ESG investing: should you be negative or positive?

 With concerns around climate change and human welfare growing, investors are increasingly looking for investment options that do not harm society or the planet. These investments are generally referred to as Environmental, Social & Governance (ESG). 

The managers of such investment funds seek to meet an investor's desire to help by typically ensuring that they do not invest in certain industries. The likes of munitions, fossil fuels, and gambling are typically excluded. 

This process is known as "negative screening". So it excludes those investments that fail to have the correct criteria. However commentators and investors are increasingly querying this approach. 

For example, what about the impact of supply chains? Should you not also exclude a firm or even an industry that relies on the use of an excluded industry's product? If the manufacturing of a device entails a huge amount of oil to be burnt, then shouldn't the firm producing the device also be excluded?

Similarly what about good Governance? Many have cited the example of Apple and its reliance on Foxcon in China for the production of the iPhone. Here is a modern tech firm with a fantastic brand, whose main product is produced by workers seemingly suffering appalling working conditions. Shouldn't an ESG fund also exclude investments in Apple, therefore?

So some wonder "where does it all stop?" If you take a view that something is bad and so you do not wish to invest in any firm with a connection to it, you could end up with a very small list of stocks which are acceptable. 

It has been noted in the past that those attracted to "ethical investing" are often also relatively inexperienced investors. Such investors would therefore often be described as cautious/risk-averse. However investing ethically narrows the investment options. Historically the evidence has shown that this screening process makes their portfolio more volatile - and therefore better suited to someone with a higher risk tolerance. So their ethical stance may be placing them in an unsuitable investment profile.

However more recent evidence tends to imply that, since the "ethical" description was broadened to "ESG", this contradiction may be less prevalent. A study by New Amsterdam Partners found that stocks with a strong commitment to the principles of ESG enjoyed more stable valuations. Meaning that investing in the an ESG fund could reduce the volatility an investor is exposed to.

Another question is whether exclusion is too blunt a tool. For example, what about an oil company that has decided to use it's vast wealth to further the cause of green energy? BP recently announced this move. Shouldn't it therefore be rewarded for trying to help the situation?

Perhaps therefore instead of working on a negative screening approach, managers should adopt a positive screening approach as well or instead. So actively select firms that are making a contribution in the fight against climate change or assisting in improving peoples welfare.

The author can find little evidence of such an approach being actively promoted by the fund management community. A couple of minor funds in Australia and the UK, but nothing of significant scale (please do let me know if you know of options!)

Despite its enormous clout the fund management community has arguably resisted holding companies to account (for various unwelcome actions or practices) until quite recently. Fund managers are now catering for the demand for ESG investments on a rapidly growing scale. 

However it could be argued that having belatedly adapted to investor demand, they are going about it the wrong way. Investors who care about ESG should keep up the pressure for their money to make real change.

POSTSCRIPT (April 2021) : Just come across this excellent piece by the extraordinary team at Baillie Gifford.

POSTSCRIPT (August 2021) : Also this interesting piece arguing that passive investments (ETFs) are impeding change

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Disclaimer: This communication is purely meant as information for general interest. It is in no way to be taken as financial advice or relied upon in any way for investment decisions.