Lockdown changed the world, and now ethical investing will too

Ethical and environmental considerations in our daily lives have been thrown into sharp relief by the coronavirus crisis. Holidays, working from home and how much we exercise are just some of the things people are looking at more closely than ever, as we enter an era where many are reflecting far more closely on how they live and the impact it has on their surroundings.

Discussions about the way in which we live our lives during the coronavirus pandemic have become omnipresent. Who hasn’t talked to friends about ditching the train for a bike, or cutting back on unhealthy foods to look after our own wellbeing? Likewise, consumer choices are changing too.

People are also more concerned than ever about what they spend and where. There is an increasing move to reject companies that do not look after their workers and customers, or to stop paying for services from companies that have been found wanting on their diversity policies. These issues have captured the zeitgeist during the pandemic in a way that seemed like it would never take hold before.

It is perhaps no surprise that our investment choices are shifting to align with these choices. While peoples’ main aim when it comes to investing will still, for many, be about making a return, the evidence is there already that the most ethically-driven investment choices are already paying off as global markets recover. So-called environmental, social and governance (ESG) focused investments have come to the fore of many investors’ minds in the past few months as a result.

For instance, more than half of ESG funds beat the MSCI World stock index as the crisis took hold, mainly driven by the omission of oil stocks from portfolios.

Recent research shows that two in five ESG funds were in the top quartile for fund performance in the first half of the year, with a further 25% in the second quartile. The days of investors taking lower returns for ethical choices (something that was never really that well proven anyway) are firmly over.

This isn’t just a pandemic trend either. Sustainable funds are far more likely to outperform the market than standard funds, whether over one, three, five or 10 years. For example, UK sustainable funds returned 9.1% over the past five years, compared with a loss of 0.1% for funds investing broadly across British stocks.

The problem with ESG

But things aren’t all plain sailing for ESG-focused investors. Recent controversies have shown that not all ESG-focused products, funds or companies that claim ethical credentials are what they purport to be.

The Boohoo scandal is a recent case in point. The company has been a darling of many fund managers and investors in the past few years, turning the “fast fashion” market on its head with nimble clothing ranges and affordable items that consumers love.

But in June, a scandal broke that soured this image, potentially for ever. It emerged that a supplier to Boohoo was engaged in modern slavery practices, a total antithesis to ESG principles. Many ESG investment funds were caught holding the stock, and it had ironically, just a week before the scandal broke, been rated as having above average labour standards by MSCI.

Boohoo is perhaps the most extreme example of the problem, but it is not the only one. Other issues that plague ESG funds, and companies given good ethical ratings, is the phenomenon of ‘negative screening’. This is a process whereby a company gets a good ESG rating, not for having actively engaged in good practices, but simply having avoided bad ones such as polluting, exploitation or other actively ‘bad’ actions.

For example, many so-called ESG funds have come under fire from campaigners that they aren’t actively picking companies that are ‘good for the world’, and are instead filling up their funds with high-growth US tech firms*. Companies such as Google and Microsoft don’t do anything wrong per se, they argue, but they also aren’t actively engaged in improving the environment.

This issue is perhaps more problematic for investors than a firm like Boohoo, where the problem was clear cut. Google doesn’t do anything wrong, but should you exclude it from your portfolio just because it doesn’t do anything particularly ethical either? Excluding these kinds of stocks can limit opportunities for investors and be harmful to portfolio performance.

One of the issues with ESG is many firms and investment funds are self-auditing and don’t have transparent processes for assessing their own credentials. It can sometimes amount to little more than marketing patter.

This is where a strong reporting and rating framework becomes really important for any investor considering taking the ESG route. For example, EQi relies upon Square Mile, an independent investment research firm, for its fund selections. Square Mile is able to independently assess investments on their ESG merits and it has its own ratings scale for both companies and funds to measure this.

Using an independent third-party framework such as Square Mile’s is a great way to benchmark companies and funds without becoming reliant on conflicting views. Gathering information from a variety of sources matters, but having a clear benchmark will help cut through the noise.

ESG is the future

While it has some wrinkles to iron out, there is little doubt ESG is the future. While coronavirus has accelerated the way in which we consider the world we live in, this tide was already rising before the pandemic. While many might not agree with the activities of organisations such as Extinction Rebellion, no one can deny the way in which they, and high-profile campaigners such as Greta Thunberg, forced a new focus on ethical issues.

We are now at a tipping point where it is not just ethically-minded individuals that are engaging with the issues. Governments are stepping up. Take for example the French government, which stipulated in its bail out terms to Air France that it had to stop offering short-haul flights that could feasibly be made by train.

Or indeed in the UK where the Chancellor Rishi Sunak announced a Green Homes Grant at the Budget in July, where families get up to £5,000 (and up to £10,000 for poorer households) to make environmentally-friendly upgrades to their properties.

The point is, ESG is here to stay, and is more than a fad. In fact, many fund managers will admit that ESG factors are a really good way of actually determining the long-term viability of a business. Indeed, it is no exaggeration to say that many of the polluting, exploiting and unhealthy firms of the world will have to change or vanish in the next decade.

Given investing is very much for the long-term, incorporating ESG to your investments could be one of the key factors as to its success over the next 30 years.

September 2020
_{*Financial Times Women In Business UK Forum, Why ESG is important for your business report, 8 July 2020.}