The main principles of ESG investing

According to data from Morningstar, annual European sustainable fund flows increased from €50bn (£45bn) in 2018 to a record-breaking €120bn in 2019, bringing the total assets under management to €668bn.

This increase was mirrored in the number of sustainable funds, which increased by 360 in 2019, to total 2,405.

This interest has, if anything, increased since the start of the Covid-19 crisis.

For example, people have noticed and appreciated the lower levels of pollution (due to much lower economic activity), while companies that treated their employees badly were punished by the consumer and those that behaved well rewarded.

Ethical investing

The original form of this type of investing, often known as ethical investing, was just negative/exclusionary screening - the screening out of companies or even industries based on specific criteria, such as a significant portion of the firm’s profit coming from: alcohol, gambling, tobacco or weapons; or the company using animal testing or child labour.

ESG investing involves searching out and including companies based on desired ESG characteristics rather than just excluding firms

Such funds, however, usually had lower returns and higher risk compared to equivalent funds which had not been screened.

This is to be expected from a theoretical point of view - when investors limit their universe they risk underperformance and greater risk because they are not selecting the most ‘efficient’ set of investments - and is probably the main reason why this type of investing never really took off. 

ESG investing involves searching out and including companies based on desired ESG characteristics rather than just excluding firms with undesirable business activities.

The approach involves a systematic consideration of specified ESG issues throughout the entire investment process in order to increase returns and reduce risk.

IA responsible investment framework

Using the Investment Association responsible investment framework, there are three different levels to ESG investing.

Exclusions, similar to the ethical investing described above, involves the exclusion of investments in certain companies and sectors from the fund or portfolio based on pre-defined criteria.

Sustainability focus is where investment is made in companies on the basis of their fulfilling certain sustainability criteria and/or delivering on specific sustainability outcomes.

This can take the form of positive screening, where the investment manager looks for businesses that are ‘best-in-class’ based on ESG ratings; or sustainability-themed investing, where investment is made in companies that target specific sustainability themes such as climate change mitigation, pollution prevention sustainability solutions and approaches that relate to one or more of the UN Sustainable Development Goals (SDGs).