Many investors would like to invest ethically. The problem is defining exactly what “ethical” means.
Consider the flurry of high-minded ETFs that have hit the Canadian market over the past two years. These funds attempt to find companies with good records on environmental, social and governance issues – ESG, as the jargon goes. But what an ESG strategy means in practice is likely to surprise many people.
BP PLC, the major oil producer, and Nestlé SA, the consumer-goods company with a controversial past, are among the top three holdings of one ESG fund. Another fund, designed to appeal to those worried about climate change, lists Enbridge Inc., the oil and gas pipeline operator, as its biggest single holding. Meanwhile, shares of tech superstars, such as Facebook Inc. and Alphabet Inc., feature prominently in still other ESG funds, despite growing concerns about how these online giants are using – or possibly misusing – personal data.
In some cases, the differences between ESG funds and their less socially responsible counterparts isn’t exactly glaring. (When it comes to the Canadian stock market, for instance, both ESG and non-ESG funds tend to kick things off with a hefty helping of bank shares.) On the other hand, two funds that both insist they’re investing on ESG principles can wind up with radically different portfolios depending on their view of fossil-fuel companies.
No wonder investors are confused. “You really need to do some serious homework about any approach you’re interested in,” says Keith Ambachtsheer, director emeritus of the International Centre for Pension Management at the University of Toronto. “Different ESG approaches vary in what they choose to look at, how they measure things, and how they weight the results.”
But the discrepancies between ESG strategies are not a reason to ditch the approach, Mr. Ambachtsheer argues. Rather, they are a reason to drill down and find a strategy that fits your own goals.
Morality aside, this can help reduce risk and improve returns. By insisting on high standards of corporate behaviour, ESG strategies can help investors sidestep problem companies – such as those in industries facing regulatory backlashes to their products. “Ultimately, good investors want to invest in sustainable companies that do the right things really well,” Mr. Ambachtsheer says. “ESG approaches can help you spot those companies.”
Ethical funds have already demonstrated they can produce returns that are just as good as conventional investments, according to Tim Nash, founder of Good Investing (goodinvesting.com), a financial-planning firm in Toronto that coaches people on how to invest in line with their moral principles. Since 2007, for instance, the iShares Jantzi Social Index ETF has achieved results that are next to indistinguishable from the plain-vanilla S&P/TSX 60, the benchmark for large Canadian stocks.
This similarity in performance is no accident, Mr. Nash notes. While investors once assumed they had to sacrifice profits in pursuit of ethical goals, many ESG indexes now select and weight their holdings to achieve levels of risk and reward similar to the overall stock market. A recent International Monetary Fund report found little difference between the performance of ESG funds and conventional ones in recent years.
Investors should still do their due diligence, though. It’s no accident that fund companies are rushing to promote ESG approaches at the same time as ferocious competition is pushing fees on plain-vanilla index funds ever closer to zero. In some cases, slapping an ESG sticker on an investment approach may simply be a way to justify higher fees for a fund that doesn’t differ all that much from a less enlightened strategy.
Here are four starting points for anybody thinking of investing in an ESG fund:
It’s murky out there: In theory, an ESG rating offers a definitive, objective guide to a company’s environmental, social and governance prowess. In practice? Opinions can differ. A company that has a dismal history of polluting offences may also have a stellar record on gender representation. There is no obviously correct ESG grade to put on such a mixed bag of achievement.
A recent study from researchers at the Massachusetts Institute of Technology and the University of Zurich compared ESG scores from five rating agencies and found they frequently diverged in significant ways. “Raters disagree both on the extent of the definition of ESG, as much as they disagree on how the various aspects of ESG are measured,” according to the study, titled Aggregate Confusion: The Divergence of ESG Ratings.
Bottom line: An ESG label by itself says little about a fund.
Fossil fuels divide opinion: Investors who are primarily concerned about climate change may be surprised to discover that many ESG indexes are fine with companies that produce oil and gas or are otherwise involved with fossil fuels.
The iShares ESG MSCI Canada Index ETF, for instance, has 16 per cent of its money in the energy sector. It lists Enbridge and Suncor Energy Inc. among its top 10 holdings. The Desjardins RI Canada Multifactor – Low CO2 ETF has pipeline operator Enbridge as its top holding, according to Bloomberg.
Despite that inclusion, those concerned about climate change should still take a close look at Desjardins Funds’ suite of low-carbon funds. They should also consider CI First Asset’s MSCI World ESG Impact ETFs. They exclude fossil-fuel companies.
Look beneath the label: Mr. Nash, the financial planner, says investors interested in an ESG approach have to decide which issues are most important to them. Climate change? Women in leadership? Diversity in hiring?
Different ESG rating schemes emphasize different issues. The only way to see how these priorities play out is to look at a fund’s individual holdings – something that can usually be found on the ETF’s website. Mr. Nash says many of his clients are surprised to see which companies make the ESG cut and which don’t.
In part, this reflects a shift in ESG thinking. Early approaches to ethical investing often grew out of religious principles. They focused on ruling out sin industries, such as tobacco, alcohol and pornography.
Newer approaches tend to emphasize a different roster of concerns, from climate change to gender diversity in top management, Mr. Nash says. They also tend to be more inclusive, rewarding companies that are improving their behaviour rather than simply excluding entire industries.
Look at alternatives: Daniel Straus, a vice-president in National Bank’s ETF research group, says investors have to consider the higher costs involved with many ESG funds. They should also ask themselves how many percentage points of return they would be willing to give up in pursuit of their ethical goals.
If they can’t find a product that fits their own preferences and risk tolerance, they may want to consider a “barbell” approach, putting 80 per cent of their portfolio in more conventional investments and 20 per cent in a fund or specific companies that are championing a particular priority – solar energy, say, or diversity in hiring. “For some people, that can be a good alternative to a more broad-based ESG approach,” he says.