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Clarity has not always been a word one can associate with investing along environmental, social and governance lines but that is starting to change

Over the past three or four decades, those looking to invest in line with their principles have had to contend with a variety of labels that, unfortunately, may only have succeeded in confusing the issue. ‘Environmental, social and governance’ or ‘ESG’, ‘ethical’, ‘impact’, ‘positive future’, ‘responsible’, ‘SRI’ and ‘sustainable’ – not to mention more specific options such as ‘biodiversity’, ‘circular economy’, ‘climate change’ and ‘energy transition’ – how, if at all, do they differ?

Further nuances, such as ‘light’, ‘mid’ and ‘dark green’, and ‘positive’ and ‘negative screening’, may not always have made the available choices any clearer. With green funds, for example, the general rule of thumb has been the darker the shade, the stricter a fund’s ethical criteria.

Over the years, however, funds have not always been what they seemed. For instance, a ‘green fund’ might have a huge overweight in a sector such as information technology. Avoiding fossil fuels, tobacco, gambling, cosmetics and so on may indeed tick the necessary boxes, and yet, to all intents and purposes, this would be a tech fund packaged as something else.

A ‘light green’ fund, on the other hand, might be well diversified across a broad number of sectors – but only exclude, say, oil stocks.

And then consider the words ‘climate change’ in the name of an index fund containing one of the world’s biggest oil companies as well as a car manufacturer. When pressed, the manager could well justify these inclusions on the basis the companies in question have clearly acknowledged the goals of the Paris Agreement and are actively promoting sustainability – and yet that explanation might not satisfy every investor.

Suffice to say, clarity has not always been a word one can associate with what, for the rest of this piece, we will lump together as ESG investing – but that is starting to change. For one thing, as discussed on p4, ESG investing is certainly no longer ‘niche’ – ESG-oriented funds attracted a record $51.1bn (£37.3bn) of net new money from investors in 2020, more than double the prior year, according to Morningstar data.

As ESG investing has become more mainstream, so the number of investors wanting a better idea of how their money has been invested has multiplied – and, in March this year, the European Union set out to oblige them. Whatever criteria investment companies use in their stock selection, the Sustainable Finance Disclosure Regulation (SFDR) is intended to clarify the process.

The new rules require asset managers to publish statements on their websites about which of their products fall into three distinct categories:

● Article 6 funds: those that are not promoted as having ESG factors or objectives;

● Article 8 funds: those that promote environmental or social characteristics but do not have them as the overarching objective; and

● Article 9 funds: those that specifically have sustainable goals as their objective – for example, investing in companies whose goal it is to reduce carbon emissions.

For Royal London Asset Management (RLAM) head of sustainable investments Mike Fox, the SFDR represents a step forward for the sector. “Sustainable investment processes have been evolving since they were created nearly 20 years ago and regulation is another factor in this evolution,” he says.

“While it is for fund managers to devise and articulate their investment processes in relation to where they can create value, we will always be mindful of any regulatory requirements in doing this. The SFDR is sharpening up many screening processes and bringing back negative screening – in the form of ‘Do no significant harm’ – which we think is broadly good news.”

A recent report on asset management in Europe from ratings agency Moody’s also sees merit in the new rules, noting: “Requiring asset managers to disclose how they account for ESG risks will contribute to establishing industry-wide standards for sustainable investment.” It goes on to add: “The disclosures align with investor demand for ESG-compliant products, which has increased because of the coronavirus pandemic and should boost net inflows.”

Not everyone is quite so enthused, though. For example, Candriam head of ESG development David Czupryna told Portfolio Adviser earlier this year that while the SFDR will be remembered as “a steppingstone in making finance sustainable”, it is also likely to end up as the source of more confusion.

“The SFDR is vague, imprecise, open for interpretation – and probably knowingly so,” he adds, before acknowledging the rules could also prove a deterrent for so-called ‘greenwashers’ – halfhearted ESG asset managers who overly emphasise sustainability among their credentials.

To some extent, portfolio screening has always had contentious elements. Take, for example, ‘negative screening’, which aims to weed out companies that score poorly in such areas as their environmental record, workers’ rights, gender equality and corporate governance. Relying on negative screening to build a values-aligned portfolio could potentially lead to belowmarket returns if, as an investor, you are excluded from the best-performing stocks in a market index such as the FTSE 250 or S&P 500.

Negative screens generally eliminate investments in traditional ‘sin’ industries, such as tobacco, gambling, alcohol, pornography and weapons manufacture yet exclusions can be specific to individual clients and their own values. As such, a fund manager’s screening criteria cannot accommodate everyone’s preferences exactly.

For his part, Insight Investment portfolio manager Damien Hill believes that, while negative screening has its uses, it can also carry risks when used in isolation. Investors should instead consider a broader approach, he argues, combining other responsible investment techniques and strategies – such as conducting detailed analysis of companies and targeting materially positiveimpact allocations via green bonds and other impactbased investment instruments.

Commenting on the specific pros and cons of negative screening in credit markets, Hill notes: “If investors screen out whole sectors for ethical reasons, this can expose them to more concentrated sector allocations. This means that, if they are left with large allocations to, say, the banking or insurance sectors, they may be exposed to more risk than they think. While the banking sector may seem a benign place to invest, it has not been without its governance red flags over the years.

“Rather than just adopting negative screening, we believe there is a greater need for investors to engage with underlying bond issuers and build detailed analysis and increased scrutiny of companies they invest in across all sectors. When looking at the banking sector, for example, investors need to pay particular attention to the carbon footprint of issuers’ lending books.”

At the same time, so-called ‘positive screening’ – where companies are ranked on ESG factors relative to their peers and only the ‘best of breed’ businesses are backed – has its own shortcomings. What if the ESG record of most of the companies in a sector leaves the bar especially low? Does the ‘best of breed’ argument really work here?

No, is the definitive response of RLAM’s Fox. “We think all companies must meet a minimum hurdle rate, so we agree good ESG must be judged both relative to a sector and in absolute,” he argues.

“In a sector with low ESG standards, ‘best of breed’ just does not stack up.”

As for how screening processes might evolve further, Fox believes they will need to become more sophisticated as the availability of ESG information increases. “This will allow more detailed work to be undertaken and more nuanced judgements to be made,” he adds. “Ultimately this will allow screening processes to identify companies where sustainability is truly embedded versus those where it is more superficial.” ■