VW, Morningstar and COP 21: Welcome to the year of ethical investing


Fighting climate change and promoting human rights are worthy goals for investors. An even better one is doing it while making a killing in financial markets.

That is the reasoning behind the development of sustainable investment in recent years. The times when only do-gooders were looking for securities that complied with environmental, social and governance principles appear to be long gone. Among institutional investors a focus on ESG is fast becoming a reliable way to predict solid performance, and the trend is quickly taking hold in the retail market too.

The number of retail funds whose investment strategies incorporate ESG principles is growing fast. According to Vigeo Eiris, a ratings agency, there were 1,204 socially responsible investment funds in Europe by June 2015, which was 25 per cent more than a year before and a 221 per cent increase over a decade ago. They managed, together, more than €136bn (£107bn), almost six times as much as in 2005.

Those are important numbers, but they still represent a mere 1.7 per cent of the European retail funds market. “In the world of retail investors, the progress of ESG investments has been surprisingly slow,” says Jason Hollands, a managing director at Tilney Bestinvest. Not enough to convince many issuers to embrace a large set of principles that some companies see as costly, restrictive and cumbersome: a report by the University of Oxford lists no fewer than 30 ESG issues, ranging from carbon emissions and human rights to corruption, water management and executive pay. But many are realising that ESG has moved away from the niche of funds focused on ethical and moral investments and could soon encompass most, if not all, of the market.

“In the past 24 months, in particular, we have seen an enormous increase in demand for ESG strategies.”

Important factors

“More asset managers are incorporating ESG in their investment processes because they are recognising that these are important factors that should be a part of any reasonable, comprehensive security analysis,” says Jon Hale, head of sustainability research at Morningstar. “They are also seeing increasing demand from both the institutional side and the mainstream investment community.”

The reasoning is that, if a company respects the environment, plays a social role and complies with the rules applicable to its business, this can only be good news for stakeholders. Consequently, its market value tends to go up and its ability to pay bonds is less likely to be compromised. “We see them as prudently managed companies,” says Andreas Feiner, a partner at Arabesque Asset Management, an ESG specialist.


The other side of the argument, of course, is that ESG principles may not be particularly conducive to strong business performance. This point of view was perfectly explained by Exxon Mobil chief executive Rex Tillerson, during the presentation of the company’s annual results earlier this year. Asked by investors whether the group would put more money into the development of renewable energies, he said: “We chose not to lose money on purpose.”

In the funds industry, some managers rely on securities that are not particularly ESG compliant in order to achieve their goals. The Woodford Equity Income fund is one example. A perennial bestseller among retail investors, it has several tobacco companies among its main holdings. “I’m not paid to exercise my moral judgements in my portfolio,” fund manager Neil Woodford has said.

Stephen Peters, an investment manager at Charles Stanley, says: “Performance can be compromised for ESG considerations, that’s for sure. Without investments in tobacco it would get more difficult for income funds, for example. We will do it for clients if they are inclined to, but we have never seen that there are huge amounts of money to be made in it.”

The fact is that, for many people in the business world, there is a big difference between delivering returns for shareholders and hoping to save the world from its many problems. But ever more investors are tapping into a growing body of literature that shows that playing by the rules and being good citizens actually helps companies deliver good performance.

As the managers of New Zealand’s official pension fund explained in a recent white paper, companies that apply good ESG management face benefits such as higher levels of consumer support, an ability to detect risks early, less exposure to legal and regulatory risks and a propensity to innovate. Investors in the likes of BP (pollution), Volkswagen (poor governance) and Petrobras (corruption) can well attest that ESG-related events can have a huge effect on a portfolio.

The argument of the managers also states that ESG-compliant firms have lower equity costs and can borrow at lower rates. Besides, the paper goes on, their profitability has a tendency to be higher and stock prices to fare better than those of companies with a less sustainable approach. The prize is especially rewarding for issuers based in countries where regulatory environments are less well developed, a fact that emerging markets investors can well vouch for.

According to Feiner, taking ESG factors into account is nothing more than considering extra financial information while evaluating the attractiveness of an asset. “We are worried about the DNA of the company, and not about something that it does in terms of charity,” Feiner says.


The value added by a focus on ESG can be exemplified by a number of specialised funds that have provided strong performance in recent years. For example, the Delphi Nordic fund  has delivered returns of 38.7 per cent a year since 2012, while the Federal Actions Ethiques fund posted an average annual return of 17.2 per cent in the same period (both have been in the negatives in 2016, though). The performance is certainly not due only to the focus on ESG principles in which their strategies are grounded, but the numbers at least show that these principles are not an impediment to performance for some funds.

A series of indices from MSCI help to bolster the case. The ESG-compliant version of the MSCI ACWI index has beaten its parent in each of the past three years, and the same has happened with the MSCI Emerging Market ESG index every year since 2010. In the latter case, the difference in performance in some years was striking, which only strengthens the point that good governance pays out particularly well in the emerging world. The results are more mixed, however, among MSCI’s USA and World large and mid-cap indices.

The good performance of ESG investments has also been boosted by a change of approach by investors with sustainable goals. The traditional way of ESG investing has been to exclude from a portfolio companies that do not satisfy sets of principles or beliefs. That is the kind of reasoning that has kept tobacco and weapons producers out of the investment universe of many players in the market for several decades. The flip side, however, is that it can narrow considerably the group of companies in which a fund can invest, as investors expand the universe of issues they are worried about.

Despite its limitations, this strategy continues to be a common one, but others have flourished in the past few years that lend a more positive approach to the subject. They call for the engagement of investors towards the promotion of improvements at companies, or issue rewards for those that make efforts in the right direction, even if they are not right there at the  moment. Some increasingly popular strategies integrate ESG variables with traditional criteria of analysis, under the argument that they can only help issuers to perform better.

Kate Brett, an investment consultant at Mercer, says a growing number of funds have integrated ESG principles into their strategies. The situation varies, however, according to the type of investment vehicle. Mercer has had an ESG ratings system in place since 2008. Infrastructure funds have the highest number of securities boasting the top two ratings, followed by real estate funds. At the other end of the spectrum, more than 80 per cent of hedge funds get the lowest possible ratings, with fixed income coming second from bottom with more than 70 per cent. Equity funds come right afterwards with around 60 per cent.

“Although governance has long been regarded as a driver of shareholder value, it is only more recently that sustainability has been more widely recognised as a driver of shareholder value,” says Justin Simler, an investment director at Investec. “It is, therefore, the explicit measurement of ESG factors and their integration into the investment process that is the key change and which will have the greatest impact on how companies and governments operate.”

He adds: “This does not mean that funds will not make investments into companies with poorer ESG ratings, but that this creates a hurdle that might require the valuation to compensate for the greater risks, or costs, or a greater level of engagement.”

As a result of broader approaches to ESG investments, the universe of securities that can be included in such portfolios has widened considerably, and fears that making an option for ESG necessarily implied a sacrifice of returns has been assuaged. “The traditional approach to ESG investments relied on exclusionary screening,” Hale says. “But, with a more positive and holistic  approach, concerns about performance have been addressed.”


At present, this process is taking place mostly at the level of institutional investors. In the past few years, dozens of pension fund managers, wealth advisers, private equity firms and insurance companies have been under pressure from stakeholders to put more emphasis on issues such as climate change and human rights. They have reacted accordingly by upping the pressure on issuers and asset managers. Consequently, in the past few months companies such as Exxon Mobil have been called by shareholder groups into making firmer ESG commitments.

The activism of investors, whose good intentions have certainly not been diminished by expectations of larger returns, have included episodes of public shaming. A recent letter published by the investor group ShareAction named car makers Renault/Nissan, Peugeot Citroen PSA and Ford for failing to give them information on lobbying and compliance with carbon emission standards after the Volkswagen scandal.

There is little doubt that this kind of expectation is gaining ground among clients. In a survey released by Cerulli Associates last year, 50 per cent of asset managers interviewed said that requests by institutional clients about responsible investment strategies had increased. “In the past 24 months, in particular, we have seen an enormous increase in demand for ESG strategies,” Feiner said.

Hale believes the trend will become ever more widespread, and retail investors do not constitute an exception. “A lot of trends that we see take hold in investing more generally start out in the institutional level and move into the mainstream,” he says. “Women and the millennial generation are becoming more prominent investment decision-makers day by day, and surveys show that they have high levels of interest in sustainable investment.”

A survey commissioned by the UK Sustainable Investment and Finance Association last year found 54 per cent of the retail investors interviewed wanted their pensions and savings to have a positive effect in the world, in addition to making money.

Rating funds

The idea that ESG investment is not purely a declaration of moral purpose but a means to achieve reliable, strong returns underlies the creation by Morningstar of a rating system that aims to give investors information about the sustainability of funds. The ratings will be awarded not just to ESG-focused funds but to all funds.

“The goal is to evaluate how well the companies included in portfolios are addressing the various ESG risks and opportunities that they face in their businesses,” Hale says.

In the system, data on companies will be provided by Sustainalytics, a ratings agency that focuses on the sustainability of securities. The data will be added to Morningstar’s own rating criteria, resulting in a ESG score for each fund. The top 10 per cent of funds in terms of ESG will get the highest ratings, and the bottom 10 per cent the lowest.

Morningstar’s data providers are also able to send out flash updates when a controversy comes to light, such as the VW emissions scandal. Ratings of funds with a large exposure to the security involved will not be immediately changed to assimilate the news, but the downgrade or upgrade will take place “on a fairly timely basis”, according to Hale.

Observers believe that Morningstar’s system may have a strong influence in the market as no fund will want to have low ratings for ethical and sustainable investment strategies. It also means that fund managers who ignore ESG principles in their strategies under the argument that it was not part of their fiduciary duty will find it more difficult to do so in the future.

Some have also expressed concern that the focus of the system on the ratings provided by Sustainalytics will make it easier for funds to purchase securities issued by highly rated companies than to make an effort to improve the management practices at those that still have work to do.

“Managers might aim to unlock value for their clients through focused engagement that improves the companies’ ESG practices, disclosure and market ratings,” points out Investec in a written comment on the matter. “This will not be reflected in the current Morningstar ESG rating. So while the Morningstar ratings will help to drive awareness of ESG issues, there is the danger that they will be misunderstood and misinterpreted.”

Another issue is the quality of the data employed to rate a company’s commitment to ESG principles, which is notoriously hard to measure. The information is reported by companies themselves and raters need to make a considerable effort to check its reliability. Furthermore, there is not much data to be crunched to begin with. “ESG data is still in its infancy,” Feiner says. “It is still more art than science, but there is enough information available to make a difference in portfolios.”

In any case, no one should think that the adoption or not of ESG principles alone could be a substitute for other kinds of analysis to determine the success or failure of an investment. Every year, for example, Sustainalytics releases its views on the market prospects for 10 companies whose sustainable efforts it rates. Last year, it got some of them right, but others did not evolve as expected. For example, the company expressed concerns about governance issues at on demand TV provider Netflix, but the company’s shares went up by 134 per cent in 2015. Similarly, it showed enthusiasm with the merger of Lafarge and Holcim as both cement makers had a good ESG profile. Markets were much less impressed with the operation, and shares of the new group fell by 26 per cent.

Sustainalytics says it still stands by its views on both companies, and that the future should prove it right. But the case shows earning the stamp of good corporate citizen is still not enough to isolate a company from the whims of financial markets.

The numbers

221% Increase in the number of socially responsible investment funds in Europe over the past decade

€136bn Funds under management in socially responsible funds in Europe

50% Proportion of asset managers seeing an increase in enquiries from investors about responsible investment strategies


Sustainable investment strategies will become more important by the day. A good example is the agreement signed by almost 200 countries during the COP21 conference in Paris in 2015. In addition to agreeing with targets to fight climate change by restricting the heating of the planet to 2.7C, compared to 4.8 C if nothing was done, the governments pledged to raise $100bn (£72bn) a year for investments in renewable energies.

It is a significant amount by any account. However, according to Edward Cameron, a New York-based managing director at think tank Business for Social Responsibility, it could actually be only the tip of the iceberg. “A whole new global economy has been created in the space between 4.8C and 2.7C,” he says “It represents trillions of dollars in investments, in procure-ment practices that need to change.”

The idea is that the money will come not only from governments but also from private investors, such as pension funds and insurance companies. These will be spending much time looking at companies whose activities could help meet the goals of COP21 while at the same time making them a profit.

In a recent webinar, ratings agency Sustainalytics listed a number of issuers that fit this profile – for example, Tesla, which is famous for its electrical cars but is also developing solutions for the problem of storing energy generated from renewable sources. “We are really intrigued by [Tesla’s] ability to develop batteries for the storage of energy for households, businesses and utilities,” says Doug Morrow, an associate director of Sustainalytics.

Other examples include South Korean chemical giant LG Chem, which is also developing energy storage technologies, and Norway’s Borregaard, a maker of bio-based chemicals whose consumption is expected to increase by 90 per cent between 2008 and 2020.

For its part, MSCI noted in a report that energy companies that want to benefit from the new trends illustrated by the success of COP21 are adopting measures such as splitting their operations between fossil and renewable fuels. In some cases the goal is to be in a better position to get some of the money that is coming into the development of renewable energy. In others, companies appear to be aiming at a future IPO of their renewable activities, as investors are expected to show a growing appetite for this kind of asset.

“COP21 will boost demand because it underscored the urgency of action to combat climate change, and citizens are increasingly understanding that the way they can make a difference in this global issue is through investment,” says Jon Hale, head of sustainability research at Morningstar.

The Paris agreement could also further empower investors who have been putting pressure on companies to embrace the fight against climate change. For example, right after the conference, a group of 60 investors with combined assets under management of more than $4trn filed shareholder resolutions at 11 oil and gas companies with the goal of learning more about their climate change commitments.

“Shareholders have every right to know how company resources are being expended to lobby around these issues, as well as the measures taken to protect the company’s financial health and shareholder value,” says Connecticut State Treasurer Denise Nappier, one of the signatories.