There’s a common misconception that investing based on environmental, social and governance issues — ESG investing, for short — is only for millennials. It isn’t. Over the past year I’ve noticed a steady increase in interest in the niche from old and young investors alike, as well as private and institutional investors. A growing number of active fund managers — two examples are Alliance Trust and Mid Wynd (Artemis) — are putting ESG investing at the centre of their stockpicking strategy, targeting companies with a “ sustainable” long-term strategy. I was also struck by the news that the Japanese government’s $1.3tn pension investment fund has decided to apply ESG to more of its assets, based on low carbon outcomes. But here’s the twist. When it announced its decision, it said that most existing environmental stock indices seek to reduce carbon outputs by excluding certain industries — rather than aiming to build a green economy by evaluating companies that boost a sustainable environment. “Therefore, we have decided to request proposals for global environmental stock indices,” it said. The Japanese pension fund is struggling with the same issue as the rest of us. If you want to build a low-cost ESG portfolio using tracker funds, which indices should you follow? The Japanese have chosen to focus on one part of the ESG spectrum — building a low carbon future. I happen to think this is the right approach. Nevertheless, ESG investing also embraces other issues — gender equality, for instance. Last year, for instance, Lyxor launched its Global Gender Equality (DR) UCITS ETF — the first in Europe — tracking an equally weighted benchmark of 150 companies from around the world that score highly for gender equality, the idea being that gender neutrality makes for a better company.
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Religious investors have also muscled in on the act, especially in the US. Inspire Investing launched its Global Hope Large Cap and its Small/Mid Cap Impact ETFs, built around Christian values. This rivals not only existing Christian ETFs such as Global X’s Catholic Values ETF, but also a long list of existing ETFs with Islamic values. We have even seen the emergence of Anti-ESG indices, most notably the wonderfully named AdvisorShares Vice ETF (ACT), which tracks companies involved in drugs, alcohol and cigarettes. But for most investors, the transition to a low-carbon economy remains the biggest challenge. The question they face is how best to build an investment portfolio that will support this objective. You can invest in individual green businesses but identifying the losers is arguably easier than spotting the winners. That leaves us with the option of somehow working out how to invest in broad sectors. Do you exclude whole sectors such as the fossil fuel industry or do you only exclude some companies in all sectors for not working hard enough to advance a low carbon future? In simple terms, is it the carrot or the stick? On the stick side of the debate — divestment — there aren’t very many exclusion-based funds, especially in the low-cost passive space. In the US you can track the S&P 500 with fossil fuel businesses excluded. The ETF is from State Street and has a US ticker of SPYX. But sceptics might ask why you are not choosing also to exclude polluting companies such as utilities or even banks financing the energy sector? The other downside of divestment is its one-off nature: having done it, you relinquish the ability to influence corporate behaviour in the future. A better approach is to work actively with companies to nudge their improvement. But doing this transparently and objectively so that it can be built into an index is a challenge.
Specialist groups such as Arabesque are tackling it by building institutional grade databases that score businesses. But what about actual funds you and I can invest in? In the US, ETF issuers are busily at work coming up with new products at a brisk pace. One manager, Hartford Funds, has issued a fund called the Global Impact NextShares Fund (HFGIC), which will invest in global companies that it believes are likely to address major social and environmental challenges. In Europe, the most thought-through answer seems to come from France, where companies such as Amundi have a range of cheap, tracker funds which mimic the strategies already used by the big pension funds. Amundi has a handful of ETFs listed in Europe, all built using the big index firm MSCi. The broadest ETF focuses on all-world developed stocks, while another focuses on Europe. All are built around low-carbon solutions and total assets stand at €750m, although total funds under management using this same approach come to €5.1bn. The aim of these indices is to further a reduction of at least 50 per cent in the level of carbon emissions. This is partly achieved by excluding 20 per cent of stocks based on their “carbon emission intensity criteria”, defined as the weight of carbon emissions (tons of CO2) of a company relative to market capitalisation. For those looking to invest in environmentally unblemished businesses, beware the catch in this approach: you might end up with some of your money in oil and gas businesses.