something shouldn’t be in their portfolio then they should be able to to exclude it.
‘Our fossil free plan is definitely a passive approach, but with an active component around the engagement our fund managers have with companies within that index.
‘In the long term engagement around environmental, social and governance issues should actually lead to improved returns. That is a form of actively managing the investment, but it is a softer form than saying you’re in or you’re out.
Our fossil free plan is definitely a passive approach, but with an active component around the engagement our fund managers have with companies within that index.
‘The benefit of this hybrid approach is that you can achieve it at a lower cost point than you usually can for an active fund. That is important for a very long-term investment for retirement because your cost over a 30-year period can be a significant component.
‘Keeping keeping the cost at a reasonable level while maintaining a very high level of diversification and allowing people to express their views and values, I do think that it achieves a very good balance of many things.’
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