Sustainable investing

Inflows into socially responsible and ethical investment vehicles have increased substantially in recent years, with the number of funds with an SRI component also growing exponentially.

The Investment Association reports net retail sales of ethical funds hitting £807m in 2016, a record high.

Meanwhile, IHS Markit’s ETF analytics database recorded a total of $950m invested into SRI ETFs in 2016, and this year is set to be even stronger, with inflows of $800m already by the end of July 2017.

Doing good

These figures are backed up by the annual Schroders Global Investor Study, which found that 54 per cent of UK investors have increased their allocation to sustainable investment funds compared with five years ago.

Meanwhile, 67 per cent of UK respondents report that sustainable investing was more important to them now than it was five years ago, with a significant proportion citing the potential for long-term returns as a greater factor than ethical considerations.

Over half, when asked to choose a phrase they associate with sustainable investment, selected something linked to profitability.

A report by Rathbone Greenbank Investments, the specialist ethical and sustainable investments team at Rathbones, demonstrates that the people they surveyed, on the whole, were looking for more than simply a good return from their investments.

Rather, they also wanted to either actively do good or, at the very least, avoid putting money into areas that would do harm, either environmentally or socially.

The report also showed the demographic of those interested in SRI and ethical investing was getting younger, with a relatively high proportion of wealthy millennials looking to align their finances more closely with their values.

“Our research shows that individuals more often want their values applied consistently across everything they are doing,” explains Matt Crossman, engagement manager at Rathbone Greenbank. “They place importance on authenticity and a sense of connection with the investments they are making.”

Tracking its evolution

With evidence demonstrating consistently strong growth in the sector, as well as the potential for strong future growth, it is valuable to consider how this style of investing has gained traction over the past decade, as well as how it has evolved over that period.

In essence, the main trends in socially-responsible investing have centred on three areas: the style of investments, the growth in the number of assets and investment performance.

“It is very easy for investors to get bogged down in the jargon and different terms applied to these types of investments,” explains Mike Appleby, an investment manager on the Sustainable Futures team at Liontrust Asset Management.

He says: “In general, when funds are described as ‘ethical’, it tends to be based on a negative screening process. They are generally defined by what they do not invest in, whether that is tobacco or weapons, for example.

“Another area is sustainable or socially-responsible themed funds, which look to gain exposure to areas benefitting from the phenomenal positive growth in the sustainability trend. Finally, there is active engagement, where the fund is actively seeking to encourage positive change.

“The overarching story is that the investment style has continued to evolve from avoidance strategies where the focus was on looking to avoid certain companies or areas, to a style of more positive involvement.”

He adds: “It is a win/win situation as it is possible to achieve competitive investment returns while also helping make the world a better place.”

Keep on moving

Amanda Young, head of responsible investment at Aberdeen Standard Investments agrees, stating that: “Until fairly recently, ethical investing was the main option if you wanted to invest to reflect your values, but the good money sector has moved along at pace in the last few years, with a range of options now available to investors.

“Where ethical investing seeks to exclude certain industries, such as tobacco and armaments, SRI funds look to invest in the most sustainable companies.

“Impact investing is the latest in the range, and involves investing with the intention to generate positive social and environmental impacts alongside financial returns.”

Meanwhile, for Andrew Howard, head of sustainable research at Schroders, a fundamental shift over the past decade has come from the replacement of the notion of socially responsible investment (SRI) with the more exact and descriptive environmental, social and governance (ESG).

Notably, this broadens out the options for investors far beyond those funds ascribed as “ethical”, encompassing instead the whole investment universe.

He says: “SRI has given way to ESG as the industry’s favoured term. It is a minor point, but it also reflects a wider recognition that environmental and social factors are not contained to SRI-labelled funds.

“The market has grown a great deal; it is very hard to find an investment manager who does not push their ESG commitment.”

Mr Howard continues: “This no doubt makes it difficult for fund investors. But it also puts the industry at a point where simply saying you look at ESG topics or run SRI funds is no longer enough.

“The question is turning from whether managers consider them, to how they look at ESG factors and the role that analysis plays in their investment decisions.

“Our own Global Investor Study highlights a growing recognition that ESG investing comes in different flavours with different goals.

“The market is maturing through an exciting shift where the attention turns from ESG as a generic idea, to the specific details of how different organisations and products are approaching the topic.”

Growing sophistication

Rathbones’ Mr Crossman also points to the increasing level of sophistication in products in this area, citing the growing demand among clients for the carbon footprint of their portfolio to be included alongside other key facts.

They also typically want comprehensive analysis of all of the screens applied, both positive and negative, to ensure the portfolio remains in line with their principles.

In addition, Ms Young sees a focus on more nuanced products that meet individual investors' needs.

She says: “Specifically at a product level, products continue to be launched that incorporate values into their construction.

“These include traditional ethically screened funds that avoid investing in companies in so-called ‘sin’ sectors such as defence or tobacco.

“Some funds take a thematic approach to sustainability issues, such as climate funds or water funds. In addition, fund choices reflect personal religious values, with various Christian or Sharia-based funds available to the consumer.”

She notes that, more recently, the social impact investment market has grown, which allows investors to direct their capital into social enterprises that will achieve both a financial and social return.

According to Ms Young: “This niche investment choice is slowly moving into the mainstream, with impact products that positively screen companies on their products or services, or select companies that have issued bonds to support social projects.

“Impact investing products are being considered and launched across a variety of asset classes.”

Performance

With almost as many options as investors, the question of whether it is necessary to sacrifice profit for principles is not straightforward.

Indeed, it is easy to see how UK equity income strategies, for example, with their traditional focus on the dividend-paying capacity of the mega-cap names, could suffer by excluding the giants in tobacco and oil and gas.

However, on the flipside, managers argue that stockpicking among companies that have a focus on environmental and social issues within their business often necessarily leads to firms with strong management and an element of future-proofing.

What is more, identifying companies that are well-placed to benefit from specific trends in sustainability can also help drive returns.

“Companies don’t operate in a vacuum; in the end, companies can’t succeed swimming against the tides in the societies they are part of,” says Schroders' Mr Howard.

“It is also very clear that we are in the middle of some major social changes and at the sharp point of acute environmental challenges. Identifying successful companies of the future means finding companies that are able to adapt and thrive.

“We are long term, fundamental investors and our commitment to environmental, social and governance issues reflects our understanding that traditional investment analysis and ESG research are inter-twined.”

Mr Howard also points out that some investors have goals beyond investment returns in isolation and, in those cases, different tools are needed.

"But it’s critical to design the ESG analysis we do to the goals we are trying to achieve", he adds.

A further question for advisers and their clients is whether it is better to opt for an actively managed fund or a tracker.

It is fair to say ETF SRI funds have proved popular and hold the same appeal as other passive vehicles, namely lower fees and index-linked performance, which is often stronger than active funds over time.

The indices are typically based on a parent index, which is then screened for positive and negative characteristics to create a SRI-friendly universe.

In this instance, it is crucial for investors to determine exactly what those screens are and how well they match up with their clients’ requirements.

Proponents of actively managed funds, however, argue that skilled qualitative analysis leads to strong returns.

Liontrust’s Mr Appleby, for example, states that it is integration between sustainability and general business fundamentals that is key.

Rather than looking for “the most lovely companies” from a values-based position, there is a need to refine that and look at the potential for long-term outperformance, he says.

Navigating the landscape

Overall, having gone through a period of rapid evolution, SRI does not necessarily offer advisers a clear landscape to navigate.

Victoria Hasler, head of research at Square Mile Consulting, which is tasked with providing ratings and analysis for a range of funds, points to the fact that it is almost impossible to rank one SRI or ethical fund as being “better” than another in terms of its moral integrity.

She stresses it is necessary to focus in on exactly what the client is looking for, their risk appetite and their performance objectives.

“Every investor has a line of things they think are acceptable and areas they definitely do not want to invest in,” she says.

“The difficulty is that line is different for everyone. In the work we do, ‘ethical’ funds have to meet the same standards as any other fund and are approached in the same way.

“We then provide additional qualitative information on all the funds we look at, covering any SRI or ESG credentials.

“It is up to the adviser and client in the end to find the fund that best meets all of their needs.”

Laura Mossman is a freelance financial journalist