How do the biggest UK equity funds perform on ESG factors?

Green-Shoots-Emerging-Growth-700.jpgSustainable investing is generally depicted as a concept that is implemented through specialist mandates: that is, those which explicitly express a commitment to sustainability objectives. As a result, investors have developed a polarised view of investment strategies – sustainable versus mainstream.

This is not only because funds are often marketed that way, but also because the language cited in investment literature, where terms such as ethical, socially conscious/responsible, sustainable, mission-based, green, ESG (environmental, social and governance) and so on are used interchangeably, has left those funds lumped into an undifferentiated mass.

Taking a bird’s eye view, sustainable investing is a long-term approach that captures the ESG disciplines of companies. It has very little to do with “negative screens”, instead focusing on the behaviour of companies in areas such as product safety, climate change and carbon emissions, board composition, gender and diversity in the workplace, executive compensation and energy efficiency, to name but a few.

By and large, unless an investor has opted for a fund that is labelled “sustainable”, it is safe to assume that the sustainability profile of their investments doesn’t keep them awake at night. We think sustainability warrants greater attention, though, as time and time again we are reminded about the significant impact that ESG-related mishaps have on companies’ financial performance. Therefore, this concept need not be confined to a specific group of funds that carry the “sustainable” label. It is relevant to all funds.

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How are some of the most popular UK-equity funds performing on ESG factors? Until recently, it would have been difficult to answer this question. However, Morningstar has launched a rating that gives investors a new measure of how well the underlying companies in a fund are doing on sustainability relative to their peers.

The Morningstar Sustainability Rating is based on research from Sustainalytics, a  provider of ESG and corporate governance ratings and research. To arrive at the rating, we first calculate a Portfolio Sustain-ability Score, which is based on a portfolio’s ESG score and a deduction for current ESG-related controversies. Sustainalytics classifies controversial events involving companies by severity across five categories, with category 5 being the most severe. To establish the rating we then sort funds into five normally distributed groups by comparing a fund’s portfolio sustainability score with that of its Morningstar category peers.

Among the 10 largest active UK equity funds in the Morningstar UK Large-Cap Blend Equity category, the results are varied. Threadneedle UK combines a favourable ESG score relative to peers, as well as a limited exposure to companies with controversies when compared with peers, therefore achieving a five-globe rating.

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It is worth mentioning that on average across its fund range, the ratings of Columbia Threadneedle – a signatory of the UN Principles for Responsible Investments – have been slightly above average. However, that’s not to say that the fund has zero exposure to companies with controversies. Indeed, Royal Dutch Shell, which has featured in this portfolio, as well as eight out of the 10 funds, has a category 4 controversy score. According to Sustainalytics the company’s operations through its subsidiaries in Nigeria are linked to severe environmental pollution in relation to oil spills over several decades. During the past five years the company has spilled 12,600 tonnes of oil worldwide.

If we look closely at the scores, JOHCM UK Opportunities has an average ESG score relative to its peers, but its favourable controversy score has pushed its overall rating to above average, which is equivalent to a four globe rating. The fund’s manager, John Wood, has a long-term strategy focused on identifying quality stocks and stable growers, which tends to favour stocks that score well in sustainability. Among holdings in the portfolio is Sage Group, supplier of accounting and business management software, which has not been involved in any controversies.

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Although the Morningstar Sustainability Rating reflects a best-in-class approach to ESG, controversies may be prevalent in some sectors more than others and therefore sector biases within funds can still have an impact on the overall rating. Looking at the JOHCM fund’s sector exposures, it seems the muted exposure to financials and metals and mining, as well as the underweight exposure to energy relative to peers, may have also contributed to its strong rating, given the higher incidence of controversies in those sectors.

In a similar vein, Majedie UK Equity has an average ESG score; however, its controversy score ranks among the worst in its category, dragging its overall rating down to two globes. The fund is structured into four subportfolios run by different managers. Overall, the managers seek to identify attractively valued companies whose price is below their real, industrial, or long-term worth. The fund owns five out of six of the most commonly held stocks, omitting only Sage Group. Given the growth-oriented nature of the stock and its valuation metrics, we wouldn’t expect to see it in this value-driven portfolio.

GlaxoSmithKline, which is an outperformer in its sector, has featured in the portfolio. The stock is, however, contributing to the fund’s poor controversy score as it has a category 4 controversy rating. The company has been involved in several controversies, including severe bribery cases between 2007 and 2013, after which the company has progressively improved its programmes and management systems to mitigate risks of recurrence. It has also been accused of being involved in a series of unethical clinical trial practices.

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At the other end of the spectrum, Invesco Perpetual UK Growth has a low sustainability rating. Although the fund has an average ESG score, its controversy score is below average. The fund’s manager, Martin Walker, adopts a pragmatic, unconstrained approach that is contrarian in nature.

The manager’s value orientation can partly explain his ownership of stocks such as Rio Tinto, BP, Barclays and Shell, which have been battered in recent years and have delivered a negative annualised return during the past three years. BP, for example, which has a category 3 controversy rating, has been involved in several controversies relating to employee safety violations across its global operations. It also remains exposed to shareholder litigations in relation to the 2010 Deepwater Horizon incident.

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Interestingly, Barclays has been owned across eight of the 10 funds. Although it scores broadly in line with its sector, its record shows several controversies, with the highest being a category 4 as the bank has faced multiple investigations and lawsuits. In 2012 Barclays was the first bank to settle investigations over Libor manipulation with US and UK regulators, accepting a fine of $453m. In 2014 the SEC started an investigation over big “dark pools”, and in 2015 Barclays pleaded guilty to criminally manipulating the foreign exchange markets between 2007 and 2011 and agreed to pay a record fine of $2.4bn.

Some companies clearly do a better job of managing their ESG risks and opportunities than others, and this not only feeds into funds with sustainable mandates, it is also rele-vant for mainstream funds. Morningstar’s new ratings will contribute to the mainstreaming of sustainable investing, helping the field move from the province of the institutional and high-net-worth investor to the everyday investor. However, investors should also expect greater scrutiny from fund managers as they interact with companies on corporate sustainability issues.

Muna Abu-Habsa is senior analyst at Morningstar