Investing with a conscience: choosing sustainable funds

There are sound reasons for seeking out responsible investment funds. Not only can sustainable funds help you invest in companies and initiatives that support energy transition, environmental protection and social equality, but it has also arguably proved a better way to invest. Research by US asset manager Federated Hermes suggests that companies scoring well according to ESG metrics also tend to perform better than their peers over the long term, although the evidence is not conclusive. Ultimately, investing in sustainable funds is a way to support a cause that is important to you and to make a positive impact on the world.

However, finding the right investment funds is not necessarily straightforward. The labels assigned to funds may not have much consistency: for example, how does an ESG fund differ from an ‘energy transition’, ‘clean energy’ or ‘sustainably managed’ fund? The industry has been quick to recognise the potential in responsible investing, so sustainability-related labels abound, but this hasn’t meant that fund names embody robust or clear definitions.

Labelling complexities

One of the challenges with ESG fund labelling is the lack of consistency across different labels, with various labels having different criteria for ESG funds. Some funds may be labelled as ESG despite not meeting certain standards or criteria.

In the early years, there was little consensus on the parameters for a fund proclaiming environmental, social impact or governance characteristics. For some fund groups, this meant that the asset manager would look at whether a company was well governed, not obviously worse than its peers in terms of carbon emissions, nor culpable in areas such as labour rights or pollution. The approach represented a risk management tool as much as a driver of stronger performance.

For others, sustainable investing was a far more complex process, involving exclusion of sectors such as tobacco or armaments, and often in-depth engagement with investee companies to bring about change, as well as using their voting power in shareholders’ meetings or the threat of disinvestment to sway the practices of companies that failed to meet their requirements. However, it wasn’t always easy to follow for investors, who needed to conduct extensive research to work out which one was which.

Investors were left to work out for themselves whether a fund matched their values, and whether they were getting something meaningfully different from mainstream investments.

Investors also had to make their own judgements on suspicions of greenwashing, a deceptive but common marketing practice, where asset managers slapped labels such as ESG or sustainable on products with an investment approach that did not appear to differ significantly from funds with no claim to ethical standards or environmental responsibility. Investors were left to work out for themselves whether a fund genuinely matched their values, and whether they were getting something meaningfully different from mainstream investments.

This is starting to change with the emergence of new fund classifications, especially those set out by the EU’s Sustainable Finance Disclosure Regulation (SFDR), which are intended to ensure that investors understand what they’re buying. Increasingly, there are also clearer definitions on the parameters and language of responsible investing, led by the EU’s green taxonomy and other sets of standardised definitions and classifications under development in various jurisdictions.

Different investment approaches

Now funds for sale in the EU fall into three categories under article 6, article 8 (light green) and article 9 (dark green) of the SFDR legislation. Article 6 funds do not integrate any sustainability metrics into their investment process. They are are free to include assets linked for example to tobacco, gambling or armaments, as well as fossil fuel-related companies.

Article 8 funds promote environmental and social impact characteristics, with these aspects embedded in the investment decision-making. Article 9 are investment products with a sustainable purpose and with a predefined minimum threshold of sustainable investments as defined by the taxonomy. This covers funds targeting bespoke sustainable investments, such as impact investing funds, or those that are aligned with climate change benchmarks based on the Paris Agreement target of net zero emissions. But don’t be surprised, Art 8 or Art 9 could still be investing in “transitioning” companies and as such have exposure to controversial activities (like fossil fuels for instance).

However, this still leaves a lot of scope for different investment approaches, and fund analysis groups have sought to set their own parameters for responsible investing. For example, fund research business Defaqto uses four levels of a pyramid, with ESG integration as the bottom layer and the most widely-used approach. The most recent ESG Report by the UK’s Investment Association found that 22% of member fund groups integrate ESG factors into at least 75% of their portfolios, a proportion that the organisation expects to increase by 2024.

Sustainable Development Goals

The next level identified by Defaqto is to exclude certain harmful sectors, usually tobacco, armaments or pornography – although many funds without sustainability revendications often shun these sectors – followed by funds with a sustainability focus. These aim to invest in companies targeting specific sustainability goals, such as clean energy or preserving biodiversity. At the top of the pyramid are impact investing funds with a dual mandate to meet specific sustainability goals as well as providing financial returns for investors.

The UN’s Sustainable Development Goals, which were defined in 2015 and have been approved by 193 countries, have provided important benchmarks for setting targets and building a consensus behind responsible investment. There are currently 17 goals including environment aims, such as curbing climate change or preventing pollution of the world’s oceans, alongside social ambitions such as offering high-quality education or reducing inequality.

Rating agencies are increasingly providing software tools to help investors judge the ESG credentials of particular funds.

Rating agencies are increasingly providing software tools to help investors judge the ESG credentials of particular funds. Morningstar, for instance, has drawn up fund-level sustainability ratings, which can help guide investors to the products they prefer. Investors can also delegate the selection of individual funds according to an investor’s specific goal to a discretionary or multi-asset manager. This has become easier with the increasing diversification of sustainable investment through the creation of dedicated bond, property and infrastructure as well as equity funds.

ESG resources

Most asset management firms are keen to share their ESG credentials with investors and often provide details on their website relating to engagement with individual companies, their voting records, and issuers or sectors from which they have disinvested. This can provide investors with evidence as to whether an investment manager is as serious about responsible investing as they say.

Investors can also take a closer look at a fund group’s ESG resources: do they have a dedicated ESG analysis team, proprietary systems or access to independent research? Such information, often available on firms’ websites, provides more evidence of the depth of a fund group’s commitment.

Obviously, when discussing sustainable investment there is no “one-size-fit-all” solution. The best way to get your investment aligned with your personal values is to check every individual underlying of the specific fund.

A final point is that sustainability credentials should not be allowed to swamp completely other considerations. A fund manager still needs to be good at the fundamentals of the job – picking profitable, robust companies and seizing opportunities without taking unjustified risk. However, the options are growing all the time for investors who want to ensure that their portfolio matches their principles.

New fund classifications, especially those set out by the EU’s Sustainable Finance Disclosure Regulation, are intended to ensure that investors understand what they’re buying.