Will ethical investing come good as part of the mainstream?


With another National Ethical Investment Week recently drawing to a close, interest in responsible investment is on the rise, not only from those who share such values personally but also from managers who are not necessarily looking at these criteria from an ethical point of view.

After falling from £200m in 2011 to £12m in 2012, net retail sales of ethical funds reached £37m in July 2013, the highest level in more than two years according to the IMA, with the sector representing 1.2 per cent of total industry funds under management. Corporate environmental, social and governance (ESG) research provider Eiris reports that investment in the UK’s green and ethical retail funds reached an all-time high of £12.2bn earlier this year. 

Indeed, interest in ethical investment is high at the moment, says John Ditchfield, director at ethical IFA Barchester Green and chair of the Ethical Investment Association.

“We have never been busier, we have seen about 30 per cent growth in our assets under management over the past four years,” he says. “Post-credit crisis, private retail investors are a little bit more tuned into the idea of responsible investing.” 

Chelsea Financial Services managing director Darius McDermott says ethical remains a small portion of his business, although when ethical funds start to perform well, investors become interested.

Sixty funds identified as having a dedicated ethical or sustainability mandate have returned an average 20.5 per cent in the year to 15 October, according to Morningstar, with the top five funds returning more than 30 per cent over the same period. This compares with a 19.3 per cent return for the FTSE All-Share. From June 2012 to June 2013, Eiris says 10 ethical funds grew by over 50 per cent.

At the same time, while ethical portfolios continue to appeal to a segment of the market and managers are at the forefront of new trends across various sustainability themes, those close to the industry say socially responsible investment is no longer an all-or-nothing proposition for investors. 

Elements of these criteria, they say, are also filtering slowly into the mainstream, as funds and companies increasingly realise the value in analysing ESG factors, not from an ethical point of view but in terms of how they can help deliver outperformance.

ESG integration

Environmental risk factors are being taken very seriously by a number of non-screened funds, says Ecclesiastical Investment Management senior socially responsible investment analyst Ketan Patel. This is as a result of the link to reputational risk, which translates into loss of profits or dividends. 

Ditchfield explains: “Some of the macro themes applied by SRI managers such as resource scarcity and access to water, energy issues – so broad macro themes – are also incorporated into many mainstream funds, so you have got some crossover.” 

F&C Asset Management head of governance and sustainable investment Vicki Bakhshi says the million-dollar question when it comes to ESG integration, or responsible investment, in general is how to demonstrate that these factors add value, but it is also important to consider when a company’s neglect of ESG factors has led to underperformance.

Indeed, a mix of environmental and governance-related crises may have recently provided the industry with a concrete answer to the ‘value-add’ dilemma. For many managers, the decision is no longer whether to incorporate sustainability into their process, but how. 

“That question of ‘is it material’ has now been so unfortunately, tragically answered by BP’s accident in the Gulf of Mexico and the global financial crisis, which was a crisis of governance and culture, that we do not have to answer that question anymore,” says Alliance Trust Investments head of sustainable and responsible investment Peter Michaelis.

Between the financial crisis and improving standardised information related to ESG, Matt Christensen, global head of responsible investment at Axa Investment Managers, says there is a “rapid increasing rate of those who find this interesting and want to use the data”. 

However, the greatest sea-change in this area in the past decade, says Eiris head of responsible investment development Stephen Hine, has been the growth of the United Nations-supported Principles for Responsible Investment. The PRI are a set of six principles for incorporating ESG issues that signatories voluntarily commit to considering in their investment decision-making and ownership practices. To date, more than 1,200 asset owners, investment managers and others have signed up to the principles and the PRI Association reports that 94 per cent of signatories have a responsible investment policy in place.

“To that extent, you are getting an increasing number of mainstream managers, be they running retail funds or other vehicles, taking environmental social governance matters into account,” says Hine. “Not necessarily from a normative point of view, although some of them do that as well, but more from a belief that proper consideration of the financially material risks that may be derived from ESG matters can have an effect on the long-term profitability of a company.”

A white paper released earlier this year by the Deutsche Asset & Wealth Management Global Financial Institute written by St Andrews University banking and finance lecturer Andreas Hoepner looked at whether ESG data can enhance investment returns and reduce risk. Hoepner found that portfolios of assets with high ESG ratings have outperformed their benchmarks in various contexts. 

“This is especially true for popular ESG criteria such as corporate governance, eco-efficiency and employee relations,” he writes. “Firms with better ESG ratings experience higher credit ratings and lower cost of debt. Portfolios with better ESG ratings display substantially less downside risk of more than 200 basis points, even if they have a substantially lower number of constituents.” 

Managers say there has also been a shift in the way companies are seeing the environmental part of ESG. According to the UN Global Compact-Accenture CEO Study 2013, 78 per cent of more than 1,000 CEOs surveyed see sustainability primarily as an opportunity for growth and innovation. 

Just over a decade ago, says Michaelis, only a handful of FTSE 100 companies produced sustainability reports. Now, he says, “companies that feel they have got something really positive to talk about are very keen to make that clear. They want to be seen that ‘we are a company – we are making strong profits but we are actually doing a vast amount of good for society and the world’.”

Patel says: “If you can turn something that was costing you money, such as energy costs or the costs of how you manage your waste or water, and convert that into efficiency gains, those gains enter the P&L and go to the bottom line. No CEO is going to say no to that kind of money.” 

Corporate governance, he adds, frequently comes up as a topic of conversation, not just for SRI funds but across the market.

As such, Scott Spencer, a portfolio manager in Aberdeen’s multi-manager team, says that a number of big investment houses have stepped up the resources they devote to ESG, with many now using a system or separate team that screens for these factors. 

“More and more groups are using it and more and more groups are beefing up their teams in this area. It shows that it must be adding value,” he says.

In September, for example, Old Mutual Asset Managers released a guideline for responsible investment practices, applicable to all investment processes across the group. Other asset managers employ a similar model – BlackRock’s corporate governance and responsible investment team partners with its portfolio managers to integrate ESG issues into investment processes. 

Although AXA IM offers a dedicated ethical portfolio – the £118m Axa Ethical Distribution fund, Christensen explains that ESG information is available for all of its fund managers through the RI Search platform, launched in 2008. 

“We have trained all the portfolio managers on how to use it so they are able to grab information on ESG factors and incorporate that into the thinking on how they do portfolio management,” he says. 


Use of the ESG integration approach varies depending on strategy and asset class – from teams that use it on a deep level to create their own integrated systems using the data and follow up with questions on their own research, to teams that have not yet spent much time considering it.

Christensen points to one portfolio manager who is integrating ESG criteria into a mainstream fund in an ideal way. The manager, he says, looks at ESG risks that the RI team has uncovered as a way to validate any doubts he has in his portfolio. 

“I see that as a growing way to use ESG in the mainstream fund space. And he is the first to say it adds value. That is helping him to manage his risks and to put performance, including ESG, as part of the criteria,” he says.

Parent company Axa Group, he adds, is asking for managers to show how they are integrating ESG for all of Axa IM’s assets under management. 

F&C’s Bakhshi explains that her team runs a two-pronged approach to this type of investing – it supports the screening research for the group’s ethical and sustainable funds, but it also looks at ESG integration for non-screened funds. This is something F&C has done for a long time, but for this year it has created a more systematic process.

“ESG integration is not about exclusion or ethics, we see this as saying ‘environmental, social and governance issues frequently can and do have an impact on company performance and companies’ ability to execute on their strategies’, and you see that across multiple company sectors,” she says.

Bakhshi says F&C takes a proactive approach with companies, using its tools to identify those with poor ESG standards and trying to encourage them to be ready for risks as they come forward. “We enter into a dialogue with those companies to encourage them to improve the way that they manage ESG issues,” she says, adding that the team has also shifted towards engaging more with emerging market companies.

At F&C, an ESG risk tool that includes various sources of external data and proprietary research, gives risk scores for about 3,500 companies. This information is then passed to credit analysts and equity fund managers so they can see whether there could be ESG issues that might not have been picked up in their standard research.

“ESG integration means taking some of that information on ESG risks and ensuring our fund managers, when they are looking at the investment case for companies, are taking those factors into account,” she adds.

Already, Bakhshi explains, the process has resulted in the corporate credit team changing credit recommendations on the basis of ESG factors.

“They have not done that on ethical grounds and they have not done it as a point of principle, that information has revealed extra things which have influenced their view on the company’s strategy,” she explains.

Christensen adds that sovereign debt is one area his team is doing a lot of work on when it comes to responsible investment criteria. This is partly as a result of the financial crisis leading investors to look at ESG factors when the ratings agencies failed to identify the issues.

“That asset class that people thought was standard, kind of risk-free – there are risks and those risks have not been picked up by traditional metrics,” he says.

ESG integration versus SRI funds

With more managers considering ESG factors, will the gap between ethical funds and mainstream portfolios begin to narrow?

Not likely, says Spencer. Having SRI criteria embedded deep in their process will always set ethical funds apart from the mainstream, for which, he says, ESG is just another tool.

“I do not see all funds getting closer and closer so there would be no need for dedicated ethical funds or no need for mainstream. There will always be that divide and differences, because people buy socially responsible funds or people buy ethical funds for particular reasons,” he says.

Christensen describes the difference between dedicated SRI funds and those mainstream funds that employ ESG criteria as akin to the choice between ordinary milk and the organic variety.

“There will be always a part of the market that is interested in being organic in the way that they look at their entire consumption of life,” he says.

While Michaelis says he would love for the mainstream to devote more resources to analysing ESG issues, he thinks there will always be a role for sustainable responsible investing as a more concentrated investment strategy.

While non-screened funds add SRI almost like a satellite, sustainable funds work the other way around. “SRI is core, it is what we do, our ownership structure, everything about us is focused on that,” says Patel.

Ultimately, Michaelis says SRI-focused managers invest in companies which they are reasonably confident mainstream managers will eventually see the attraction of. 

“It is just we think that through analysing things through a perspective of sustainable development, we are going to be earlier onto these trends and I guess we are going to have higher convictions in their coming to fruition,” he adds.

One example, he says, is the building materials company Kingspan, a holding he began assessing because of climate change. First he considered companies involved in energy efficiency, building and solar insulation and then he assessed them for the strength of their businesses and whether they were valued attractively.

Patel points to Burma as one area where there is likely to be debate in the next 12 to 24 months, as international firms move into the country and have to manage their financial and reputational risk.

Hine expects sustainability criteria to become more sophisticated, looking at grander themes around populations, food security, information, privacy, supply chain, human rights and bribery. SRI funds, he adds, will also focus increasingly on best of class companies doing positive things to counter global challenges, engage with companies to encourage change and more actively vote proxies on governance.

Indeed, Michaelis points to a trend towards proactively selecting companies that are succeeding because they are doing good for society and the environment, rather than ethical investing being only about what you do not invest in – sectors such as tobacco, alcohol and defence, for example.

“Companies that are run better in terms of their environmental, social and governance factors and have got products or services which are helping improve the world, whether its environmental technology or quality of life, are better sets of companies to start selecting investments from,” he explains. 

There have been very few ‘darker green’ ethical funds launched in the past five years, says Spencer, with most new funds in the socially responsible arena tending to focus on sustainability, alternative energy, waste or water – the positive side of the spectrum.

Patel says the positive side of SRI is important for two reasons – risk management and generating alpha. 

“On the risk side, we think that by looking for companies that are actually adopting sustainable practices on an ESG basis will mean less risk for the stock and for the portfolio,” he says. In terms of generating alpha he says that it is useful to see ESG as a profit centre rather than a cost centre. “Investing in those companies that have made the transition is the key driver to long-term returns and long-term sustainable returns,” he adds. 

The future

Christensen expects ESG criteria to find its way increasingly into corporate fixed income, sovereign debt and private equity, tying into the growing movement of impact investing – a way of thinking that impacts society in a positive way while also helping performance and risk management. 

He expects regulatory changes on corporate governance to be what ultimately pushes this way of investing forward. 

Bakhshi says F&C’s assets under management in sustainable and ethical funds continue to grow. While ESG integration has already been rolled out across F&C’s corporate credit and European equities desks, Bakhshi says the group is talking to a number of other equities desks to see how the process can be further expanded across the business.

“We are in a period where the industry is really feeling around to see what best practice looks like and different investment managers are trying different ways of doing this – lots of people are making much more use of the ESG data that’s out there,” says Bakhshi. 

Ultimately, says Christensen, if ESG integration were a football game, the fund management industry would be in the first part of the first half. However, the game is moving much faster now. In time, this information will be part of the process for many fund managers, although it will take a while. 

“It is a complicated thing to do and it takes time to get both buy-in and the right kind of data,” he says. “There are a lot of pieces needed to make it work, but I do think it is going to continue to grow and become part of the mainstream. We see it happening.”