How to navigate the ESG maze

10 most widely held shares in UK ESG funds 

Sources: AJ Bell,  Morningstar

How to navigate the ESG maze

Right now investors face a bit of a maze when it comes to ESG investing, because there are lots of words and phrases flying around which can have different interpretations. We can expect this to improve over time, especially when the FCA introduces its green labelling regime. As things stand, there are a number of different approaches to investing ethically, and the main ones are described below. Some funds will combine a number of these different approaches, and within each approach there is a spectrum of ESG activity, from weak to strong. It just goes to show that if you do wish to invest ethically, you do need to roll your sleeves up and look under the bonnet of prospective funds if you want your fund to be ticking a lot of the right ESG boxes. You might not get a perfect match, but you can certainly find a fund which is significantly more aligned with your ethical preferences than the market as a whole. 

Stewardship

Stewardship basically means looking after the investments you manage from the point of view of the environment, society, or the economy at large. At its weakest level this would mean simply voting on proposals made by portfolio companies, at its strongest it would mean lobbying investee companies for change, either in private or in public, or both. It’s probably hard to find an active fund that couldn’t claim to engage in some form of stewardship, so it’s a pretty broad church. Stewardship is an important component of responsible investing, but in ESG funds it would normally be supplemented by further measures.

ESG integration

In this approach, ESG factors are considered when making investment decisions. The effect ESG integration has on a portfolio can be minimal, or quite substantive. For instance, a fund manager could simply receive an ESG rating for each stock, alongside other financial information which informs their investment decision. The ESG rating may therefore be a very small part of the overall decision-making process, and hardly reflected in the portfolio. It’s therefore easy to see why accusations of greenwashing might arise around ESG integration. At the other end of the spectrum, ESG integration can mean a more robust approach. For instance, a fund may decline investment in companies which don’t carry a minimum ESG rating, no matter how appealing their other characteristics.

Tilting

Some funds use ESG scores to tilt their portfolio away from companies with poor ratings, and towards companies with good ratings. This approach clearly means that some of your money may still be invested in some companies and industries which you might take issue with, but you’ll have a significantly lower exposure than the market, so it strikes a balance between ethics and pragmatism.

Best in class

This approach permits investment across a range of industries, even carbon intensive ones, but picks a portfolio of companies which are leading their sector in terms of their ESG credentials. The benefit of this approach is that it’s easier to produce a balanced portfolio, and probably suits those people who believe the likes of BP and Shell are critical to the transition to cleaner energy, and so might still merit investment. 

Exclusions

One way to invest ethically is for a fund to exclude certain industries from its portfolio. Typical examples would be tobacco, oil and gas, gambling and defence companies. This might suit investors who don’t mind too much where they invest, as long as their money isn’t held in companies which they believe are doing harm. This is a traditional way of investing ethically, and it’s also straightforward to understand and implement.

Positive impact

Some funds go a step further and seek out companies that are actually working towards solving some of the ESG problems facing the world, whether that be climate change, financial inclusion, or poverty. These funds can be more risky, often because they can invest in fairly specialist areas. Indeed, included in this category are funds which target investment in specific themes, such as renewable energy, or clean water, and which may therefore have a very focused portfolio.