You may be investing in index funds, unaware of what is in them and whether they align with your values. If you are looking for a way to invest your money that aligns with your values and positively impacts the world, you may want to consider ESG investing.
What is ESG Investing?
ESG stands for environmental, social, and governance. It’s a framework for assessing how one company performs in these three areas compared to its competitors. (Source: Nasdaq.com)
ESG investing allows socially and environmentally conscious investors to consider the following criteria when assessing a company:
Environmental: This considers how a company impacts the environment. Moreover, it looks at its policies on, for example:
- Climate change
- Deforestation
- How it treats wastewater
- Pollution
Social: This considers how an organization treats people.
- Do employees have good working conditions?
- Does the company adhere to employment law?
- Are health and safety policies in place and are they implemented?
- Does the company have an inclusion and diversity policy which is successfully implemented?
- Are management and employees engaged with the local community e.g., employees may take days off during the year to do local charity work.
Governance: This considers how a company is run.
- What is the board structure? Is it inclusive and diverse?
- Do the board members possess the necessary qualifications for their governance role?
- Are the managers running the company accountable and ethical in their conduct?
- Are there regular audits, internal and external?
- Does the company have anti-money laundering, anti-bribery, and anti-corruption policies in place?
The FTSE 100 and ESG
The FTSE 100 comprises 100 of the largest UK-listed companies by market capitalisation.
If you have invested in the FTSE 100, do you know which companies are IN the index? Do these companies align with your ESG values? Let’s take a look.
The FTSE 100 Index Funds – Understand What You Are Investing In
FTSE 100 – Tobacco and Climate Change
Bob works as a doctor and detests smoking and nicotine products. He has seen first-hand how they negatively impact people’s health and the strain it places on the NHS.
He wants to invest in an ISA. His financial advisor suggests investing in an index which tracks the FTSE 100, HSBC FTSE 100 Index Fund Accumulation S.
Bob takes his financial advisor’s advice and puts £5k lump sum in the index. He sets up a direct debit and invests £200 per month into the index.
On reading an article about ESG, Bob realises that two of the constituents of this fund provide tobacco and nicotine products to its customers.
Bob is also very concerned about climate change and has found that the fund is misaligned with the Paris Agreement’s aim of limiting temperature rises to less than 2 degrees Celsius.
Bob calls his financial advisor to discuss an ESG-driven investment strategy.
ESG Focussed Funds
If you want to invest in an ESG-focused index fund, go to your broker’s website. Under funds, search for ESG and all available ESG-focused funds will be listed.
We can take the example of Vanguard ESG Developed World All Cap Equity Index Fund. Your broker must provide a Key Investor Information Document (KIID) which is a two-page document providing key investor information on the fund.
Following that, you can use ESG Fund Ratings – MSCI to enable you to do further research on the ESG credentials of the fund.
Vanguard ESG Developed World All Cap Equity Index Fund scores quite well on ESG Fund Ratings – MSCI.
The fund aligns with the Paris Agreement’s aim of limiting global mean temperature to below 2 degrees Celsius.
It has low carbon intensity and 0% fossil fuel-based revenues.
The fund’s MSCI ESG rating is an ‘A’.
Under Corporate Governance, the fund’s weighted average percentage of:
- independent board of directors is 79.4%
- women on boards are 34.0%.
The diagram below shows how the fund scores against business activities that investors may wish to avoid.
ESG and Individual Companies
If you want to dig further into an individual company and research how it performs in relation to ESG, you could use a tool such as ESG Ratings & Climate Search Tool – MSCI.
You simply type in the name of the company or its ticker and hit the search button.
For example, Unilever scores an ESG rating of ‘AAA’ rating meaning it is a leader among 30 companies in the household & personal products industry.
Why Should You Invest in ESG Funds?
By investing in ESG focused funds you can:
- align your investment with your values and beliefs.
- grow your investment by investing in companies that have a positive impact on the environment and society.
- hold companies accountable for their performance against ESG criteria.
- exclude certain industries from your investment portfolio that you may not agree with e.g., companies that produce or trade banned weapons, and/or companies involved in gambling, tobacco, or alcohol.
Risks to Consider if Investing in ESG Funds
- Focussing on ESG may result in decreased diversification of companies in the fund thereby increasing investment risk. This could result in a diminished financial performance of the fund.
- ESG ratings are not standardised. There are over 160 providers of ESG ratings and associated data. Bloomberg describes the limitations of ESG ratings: “Each ESG rating provider uses its own proprietary system, algorithms, metrics, definitions, and sources of nonfinancial information, most of which aren’t transparent and rely heavily on self-reporting by the companies they rate. No regulator examines the methodology or the results”. (Source: ‘The ESG Mirage’, Bloomberg UK)
- It is hard to apply ESG assessment criteria across different industries and different geographical areas.
- You may pay higher fees as the fund is actively managed. The Fund Manager must do a lot of research to ensure that ESG-compliant companies are included in the fund. Higher fees eat into your long-term investment returns.
ESG – In Summary
It’s important to understand the constituents of index funds before investing in them so that you can decide whether their constituents align with your values.
There are many index funds available to invest in that are ESG-focused. If you don’t have a financial advisor, there are tools you can use such as ESG Fund Ratings – MSCI to do your research and due diligence before investing.
DISCLAIMER: Inquisitive Finance operates on principles of exchange of knowledge, ideas and opinions and learning in the community. Your decisions are entirely your own responsibility, and I am in no way responsible for your actions. I am not a financial advisor. Whilst I strive to provide accurate and up-to-date information, I make no warranties or representations as to the accuracy or completeness of this information. Use common sense, do due diligence and where necessary, use the services of a licensed financial advisor, before making any financial decision and/or transaction.
Impressive and detailed analysis; would be interesting to see what is the future for the ESG funds, would they survive the competition?
Thanks for your comment. I think that, in the future, rather than funds being ESG-focused and separate from other funds, ESG principles will be adopted by all asset managers and integrated into their investment strategy and investment management process. A study by PWC in 2020 (https://www.pwc.com/awm-revolution-2022), confirms this.