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Pay attention to how your ESG fund invests

Emma Rapaport  |  16 May 2019Text size  Decrease  Increase  |  
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Have you received advertising from a managed fund describing itself as "ESG"?

Asset managers are increasingly jumping on the ESG bandwagon – committing to considering environmental, social and governance factors in their investment process, according to new research from Morningstar.

The number of US active funds adding ESG to their criteria has soared from 51 last year to more than 70 in this first quarter of this year alone.

Morningstar head of sustainability research Jon Hale says more asset managers are recognising that incorporating taking ESG factors into account is just common sense given the material sustainability challenges many companies face today.

"Stainable investors have been arguing for years that ESG consideration should become a routine part of investing," Hale says.

"The rapidly increasing number of ESG consideration funds demonstrates that this is happening."

Fidelity portfolio manager Alex Duffy agrees, saying any asset manager worth their weight in gold cannot make good investment decisions without considering the long-term sustainability of a company, which naturally incorporates a consideration of ESG criteria.

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Duffy adds, however, that the notion asset managers could ever separate ESG criteria from their fundamental analytical and investment decision-making process is absurd.

Duffy believes ESG will cease to be a talking point in five years as more funds adopt the criteria as part of their normal process.

“In five years’ time we won’t be talking about ESG, it will be totally redundant.”

ESG fund growth outperforms

ESG integration is defined by the Responsible Investment Association of Australia as "the systematic and explicit inclusion of environmental, social and governance factors into traditional financial analysis and investment decision making". This, they say, is based on an acceptance that these factors represent a core driver of both value and risk in companies and assets.

"ESG knowledge and data is used to inform the analysis of risk, innovation, operating performance, competitive and strategic positioning, quality of management, corporate culture and governance and to enhance financial valuation, portfolio construction, engagement and voting practices," RIAA says.

US domiciled open-end and exchange-traded funds that practice sustainable investing attracted nearly US$5.5 billion in net flows last year, according to Morningstar. That marks the third straight year of record annual net flows to sustainable funds and stands in stark contrast with the overall US fund universe, which netted its lowest calendar-year flows since 2008.

And based on 2018 flows and trends over the past decade, Hale expects ESG flows to continue increasing as more investors and financial intermediaries become comfortable with the space, more passive options become available, and more ESG funds establish longer-term records.

Beware ‘greenwashing’

So, is this move to ESG consideration a good thing for investors? Hale says having more funds recognise the relevance of ESG is, of course, a good thing for investors who, after all, are paying their fund managers to provide the most relevant information in making investment decisions.

"Having more funds formally acknowledge a role for ESG in their prospectuses helps advisers and fund investors understand and identify those managers that are doing so," he says.

But the lack of of uniform rules around what ESG adherence requires of asset managers worries Hale. He fears it can lead to “greenwashing” whereby managers follow ESG principles without following through, which can ultimately confuse investors.

"Simply adding a line in a prospectus about ESG consideration doesn't necessarily reflect a real commitment to sustainable investing or a significant change in a fund's investment process," he says.

"And though these funds are not being rebranded or marketed as sustainable funds (at least not yet), the fact that they now consider ESG could be a way to sell them to consultants and advisers looking for ESG funds, allowing them to grab some of the growing ESG market share and stem the tide of outflows from these actively managed funds."

Hale says there must be a clear definition of ESG funds and suggests the following distinction:

  • ESG integration funds and impact funds: those that fully integrate ESG criteria throughout their investment processes
  • ESG consideration funds: those that merely consider ESG information to be relevant to a thorough investment process

"The typical ESG integration fund's portfolio is tilted toward companies that its managers believe are addressing material sustainability challenges in ways that will make them better investments and away from companies that are not," he says.

Hale says it's not uncommon for ESG integration funds to use some exclusionary screens. Many also actively engage with the companies they own about ESG issues and are willing to sponsor or co-sponsor shareholder resolutions, to vote in favour of ESG-related resolutions, and to work together to promote sustainable finance more broadly.

Impact funds take things a step further by seeking to generate measurable social and environmental impacts alongside financial return. Impact funds are often focused on specific themes, such as low carbon, gender equity, or green bonds.

ESG consideration funds, on the other hand, may or may not incorporate ESG criteria in the selection of any specific security, and ESG considerations generally do not come into play at the portfolio-construction stage.

Hale says these funds don't typically use exclusionary screens, impact analysis, or shareholder engagement as a formal part of their process. They are best thought of simply as funds that consider ESG information to be relevant to a thorough investment process.

Ultimately, Hale says investors who want to orient their investments around sustainability and impact should focus on ESG integration and impact funds.

is the editorial manager for Morningstar Australia. Connect with Emma on Twitter @rap_reports. You can email Morningstar's editorial team editorialAU[at]morningstar[dot]com

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