The buzz around sustainable and ethical investing has been growing in recent years as more people become environmentally and socially aware.
In response, asset managers such as Schroders, Investec and Aegon have all jumped on the bandwagon and are pushing a vast array of funds with an ethical dimension as the appetite for responsible investment increases.
Many of the largest industry players are now incorporating environmental, social and governance principles into their investment processes.
ESG is a broad term used to describe a range of considerations associated with responsible investing which typically tend to avoid stocks in tobacco or firearm companies, for example.
There is no set industry standard for ESG, so fund managers have their own criteria and scoring systems, and the only way to tell the difference is to look at what the fund is holding.
Managers argue that ESG-focused investing can increase returns over the long term and also mitigate reputational and financial risk.
Standard Life Wealth head of investments Julie-Ann Ashcroft says ESG needs to be thought about as an integral part of portfolio construction rather than one product in isolation.
She says: “ESG considerations do not include consideration of valuation or growth. However, many environmental and social considerations can highlight areas of growth, for example the opportunity in the field of clean tech for a company that produces battery components.
“We strongly believe that considering ESG gives us an advantage in understanding the key risks and assessing the quality of any investment. Fundamentally, companies that behave responsibly make better long-term investments.”
While fund managers are embracing ESG approaches, anecdotal evidence suggests advisers have been less positive about recommending them.
Capital Asset Management chief executive Alan Smith says this is because most clients are older investors and less interested in ESG investing.
He says: “Most wealth advisers primarily deal with the retirement market. A vast majority of people around retirement age are not very concerned about ESG investing, whereas the next generation of investors coming through are far more interested.
“Interest will increase over time as advisers take on younger clients who are far more passionate about it.”
Royal London Asset Management head of wholesale Phil Reid says that asset managers need to do more to help advisers.
He says: “When faced with socially responsible investment funds, ESG portfolios, responsible investment strategies and impact investing, it’s often unclear what the distinctions are. We think that asset managers should be doing more to help advisers, and to help them educate interested clients about what these strategies really involve.
“I see the level of interest in sustainable investing growing rapidly as advisers take on a new generation of younger clients, they’re likely to see more interest in these sorts of strategies, and their clients will want to dig much deeper into what’s actually going on in these funds.
“Knowing whether an ESG fund actively excludes certain sectors, or specifically picks stocks that offer some sort of net benefit to society, and what technical analysis is being used to determine this could become an important part of due diligence for lots of advisers.”
Critics argue that ESG investing can hinder returns because they avoid “less ethical” companies.
However, there is growing evidence that suggests that funds which adopt an ESG approach will boost fund performance. According to research by Hermes, well-governed companies tend to outperform poorly governed ones by an average of over 30 basis points per month.
Hermes Global Equities team portfolio manager Louise Dudley says: “We look for long-term sustainable companies that are making good business decisions.
“Increasingly we are seeing with more and more companies a lot of market value coming from the strength of their brand. So how they act and behave is very important
“We have found that companies with favourable ESG characteristics have tended to outperform companies with negative characteristics, mainly driven by good governance.
“The impact of environmental and social factors has been negligible, but there has been a strong link between underperforming companies and poor corporate governance.”
Dudley says that while Hermes does not make hard rules about how it assesses a business overall for its merits, there are some behaviours it does not think are acceptable.
She adds: “It is more about the behaviour of companies rather than the business area. We wouldn’t wish to purchase stocks and that include tobacco or child labour, for example.”
However, there have been some criticisms of ESG investing, with funds having exposure to investments that might not be seen as ethical or sustainable such as tobacco.
Some commentators have suggested that clarity is needed around the strategy funds are pursuing to avoid ‘greenwashing’ – where companies make claims about their green credentials through marketing rather than actually implementing green business practices.
Smith says: “There are huge challenges in having something that is ESG complaint.
“A one size fits all is unlikely to deliver a successful outcome for a vast majority of people who have different opinions about what they regard as ethical.
“In the past, asset managers have produced lots of very attractive brochures for funds.
“However, when you lift the lid on the holdings in the portfolio, you could frankly drive a coach and horses through it in terms of ESG responsibilities.”