Three common myths about sustainable investing

Robin Powell

5 years ago

Sustainable investing, or ESG (Environmental, Social & Governance) investing

By ROBIN POWELL

We’ve all the heard the expression, “Don’t believe what you read in the papers”. It often applies to sensationalist headlines or celebrity tittle-tattle, but the advice is equally relevant when reading the financial pages.

It’s not that journalists deliberately mislead. No, the problem is that investment magazines and the money sections of weekend newspapers are effectively paid for by advertising by fund managers. That allows product providers, to a large extent, to dictate the editorial agenda, and so much of what is written tends to suit the industry, not the consumer.

Sustainable investing, sometimes referred to as ESG investing, is a case in point (ESG, by the way, stands for Environmental, Social and Governance — three key factors that ESG funds focus on). Sustainable investors don’t just invest with financial returns in mind. They also want their investments to benefit, or at least not to harm, the environment or wider society.

This type of investing has grown rapidly in popularity in recent years, and we at RockWealth are firm believers in it. That’s not because we think sustainable portfolios will deliver significantly higher financial returns than mainstream portfolios in the future; we don’t. But we do think that everyone has a responsibility to help avert a climate catastrophe, and investing in sustainable funds is an effective way of doing it.

For the fund industry, the growth of sustainable investing presents a huge commercial opportunity. If it can persuade investors that the best way is to invest with your conscience to is to buy expensive, actively managed funds, there are huge profits to be made.

The truth, however, is that you simply don’t need to go to that expense, and you’ll be far better off if you don’t. That’s right: you can invest in a way that reflects your personal values and enjoy the benefits of low-cost index funds. We’re going to explain how in future articles. Our message for now, though, is this: don’t believe the sustainable investing myths the industry likes to peddle. Here are three common ones.

MYTH ONE: Passive fund managers are passive share owners

The first myth is that passive fund managers don’t care about sustainability. This just isn’t true; and so, by the way, is the notion that active managers are longstanding ESG enthusiasts (most of them are anything but).

In fact, index funds have a strong incentive to monitor the companies in their portfolio because they are generally unable to sell out of positions when they disagree with management. Thus, they may be more inclined to exercise their “voice” by voting at shareholder meetings.

In a study published in March 2020, (Black)Rock the Vote: Index Funds and Opposition to Management, Joseph Farizo examined the voting records of 654 index funds in the US over a ten-year period ending in 2016.

He found that:

on non-contentious proposals, index funds voted against management 3.5% of the time, 0.5% more than actively managed funds; and

on contentious issues, a majority (nearly 54% of index funds in the sample) opposed management between 20% and 60% of the time.

Farizo concluded that the evidence “dispels the concern that index funds, at least in the aggregate, completely disregard voting responsibilities”.

His findings are consistent with those of two previous studies — Passive Investors, Not Passive Owners, published in 2016, and Standing on the Shoulders of Giants: The Effect of Passive Investors on Activism, published in 2018.

This is not to say that the governance record of passive managers couldn’t be improved. It could. But it’s wrong to imply that passive managers are passive share owners when they clearly aren’t.

MYTH TWO: Passive managers help “sin stocks” to thrive

Another myth is that passive investors are somehow supporting companies they actually disapprove of — oil companies, tobacco firms and arms dealers, for example. Again, it’s a fallacy.

There are plenty of passively managed funds that use a negative filter; in other words, they weed out firms that fail to meet certain ESG criteria. Others will use a positive filter; that is to say, they only include that score highly on environmental, social and governance issues. A third type of fund will weight stocks according to their ESG credentials; in other words, funds with the highest ESG scores have the largest weighting and those with lowest the smallest.

The exciting thing is that the options available to investors in this area are increasing all the time. An example of this product evolution is the development by the European Union of two types of carbon transition indices — the EU Climate Transition and EU Paris-aligned benchmarks. It’s the first time that indices have been explicitly used to encourage people to make greener choices when investing their money.

MYTH THREE: You have to pay an active manager for decent performance

A third myth is the idea that if you want good performance you have to pay active management fees. This is as untrue in the ESG space as it is in asset management generally.

Active ESG funds are subject to the same mathematical problem as their mainstream counterparts. In aggregate, active ESG funds will deliver the market return. But when you factor in the cost of using an active fund — the higher annual management charge, for example, and the greater transaction costs — the average net returns investors receive will be substantially smaller than the market return.

Morningstar recently analysed the performance of sustainable funds across in seven different categories, and compared their returns and survivorship rates to those of mainstream funds.

While the majority of sustainable funds across the seven categories have beaten their average traditional peer over the past ten years, researchers found that success rates have varied depending on fees.

Hortense Bioy, Director of Sustainability Research for Morningstar’s EMEA division, said: “Selecting a fund in the lowest-fee quartile five years ago would have improved the odds of picking a winner in all but one category.

“The growing proportion of passive sustainable funds may have helped this trend, as passive funds tend to be cheaper.”

Conclusion

Sustainable investing is a complex subject, and far more nuanced than the media sometimes implies. Investors should be sceptical about claims made about sustainable funds — not just in relation to future performance but also the social and environmental impact they might have.

Your safest option is to consult a financial planning firm, like ours, that truly understands this subject. Get in touch if you’d like to arrange a meeting.