But there is also a growing risk that many of the ESG options available to investors are failing to meet their needs and expectations. An “ESG by the numbers” approach will not achieve the desired outcome of shifting capital toward more productive purposes, and it is essential to also take a qualitative, not just quantitative, approach to ESG investing.
We see this dichotomy of sustainable investing methods playing out with active and passive funds. Active funds use a hands-on approach to investing by making assessments of financial instruments, like stocks or bonds, from fundamentals such as cash flow modelling, analysing balance sheets, competitor comparisons, assessing the quality of the management team and culture of the business, to name a few. So, the analysis for active investing usually uses both quantitative and qualitative analysis.
On the other hand, passive investing tends to focus solely on quantitative metrics when assessing a potential investment, and this is the same for passive sustainability funds.
This quantitative ESG data that passive funds typically use are from third-party providers, yet the data produced by these providers usually don’t tell the full picture of sustainable investment measures, along with differing ESG standards between the providers. For instance, in 2018, third-party provider FTSE ranked Tesla as one of the worst carmakers according to its ESG metrics, but MSCI ranked it the best and Sustainalytics had Tesla’s ESG somewhere in the middle.
Other global giants including Alphabet, Bank of America, and Apple feature on various ESG indices such as the Dow Jones Sustainability World Index and the FTSE4Good Index, among others. Although these companies are considered solid growth companies by the investor community, do they really provide long-term sustainable and responsible growth?
It seems to us that when it comes to sustainable investment, there is an argument that you get what you pay for, with passive funds offering a cheaper, simpler product, versus active funds that can provide more in-depth and considered analysis.
For advisers and their clients, when looking to make sustainable investments, various qualitative measures help provide a fuller picture and ultimately ensure investors achieve their ESG aims. These include:
1. Contribution to society
Sustainable investing demands that companies do not exist in a silo, only providing the fruits of their labour for themselves. The products and services businesses produce need to make a positive contribution to society. Yet various products and services could have pros and cons when assessing how they affect society. Apple’s products help move society to become more digital, helping cut down on pulp and paper production, which saves trees that are vital to the environment. Yet Apple’s supply chain has risks related to conflict minerals and child labour, and the company has been implicated in various labour rights issues in their plants in China. This is just one example, but it shows the complexity of how various products and services affect society and how these must be weighted when considering proper sustainability criteria.
2. Genuine sustainability or just ‘greenwashing’
Some companies may look impressive through their communications and marketing, but their actions or business practices may look very different in reality. It is important not to get caught up in greenwashing, which is a misrepresentation of a product or service that makes it appear sustainable when in reality, it isn’t. One clear example of this is eggs that are labelled “free range”. Pretty much all or most egg cartons from various brands say that they are free-range but if you went back to the source farm, you would find that the term “free range” is used very loosely. So be sure to look beyond the label.
3. Approach to regulations
Regulations are also a big factor when considering sustainable investments. Regulations are changing quickly, particularly in relation to the environment and carbon emissions. Europe’s Green Deal and Biden’s new infrastructure packages are expected to come alongside swathes of regulatory changes to encourage more sustainable practices. The way that some companies respond to regulations can be telling.
There are some companies that respond to regulations in more of a reactionary fashion; they only follow the regulation because they must. This is of course better than not following regulations at all. Yet there are some companies that actually help create best practice and lead the way. There are other companies that are ahead of the regulators and create industry standards for best practice in their sector. These companies can then help create frameworks for future regulation.
4. Treatment of stakeholders
The companies that provide the most benefit to their stakeholders usually fit best practice sustainability standards. For example, going back to Tesla, the company’s electric cars may be high on sustainability standards due to its electric cars lessening the carbon dioxide impact on the planet’s climate, but the company is said to have governance and labour relations issues. Yet companies such as outdoor sustainable apparel business Patagonia gives its employees generous benefits including good paid leave and on-site childcare, along with encouraging its employees to treat work as play. Treating employees with respect, and nurturing them, can have various positive spillover effects into general society.
When considering sustainable investing, quantitative tick-box exercises are not enough. Sustainability is a complex topic that requires judgement and assessment of softer aspects, including a company’s culture, its contribution to society, how it treats its stakeholders, its approach to regulations, and whether its products and services are genuinely sustainable. Don’t just tick the ESG boxes, make sure to analyse companies from the bottom-up through their supply chain and all other core components of the business, to help drive sustainable long-term growth.
Lorna Logan, co-portfolio manager, Stewart Investors Sustainable Funds Group
Neil Griffiths
Neil is the Deputy Editor of the wealth titles, including ifa and InvestorDaily.
Neil is also the host of the ifa show podcast.
