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 there is also some evidence that it is 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 make a positive impact on the world and an individual contribution to a sustainable future.

However, identifying investment funds that genuinely advance sustainability goals is not necessarily straightforward. The labels assigned to funds may not have much consistency: for example, how does an ESG – environmental, social and governance-focused – fund differ from those focusing on the ‘energy transition’ or ‘clean energy’, or that are ‘sustainably managed’? The European asset management industry has been quick to recognise the potential in responsible investing, so sustainability-related labels abound, but this hasn’t meant that fund names incorporate robust or clear definitions.

Labelling complexities

One of the challenges with ESG fund labelling is the lack of consistency between different labels. In some respects even ‘ESG’ itself is problematic, since arguably governance should be a priority for all investment products and assets whether or not they focus on environmental, climate or social impact. Critics say some funds have been labelled as ESG or sustainable despite not meeting widely-accepted standards or criteria.

In the early years of sustainable or responsible investing, there was little consensus on the parameters for a fund proclaiming ESG characteristics. For some fund groups, this meant that the asset manager would look at whether a company was run according to sound governance standards, and was not obviously worse than its peers in terms of carbon emissions, nor in breach of labour rights or pollution standards. The approach was as much a risk management tool as an ethical benchmark or 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 involving engagement with investee companies to bring about change, as well as using their voting power in ’shareholders’ meetings or the threat of divestment to persuade companies’ management to meet investors’ requirements. However, such processes were not always easy to follow for investors, who needed to conduct extensive research to work out what strategy the manager was pursuing.

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.

European Union fund classifications

Investors also had to make their own judgements about suspicions of greenwashing, a deceptive but common marketing practice in which 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 has changed 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 are 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. In addition, the European Securities and Markets Authority has issued guidelines that call on retail and alternative funds whose names incorporate ESG- or sustainability-related terms to meet minimum levels of investment assets aligned with their proclaimed environmental or social characteristics or sustainable investment objectives.

Different investment approaches

Arguably some of the confusion for investors lies in the way the SFDR was first formulated. Although it was never initially intended to provide a labelling regime, the legislation effectively divided funds for sale in the EU into three categories under its articles 6, 8 and 9. Article 6 funds do not integrate any sustainability metrics into their investment process, and are free to include assets linked for example to controversial sectors such as tobacco, gambling or armaments, as well as companies active in the exploration, production, distribution and consumption of fossil fuels.

As the legislation stands at present, article 8 funds are those that promote environmental and social impact characteristics, aspects embedded in their investment decision-making, whereas article 9 comprises investment products with a sustainable purpose and with a predefined minimum threshold of sustainable investments, as defined by the EU green taxonomy. This covers funds targeting bespoke sustainable investments, such as impact investment funds, or those that are aligned with climate change benchmarks based on the Paris Agreement goals for reaching net zero greenhouse gas emissions. However, there is leeway that may surprise and confuse investors – article 8 or 9 funds could still be investing in ‘transitioning’ companies that remain active in the fossil fuel sector.

Given the wide degree of scope for different investment approaches, some fund analysis groups have sought to set their own parameters for responsible investment. 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, followed by the exclusion of sectors perceived as harmful, unethical or ‘controversial’, led by tobacco, gambling, armaments and pornography. Funds with a sustainability focus aim to invest in companies targeting specific sustainability goals, such as clean energy or preserving biodiversity. At the top of the pyramid are impact investment funds with a dual mandate to meet specific sustainability goals as well as providing financial returns for investors.

The EU hopes that reform of the SFDR may make classifications less confusing for investors. The European Commission has proposed a new framework that drops any formal definition of what constitutes a sustainable investment and introduces three reformulated product categories that would be easier to understand. A new article 7 category would include transition funds with at least 70% of their assets having measurable transition objectives; article 8 funds would integrate sustainability factors, such as assets with above-average ESG ratings; and article 9 products would require at least 70% of their assets to be in sustainable economic activities as defined by the green taxonomy, down from the current 100%. If approved by EU member states and the European Parliament, the revised legislation could take effect in 2027 or 2028.

Sustainable Development Goals

’The United Nations’ Sustainable Development Goals, which were defined in 2015 and have been approved by nearly 200 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 and preventing pollution of the world’s oceans, alongside social ambitions such as offering high-quality education, reducing inequality, and ending hunger and improving food security.

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

Rating agencies increasingly offer software tools to help investors judge the sustainability credentials of particular funds. Morningstar compiles fund-level sustainability ratings to help guide investors to the products whose strategies and ambitions are aligned with their own. Investors can also delegate the selection of individual funds to a discretionary or fund of funds manager, a task that has become easier with the increasing diversification of sustainable investment through the creation of dedicated property and infrastructure vehicles as well as equity and bond funds.

Most asset management firms are keen to share their ESG credentials with investors and often provide details on their websites of engagement with individual companies, their voting records, and issuers or sectors from which they have withdrawn or introduced exclusions. This can provide investors with evidence of 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 software systems or access to independent research? Such information, often available on firms’ websites, provides additional evidence of the depth of a fund group’s commitment to ethical and sustainable investment. There is no ’one size fits all’ solution to sustainable investment; the best way to ensure your investments are aligned with your personal values is to check each individual underlying asset held by the fund in question.

Finally, 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 to make money for investors 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.