The rise of ethical funds and sustainable investment brings into question just how broad and subjective the space can be
One of 2018’s most-used buzzwords in investment has been “ethical”. The rise in popularity of environmental, social and governance investing has been widespread, and in 2017 more than £1bn of net retail money flowed into ethical funds, the highest annual inflows on record.
As of October this year, ethical funds under management reached £16bn, representing a 1.3 per cent share of industry FUM, according to the Investment Association. In the month of October alone, net retail inflows reached £91m.
So where did it all begin? The origins of responsible investing in the UK date back to efforts of investors who were Quakers, when the society prohibited its members from the slave trade in the 18th century.
The same century saw Methodist figures align their business activities with their faith.
Faith-based investing is one approach to responsible investing. It is for clients who wish to invest in accordance with their faith, and many such investment solutions are available. The most prominent type of faith-based investment is Sharia-compliant investment, or Islamic finance.
As ethical funds have been gaining in popularity, the pressure is on for advisers to be able to understand the sector, and the diverse language that goes with it.
Investing for a better world
Ethical consultancy SRI Services founder Julia Dreblow says the work she has done in the past seven years is centred on how to classify this area of investment so it makes sense for advisers.
The interest of advisers in responsible investing has hugely increased in recent years, she adds.
Heron House Financial Management founder Saran Allott-Davey has been offering advice on investments aligned with her clients’ personal beliefs for 24 years. She too has seen a “significant increase” in clients’ interest as well as the availability of funds.
“I think part of this is due to the high profile that climate change and plastic pollution have had in recent times and people realising they have to do their part,” she says.
Offering advice on investment solutions tailored to clients’ personal beliefs could be a way for advisers to stand out from the crowd and attract new clients.
Morningstar Europe director of passive strategies and sustainability research Hortense Bioy says that it provides planners with an opportunity to have a deep conversation with clients and connect with them.
She believes that offering advice on responsible investing gives advisers a chance to truly differentiate themselves.
Women and millennials in particular are increasingly asking for advice on investment in line with their ethical principles, she adds.
When it comes to regulation, the European Commission revealed in its Action Plan on sustainable finance that it is seeking to amend Mifid II to require “incorporating sustainability when providing financial advice” over the course of 2019.
It recommended advisers should be required “to ask about, and then respond to, retail investors’ preferences about the sustainable impact of their investments, as a routine component of financial advice”.
In preparation for any potential changes to regulation, advisers will need to have knowledge of the responsible investment landscape and any available investment offerings.
Communicating responsible investing to clients
A good start to map investor preferences is via a simple fact-find. SRI Services offers a questionnaire on its website, asking clients whether they would like to consider environmental, social, ethical or religious issues when looking to invest.
Dreblow believes SRI and ESG issues should be a part of every adviser’s initial fact-find questionnaire.
Advisers should first identify what issues appeal to the client the most based on the questionnaire outcome, followed by a discussion. Allott-Davey says sometimes it is clear straight away that the client is not concerned with aligning their investments with their world views. “And that’s completely fine,” she says.
She adds that when her clients show interest, the next phase is educational. She finds that clients usually have a “basic understanding” of ethical investments. This is where the adviser can step in to help clients navigate the market and introduce what solutions are on offer.
Apart from identifying which issues are close to the client’s heart, advisers and clients should together decide on the most suitable investing style.
Dreblow notes that despite the increase in demand, this area of investing is still rather small and many advisers can get overwhelmed with it.
Similarly, Bioy says that the seemingly robust landscape with a multitude of labels and approaches can pose a barrier for advisers to enter the space. She says that her team is currently finalising a set of tools for advisers to help them learn the industry language. The whole project is set to be completed by early February.
The oldest and most commonly used approach to ethical investing is to start with a negative screen. This takes all stocks available and removes the ones that do not invest in line with the manager’s strategy. It is individual to each fund manager but can cover areas such as tobacco, arms, gambling, and can exclude companies based in countries they believe to have a repressive regime.
Dreblow explains that there are many different styles of responsible investing. She says: “Someone could look at climate change and say: ‘We need to avoid oil or mining companies’. Others would say that a better strategy would be to hold shares of a company and talk to them and encourage them to reduce their emissions.”
According to Dreblow, both investing styles – negative screening as well as responsible or active ownership and engagement – complement each other.
“They can work well together. From a company’s perspective, if [the company] thinks that people might sell their shares, then it is more likely to respond to engagement.”
Bioy calls this an “ESG value contrarian approach”, in which the manager looks for companies with low ESG ratings and an assumed potential of future increase in these scores.
ESG versus impact investing
Choosing investments with ESG issues in mind is not strictly a goodwill act. It can have financial incentives too.
As Bioy points out, excluding (for example) tobacco firms can make sense from an investing perspective as changes in consumer preferences, as well as trends in regulations, suggest that these firms are on the decline and do not hold much promise of future rewards for shareholders. The same goes for oil companies, she says.
Investing in companies which score well on environmental (such as carbon footprint), social (human rights or working conditions), or governance (this can include, but not limited to, gender equality) issues can be a savvy investment decision.
Bioy says: “Studies have proved that companies with good ESG ratings provide higher returns.”
Impact or thematic investing (investing which focuses on companies actively trying to find solutions to the world’s stinging challenges like a shift to renewable energy or waste and water management) are more likely to provide shareholders with returns than past winners like oil firms. Bioy says that the future is already happening; electric cars could fully replace petrol- or diesel-engine cars in two decades.
The final step for advisers is to identify the best fund options. SRI Services offers a comprehensive list of such funds, while Morningstar has a sustainability rating which evaluates how well companies in a fund’s portfolio are managing the ESG investing factors relevant to their industries.
With inflows continuing to go through the roof and more providers creating ethical offerings, it is one area that advisers must fully understand and be prepared for when talking to clients.