ESG investing

Environmental, social and governance (ESG) or ethical investing is an investment methodology that seeks to invest in companies, properties or bonds that are aligned with the personal values of the investor.

  • The framework for defining the ethical investment credentials of a managed fund are known as the United Nations Principles for Responsible Investment (UN PRI).
  • Australia has the fourth highest number of investment companies that have signed up to these principles.
  • Australian equities ethical investment strategies outperform over the short, medium and long term although the evidence for international equities is mixed.

The rise in awareness of climate change, concerns over pollution and alternative energy, deforestation, the harmful health effects of tobacco and excessive alcohol consumption, inequality and discrimination, and the scale of the global munitions industries have prompted some investors to direct their investments into managed funds that they believe will have a positive environmental and social impact.

When investors do this they are pursuing what are known as ESG or ethical investment principles. The subtlety with this style of investing is that what is ethical to one investor might not be ethical to another. At its simplest, ESG investing avoids companies that do the most harm to both people and the environment. These include companies involved in gambling, alcohol, tobacco and guns. These are known as "sin" stocks. When investment managers avoid these companies in their portfolios, this is known as negative screening, that is, the focus is on determining which stocks should not be included.

An alternative approach is for investment managers to focus on or seek out companies that are the best in the market or at least their industry segment on environmental or social factors. This is known as positive screening.

ESG investment manager guidelines

When managed funds and their investment managers label themselves as ESG or ethical, and if they declare they follow UN PRI guidelines, they are agreeing to be bound by the following principles:

  • They will incorporate environmental, social and governance (ESG) issues into their investment analysis and decision-making.
  • They will be active owners of investment assets and incorporate ESG issues into their investment practices, including how they vote at company shareholder meetings.
  • They will seek appropriate disclosure on ESG issues by the entities in which they invest.
  • They will promote acceptance and implementation of the UN PRI within the investment industry and work together to enhance the effectiveness of the principles.
  • They will each report on their activities and progress towards implementing the principles.

Investors looking for managed funds that have an ESG investment philosophy have two broad choices:

1. Invest in a managed fund that is explicitly labelled ESG, that is, it selects constituent assets, such as company shares, bonds or properties using a combination of positive and negative screens.

2. Invest into a managed fund where the investment manager may not use specific screens when choosing its assets because it instead uses an overarching ESG framework to guide how the managed fund operates. This is called using an ESG governance overlay.

These investment frameworks becoming more common prompted the United Nations in 2005 to establish the Principles for Responsible Investment (UN PRI) to formulate sets of environmental, social and governance guidelines around ethical investment and related overlays and to work with investment managers, superannuation funds, regulators, credit rating agencies and industry associations to promote these principles. This framework is known as ESG. Each ESG factor is described below:

Environmental concerns include screening out stocks that make their money from activities that are negative for climate change (such as coalfired power plants). On the other hand, the ESG investment process looks favourably on businesses that profit from reducing the effects of climate change, such as alternative power strategies like solar or wind farms.

Social concerns include assessing a company's policies and commitment to diversity (such as its hiring policies), human rights (such as examining the company's supply chain to make sure people work in safe conditions and are paid a living wage) and animal welfare (in particular, testing products on animals).

Governance concerns include a special focus on how UN PRI signatories run their own businesses as well as how they select and seek to influence the companies in which they invest - for example, by participating in shareholder meetings and taking activist positions.

Do ESG investments outperform?

While investors may have personal preferences about ESG or ethical investment, managed funds and their philosophies, the key question is how do these investment strategies perform compared with regular investment strategies? As this chart shows, in Australia they underperformed over the short term but over the longer term they returned about the same. In international equities the result depended on the time period.

Sharemarket indexes: ESG vs the regular market to December 2021

Sharemarket indexes: ESG vs the regular market to December 2021

Indices in this chart: Australian equities, ASX/S&P 200 and the MSCI Australian ESG Leaders
International equities, MSCI All Countries in AUD and MSCI World ESG Leaders in AUD

Source: FactSet

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