ESG and responsible investing have had a long journey in attaining the broad acceptance they now enjoy as a fully-fledged part of the asset management mainstream. While generally viewed as a recent phenomenon, as early as the 18th Century, the likes of the Quaker and Methodist movements effectively imposed the first investment exclusions by prohibiting their adherents from participating in the slave trade or other industries that were viewed as amoral – the first ‘sin stocks’.
Fast forward to the 20th Century and the practice of applying negative screens to avoid exposure to businesses that harm society or the environment was associated with what became known as ethical investing. Over the last few decades, this approach has evolved into what we today understand as ESG and responsible investing – no longer restricted to negative screening but instead encompassing a wide range of approaches to asset management and security selection.
John Monaghan: The need for clarity in ESG and responsible investing
There have been multiple factors at play in the development of this area of investment, not least of which is a desire among investors to do good with their money. Growing outrage against the apartheid regime in South Africa during the 1970s and 1980s fuelled a sense of public conscience in the UK and globally as individual investors and public and private institutions alike sought to divest from companies that had operations in the country.
Partly in recognition of this, EIRIS, the UK’s first independent research service for ethical investors, was established in 1983. A year later saw the launch of the first retail ethical fund in the UK, the Friends Provident Stewardship Life fund, followed in 1987 by the Jupiter Ecology fund, the UK’s first environment-focussed portfolio.
More recently, movements such as Extinction Rebellion and a greater awareness of the impact of climate change, conscious consumerism and calls for more diversity and social inclusion have led to a proliferation of offerings available to investors seeking to align their investments with their moral compass. According to FE Analytics, from an average three responsible funds launched a year in the 1990s, the last three years alone have seen, on average, 32 new responsible funds come to market each year.
Accommodating environment
Meanwhile, the environment within which asset managers operate has become much more accommodating towards ESG and responsible investing – even to the extent of actively encouraging greater industry participation. In 1998 the UK published the world’s first Corporate Governance Code, which enshrined a set of standards of good practice for listed companies.
Some 20 years later, the Business Roundtable, a prestigious US association of industry leaders, published a statement signed by 200 CEOs. This threw down the ESG gauntlet to the business world by redefining the purpose of a company as no longer having increased shareholder value as its primary focus. Instead, businesses should seek to further the interests of customers, workers, suppliers and communities in order to increase diversity and protect the environment.
The move towards ESG and responsible investment has been further supported by international organisations. In 2005, the Freshfields United Nations Environment Programme Finance Initiative Report (UNEP FI) forged a global partnership between the United Nations Environment Programme and organisations within the finance sector aiming to develop and promote links between the environment, sustainability and financial performance.
Its Asset Management Working Group established the legal framework through which asset managers could integrate ESG factors within their investment processes, acknowledging the “growing body of evidence that ESG issues can have a material impact on the financial performance of securities and an increased recognition of the importance of assessing ESG-related risks”.
A year later, the United Nations Principles of Responsible Investment (UN PRI) was launched to support the integration of responsible investment practices within the global investment industry by helping its network of signatories to incorporate ESG factors into their investment processes through six principles. Further initiatives aimed at protecting the planet and ending poverty followed, such as the United Nations Sustainability Development Goals and Climate Action 100+, adding greater momentum to the cause.
Role of regulation
Regulation has also played its role in the growth of ESG. An amendment to the 1995 Pensions Act in 2000, for example, enshrined in law the responsibility of occupational pension scheme trustees to declare whether or not they had taken social, environmental or ethical factors into account when making investment decisions.
More recently in 2018, the European Commission’s Action Plan on Sustainable Finance led to a raft of proposed EU legislation to help embed ESG considerations into the governance standards across the finance sector. The most recent of these involves changes to Article 25 of MiFID II, which will have significant repercussions for the financial adviser community.
It will require advisers to disclose information on the ESG characteristics of each financial product under consideration; the need for companies providing model portfolio services to explain how clients’ ESG preferences are accounted for in the selection of portfolio holdings; and a requirement to describe how ESG preferences were considered in the financial advice process.
This combination of significantly increased investor demand and the proliferation of funds that adopt ESG principles or are responsibly invested has driven the growth of this sector. For many, however, performance is still a deciding factor and the traditional view that investors must sacrifice returns in choosing an ESG strategy still persists.
Performance and perception
This is a potential headwind preventing greater uptake of these strategies. Indeed, a recent survey of advisers conducted by Square Mile, found four-fifths (82%) felt that fewer than 25% of their clients would be prepared to sacrifice performance in return for ESG. That said, the strong performance of many ESG funds over the first four months of 2020 provides evidence to the contrary, something which will doubtless be borne out as more long-term data becomes available.
This demonstrates the need for a deeper conversation between advisers and their clients on the benefits of ESG. It also highlights the need for asset managers to articulate more clearly the way ESG is integrated into their investment processes as an additional due diligence screen that can enhance rather than detract from returns.
ESG and responsible investing may trace its heritage to a relatively small group of investors who wished to invest in line with their conscience, but multiple protagonists have played their part in its evolution.
A combination of investor demand, the realisation all industries, including financial services, have a duty to improve society and protect the environment and mounting evidence the application of ESG screens can improve investment decisions seems set to guarantee the position of ESG and responsible investing as a dominant theme within the asset management industry.
John Monaghan is head of research at Square Mile Investment Consulting & Research
