Ethical and ESG fund investing: your complete guide

When you invest money, that money ends up being used temporarily by someone else – such as a company or a government, to fund their activities.

But what if some of these activities clash with your personal values, or those of your own business? For instance, if you are anti-smoking you probably won’t want your investments propping up the tobacco industry.

Some organisations may even face serious embarrassment from their investment choices – such a homeless charity finding out that it has money invested in gambling firms.

Unfortunately, it’s often not easy to tell how your money will be used.

Whether you’re investing for yourself or for your organisation, or even just building up a pension fund, you can gain reassurance that your values will be respected by choosing ethical investments.

What counts as an ethical investment?

The term ‘ethical investing’ is a fairly loose one. Broadly, it means you have another goal besides a return on your investments: you also want your money to do good (or at least, to do as little harm as possible).

For example, one ethical investor might simply aim to avoid putting their money in industries known to cause harm, such as tobacco, armaments or gambling.

A more rigorous ethical investor may look to invest in companies with particularly high standards with regard to the environment, society and how they are run.

Such standards are known as Environmental, Social and Governance (ESG) criteria, and are often used by socially conscious investors to screen their investments.

The fact that some investment funds are called ‘ethical’ doesn’t mean that all the others are necessarily immoral or harmful. Rather, with an ‘ordinary’ investment fund it is possible that your money is funding some activities that you would disapprove of.

What is ESG investing and how does it work?

ESG investing is the practice of considering a company’s environmental and social impact before deciding whether or not to invest in its stock.

As such it is a more rigorous definition of ‘ethical’ or ‘sustainable’ investing, since it looks at all of a company’s main activities and how they impact the world on a large and small scale.

The appeal of ESG investing is more than just a moral one. Investors are also drawn to it on the basis that companies with a strong ESG profile may represent better value.

For example, more sustainable companies have greater prospects for long-term stability, socially responsible companies may attract the best talent, and well-governed companies are less prone to corruption and damaging scandals.

ESG fund managers looking to invest in a particular company will first investigate its ESG credentials, often interviewing both management and staff and also those connected with the company such as suppliers, customers and local communities.

The investigation looks not just for negatives but also at positives, to achieve a rounded view of the company’s overall impact. If the company meets the fund’s threshold for ESG criteria, the fund may invest in its shares.

Learn more: ESG investing vs impact investing: which is best for you?

What factors does ESG investing look at?

ESG stands for ‘environmental, social and corporate governance’.

These are widely held to be the three main factors in judging the sustainability and impact of a business or other organisation. These broadly break down as follows:

Environmental

Environmental factors look at the business’s carbon footprint, its contribution to other forms of pollution, its sustainability (how renewable are the resources it uses?) and other impacts it may have on the environment.

Set against these will be any activities the business regularly undertakes to reduce or offset these impacts.

Social

Social factors include the diversity of the business workforce, its inclusivity, its responsibilities towards consumers, and the corporate policies relating to these.

Corporate governance

Governance relates to how the organisation is structured and run, and how fairly employees are treated in comparison with management and senior executives.

Does ESG investing actually work?

There is considerable evidence that ESG investing is effective at achieving its aims.

Of course its aims are twofold: delivering a return for the investor, but also promoting ethical and responsible practices.

Sometimes these two aims may create tension and pull against each other.

For instance, a company committed to sustainable activity and opposed to exploitation may not always be able to chase maximum profits.

Therefore in the short term its stocks may lag behind more ‘ruthless’ companies.

More serious ESG investors may have to offset their expectations of growth against their ethical goals, and decide which is more important to them.

That said, ESG investing does not necessarily mean compromising on returns – indeed, in the long term the opposite may apply.

The 2008 financial crisis was a stark example of what can happen when profits are prioritized over sustainability, where the banks least affected were the Islamic banks that avoided the reckless practices of the wider industry.

Today, worldwide focus on climate change means that green technologies are attracting more investment and government subsidies, potentially giving them a financial advantage as well as an ethical one.

Sustainability and responsible also – in theory – reduces the risk of the investment ‘hitting the wall’ when its impact becomes too damaging.

A successful ESG fund will generally target companies that are profitable first, and only then consider their ESG credentials, rather than simply investing in anything with good corporate responsibility.

This is why your choice of fund is important – a financial adviser can help you with this.

Why is ESG investing important?

If environmental and social responsibility are issues that matter to you, then ESG investing can be a good way to support them while obtaining benefit in the process.

The principle of ESG investing is simple: all investing is about the future, so it should consider the future of the world as a whole, rather than just focusing on the monetary value of the fund.

To put it another way: there is no point having a huge investment pot at the end of the process, if by then the planet is no longer a pleasant place to live.

ESG investing therefore has a holistic element, aiming to ensure that you have both money and a healthy world in which to spend it.

What ESG funds have performed well in the past?

Choosing an ESG fund is generally a more involved process than choosing an ordinary fund, since you have to consider both the ESG factors and the returns.

As with all investments, different funds also carry different levels of risk, so you need to ensure these are suited to your own risk tolerance.

Therefore you should consult an IFA about your options before making any firm choices.

For reference only, here are some of the strongest performing UK ESG funds over the past year.

Bear in mind that this period has coincided with the Covid pandemic, so performance may not be typical for the long term.

Global Macro Sustainable Fund – J P Morgan

2020 performance: 3.09%

This fund invests in a global portfolio of sustainable securities, currencies and some derivatives where appropriate.

Securities are chosen based on effective governance and superior management of environmental and social issues.

Sustainable Equity Fund Global – LGT Group

2017-2020 performance: 6.54%

This Liechtenstein-based fund is run with a defensive approach, which may have helped it to outperform its benchmark during the pandemic that saw many funds decline.

Assets include Nintendo and ITV, with the bulk of its investments being in utilities and consumer staples, which are less volatile.

Trium ESG Emissions Impact Fund – Trium Capital

2020 performance: 9.34%

The fund is based around a core of around 20 long-term investments, and targets companies that have the most to gain from reducing their carbon emissions cost-effectively.

The fund is managed with very low net market exposure, typically -10% to +10%, which helps to cushion it against the volatility of the stock market as a whole.

These are just a handful of examples of recently strong-performing funds. Past performance however is never a guarantee of future performance, so advice in this area is strongly recommended.

How can an IFA help me with ESG investing?

The most important benefit of having an IFA is that they are unbiased.

There are countless investment funds in the UK and elsewhere, all of which want to attract your money, so choosing between them is a daunting challenge.

Any information you find online may also be biased, or simply inaccurate or outdated, and you never know what vested interests the journalists themselves may have.

An IFA, by contrast, is paid to work for you and to act solely in your best interests.

Secondly, an IFA will be experienced in identifying funds and comparing them objectively.

Quite simply, they know what to look for and what qualities and/or risks to be aware of.

They won’t inevitably make the right call every time – but the odds of them picking good funds are very much better than the odds of anyone doing it by chance, or after a few hours of online research.

Thirdly, it’s much simpler and easier to use an IFA. You simply talk to them about your investment needs and your ethical preferences, and the IFA goes away and finds suitable funds for you to choose from.

The difference in returns between good and poor funds can be dramatic, which in many cases will more than justify the IFA’s fee.

What are the different kinds of ethical investments?

If you want to invest ethically, first ask yourself how strict you want to be.

If you are content just to avoid certain types of industries or business practices, then Socially Responsible Investing (SRI) may be enough for you.

SRI funds set broad criteria when constructing a portfolio, to screen out less ethical companies.

However, SRI funds tend to focus on ‘best in class’ companies rather avoiding whole industries, so may include (for example) oil companies that show more responsibility than their competitors. Such funds are sometimes described as ‘light green’.

If you prefer a more rigorous approach, then you may want to look at fully ethical funds.

These will hand-pick companies to invest in based on their strong ESG criteria, and will exclude any that don’t meet its standards.

Such funds may be described as ‘dark green’ or (for those with slightly looser restrictions) ‘medium green’.

Another kind of fund is a ‘passive’ ethical investment fund.

A passive fund invests in a range of ordinary companies, regardless of their ethics, and then uses its position as a significant shareholder to try and address any ethical concerns by voting on resolutions.

Of course there is no guarantee that the fund will succeed in improving the companies’ behaviour.

How do I choose the right ethical investment?

Even when investing ethically, consider your own interests first and foremost.

This isn’t about giving to charity, but a mutually beneficial financial arrangement.

So initially, approach this as you would any other kind of investing.

Talk to a specialist financial adviser about your investment goals, assess your risk profile together, work out how much you have to invest, and only then start looking at individual funds.

Notwithstanding their ethical credentials, assess them as rigorously as you would any other kind of investment.

You should also confirm that the fund really is ethical and not just claiming to be.

Read up on it and find out what its top 10 holdings are, check how much of its portfolio consists of social or environmental investments, and investigate further if anything doesn’t fit your idea of ‘ethical’.

Ultimately, what is ethical for you is your choice.

Are there any other advantages to ethical investing?

Investing ethically may have addition benefits beyond social responsibility.

Many ethical industries (such as low-carbon energy) attract government subsidies, which may give them a growth advantage.

One key ethical criteria is ‘sustainability’, and sustainability is also a good thing for investors if you are looking at the longer term.

Similarly, ethical funds look for companies with good governance, and these are likely to be more stable and less prone to volatility.

Also, ethical investments are growing in popularity, while the younger generation favours more ethical companies – both of which point to a bright future for this kind of investing.

Are there drawbacks to ethical investing?

There is little clear evidence that ethical funds perform less well than conventional funds.

That said, there are some factors to take into account.

Ethical investment restricts your choice of companies to invest in, which may lead to less diversity in your portfolio (and less diversity can mean higher risk). Your choice of funds may be similarly limited.

The lower volatility of ethical investments can also mean you see slower growth with fewer peaks, even if overall growth may be steadier.

Finally, ethical investment funds may require higher management fees, as fund managers need to take more time researching the companies they invest in.

You may also use more of your own time.

What else should I consider when investing ethically?

Always remember that this is still about making money for you, rather than supporting a particular cause.

Don’t confuse the cause with the investment. If you think a company is particularly admirable from a moral point of view, you may be biased towards it and give less scrutiny to the quality of the investment itself.

This is another good reason to consult a financial adviser first, as they will bring vital objectivity and ensure that you make your decisions with the head, not just the heart.

Find an adviser who specialises in ethical investments using the smart Unbiased search.

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