How you can save the world by investing in ESG funds

The Russia-Ukraine conflict and Covid-19 increased investor interest in responsible investing

A record $649 billion was poured into ESG-focused funds worldwide in the year to November 30, 2021, up from the $542bn in 2020. Nick Donaldson / Getty

Everybody dreams of saving the world and now you can do it using the power of your pensions and investments.

Instead of investing your money in greedy, polluting companies, you can direct your funds towards clean and green businesses instead, and make the planet a better place, hopefully.

There is an acronym for this, ESG, which stands for environmental, social and governance, and a growing army of investment analysts factor them in when assessing risks and rewards.

ESG has been a hot investment trend for many years and it is hard to argue against the sentiment.

Why use your retirement savings to fund companies that may have ravaged the planet by the time you reach pension age?

But as anybody who has seen a superhero movie knows, saving the world is more complicated than it looks.

Today’s ESG movement can trace its roots to the 1960s, when Vietnam War protesters demanded university endowment funds to stop investing in military contractors.

The Pax Fund, thought to be the first ethical investment vehicle, was launched in 1971, while Friends Provident Stewardship set the UK ball rolling in 1984.

Climate change, the Covid-19 pandemic, Black Lives Matter and other social justice movements have given the trend a further nudge.

ESG used to be called ethical investing. It has also been called green, sustainable, socially responsible and impact investing but for now, the go-to name is ESG.

In the year to November 30, 2021, a record $649 billion was poured into ESG-focused funds worldwide, up from the $542bn in 2020 and $285bn in 2019, according to Refinitiv Lipper.

ESG funds now account for 10 per cent of worldwide fund assets. It is no longer a niche area but big business, which makes things even more complicated.

Can it make you richer while also soothing your conscience (and maybe even doing some actual good)? Again, it’s complicated.

The ESG tipping point came in January 2020, when Larry Fink, chief executive of BlackRock, said the world’s biggest fund manager was overhauling its investment strategy to make sustainability the “new standard”.

ESG now makes economic and social sense as companies can no longer afford to ignore climate change risk, he said.

The Covid-19 pandemic offered ESG another boost by raising fundamental questions about how we live and work, and the sort of planet we want to live in, says Keith Bowman, investment analyst at Interactive Investor.

“The Ukraine war is also having an influence, with over half of investors becoming more conscious of how their money is invested in the wake of the conflict, our data shows.”

Sceptics who argued there is a price to pay for going green, in the shape of poor performance, were blown away as ESG funds soared in 2020.

The MSCI Global Environment sector grew a staggering 96.47 per cent while its MSCI World benchmark returned only 16.50 per cent.

It didn’t last, though. The sector underperformed in 2021, returning 16.36 per cent against 22.35 per cent on MSCI World.

ESG has this in common with many investment sectors — it has a tendency to be cyclical, and 2021 was a disappointment as valuations stretched and the hype faded.

The Ukraine war has been a two-edged sword, as it has also boosted oil and gas stocks, as the West looks to wean itself off Russian energy.

Investors appear to have lost interest amid more pressing concerns elsewhere, James Clark, senior fund analyst at Hawksmoor Investment Management, says.

Yet, sustainable investment isn’t done yet, he says.

“People are not suddenly going to stop caring about climate change, using resources more efficiently, promoting social harmony and ensuring companies are well-governed.”

The bigger the company, the harder it is to be ethical. ESG portfolios often have a bias towards smaller companies, which brings in another layer of risks.

Everybody also has a different idea of what ethical means, which further complicates matters. Investing in fossil fuels may be a red line to some, a green light to others. The same goes for other "sinful" stocks such as tobacco and today’s big ESG dilemma, weapons.

The Ukraine invasion has shown the importance of having a strong defence industry, prompting Europe to discuss whether armaments should be classified as ESG, as the defence sector argues that failure to do so will starve it of investment.

Every sector has positive and negative outcomes, Patrick Uribe, chief executive of FinTech company Util, says.

“The defence industry is responsible for many of the inventions that improve our living standards, as well as millions of jobs in biotechnology and pharmaceuticals, electronics and telecoms. On the other hand, it has been and continues to be responsible for millions of deaths,” he says.

Mr Uribe’s personal view is that categorising weapons manufacturers as ESG-positive is a misrepresentation of the facts.

“Their purpose is warfare, which has no clear positive social outcomes.”

Others disagree, but whatever position you take, there is no question that it adds yet another layer of complexity to ESG investing, which is already hard enough.

That is before you consider the issue of “greenwashing”, where companies only pretend to be working towards a cleaner planet and fairer society.

In February, US financial company Morningstar removed more than 1,200 funds with a combined $1.4 trillion in assets from its European “sustainable universe” list.

This underlines the challenge facing investors trying to pick funds with genuine, proven sustainability credentials, Andy Harris, commercial director at the Sustainable Pension Company, says.

“Increasing interest in responsible investing has seen growing numbers of asset management firms jumping on to the ESG bandwagon, renaming existing funds to suggest a more sustainable focus than is, in practice, the case.”

It is harder than ever “to separate those who are truly walking the walk from those who are simply talking the talk”, Mr Harris says.

Yet, every investor should review their portfolio to avoid the risk of “stranded assets” as the ESG revolution rolls on.

UK pension manager Scottish Widows screened £3bn ($3.95bn) worth of assets that it says pose an ESG risk and made a “flagship commitment” to divest from tobacco companies.

Tobacco stocks risk becoming stranded assets as they face intense pressure from investors, regulators and consumers, and fail to address the social impact of their products and supply chain, Maria Nazarova-Doyle, head of responsible investments at Scottish Widows, says.

The same will happen to carbon-intensive sources of energy such as thermal coal and tar sands, which will be replaced by greener renewable sources such as wind or solar.

“Exiting these highly damaging areas and redirecting capital to more climate-aware investments makes perfect investment sense,” she says.

Private investors can now choose from a huge range of ESG-labelled actively managed funds and passive exchange-traded funds.

Big names include iShares ESG Aware MSCI USA ETF, the Vanguard FTSE Social Index Fund, the Stewart Investors Asia-Pacific Leaders Sustainability Fund and Pictet Global Environmental Opportunities.

Even with ESG, the old rules apply. Invest for the long term. Consider your personal attitude to risk. Never put all your eggs in one basket, even if it has been ethically woven. Investments can go up and down.

You can do your bit to save the world, but you must pick your way through an ethical minefield first.

If that sounds complicated, it is.