How to do ESG due diligence and avoid greenwashing in portfolios

This applies to the investment management world as much as to anywhere else. 

The story of recent years has been the emergence of investment products with a focus on environmental, social and governance (ESG) concerns. 

And as with any trend, there has been a substantial increase in such products coming to market.

There are many ratings agencies out there to grade funds according to ESG criteria, and of course those are important.--Matt Evans

The increased desire of many clients to have their money managed in a way that has a positive impact on the world, combined with the strong performance of ESG funds in the pandemic-induced sell-off of March 2020 has drawn in many investors attracted by the favourable returns. 

Asset managers, hindered in their growth plans by the popularity of passive investing, and volatility of markets, have alighted upon ESG mandates as a way to drive inflows.    

Advisers and wealth managers looking to ensure the portfolio into which they place their client’s capital is sustainable are thus likely to be faced with a range of new offerings.

And a decision on how to identify those which genuinely are about ESG, rather than merely using the term as part of a marketing strategy, needs to be made.  

Matt Evans, sustainable equity fund manager at Ninety One, says although there are many ratings agencies to grade funds according to ESG criteria, there also has to be "an element" of personal responsibility on behalf of the provider.

"I think where there has been a lot of fund launches and fund literature where the managers talk about how ESG is 'embedded in their process and has always been’ but I don’t think those are really ESG funds.”

Francois De Bruin, a fund manager at Aviva Investors, says the ability of a product provider to supply data to back up the claims made about the ESG credentials of the portfolios they manage is key to him understanding whether the company is truly ESG compliant. 

He says: “If the data is there then it is very clear cut, and if it is not there, then it is also clear cut.”     

According to Mona Shah, an ESG fund picker at wealth management firm Stonehage Fleming, everyone has a different definition of sustainability, but some fund pickers just look at the largest holdings and base it on that. She says: "I want to see all of the holdings in an ESG fund, and then I need to know that their definition of ESG aligns with mine.” 

Greenwashing is a genuine problem for fund pickers to monitor, says Nicolo Bragazza, investment analyst in the portfolio management team at Morningstar, because some investment firms and the companies in which they invest are becoming more aware of the need to be seen to compliant, presenting a challenge for an investor, to ensure thy only invest with the firms that are truly following the rules.

Mr Bragazza's approach is to focus on providers that have had ESG portfolio offerings for many years, including periods of time when the asset class was less fashionable than is presently the case, with the result being that he can be sure that the focus on ESG is genuine.  

Peter Michaelis, head of the sustainable investment team at Liontrust, says there is a danger that the rise in the number of providers bringing ESG products to market increases the risk of greenwashed investment portfolios. 

He says: “We hope the financial services industry maintains high standards in meeting this demand and is clear and transparent to investors about the sustainable products they offer. Greenwashing is a troubling trend.

"Therefore, we expect ever-closer scrutiny of sustainable funds to evaluate if they deliver what they say they will and a growing demand for transparency. This will lead to improved reporting of the impact of funds and their engagement.”

Ama Seery, sustainability analyst at Janus Henderson investors says greenwashing is more often the result of lack of knowledge than of any attempt at malfeasance.

I want to see all of the holdings in an ESG fund, and then I need to know that their definition of ESG aligns with mine.--Mona Shah

She says: “There are professional qualifications in sustainability, just as there are in finance, but not many people in the finance industry seem to have the sustainability qualifications. To be an analyst at a fund house you need to be a CFA, but to work on a sustainability fund you aren’t required to have a chartered environmentalist qualification.

"Companies report carbon in different ways, and in ways that downplay the negatives, there is a greater sophistication, but the qualifications to identify that aren’t really valued by the industry.”

Money matters        

For David Harrison, fund manager on the Rathbones Global Sustainability fund, the companies that interest him are those that can show a link between the ESG policies being pursued and the financial returns to be earned.

Additionally, company management must be able to articulate how the ESG policies help the financial performance of the company. If they can do this, he will know they are committed to implementing stated ESG policies.

Greenwashing is a troubling trend.--Peter Michaelis

Mr Harrison says that if there are specific ESG targets, such as compliance with UN Sustainable Development Goals, one of the questions he asks is whether the remuneration of the business’s senior management is linked to the achievement of those goals, in a similar way it could be linked to meeting specific financial goals. 

Frederic Samama, chief responsible investment officer at CPR Asset Management says the problem with some portfolios is they award companies a score for each of the categories - environmental, social and governance - using the average of those three scores to decide if a company is ESG compliant.

He says this can mean a company scores very highly on one or two of the categories, and so is included in portfolios, even if it performs poorly on the third category.  

A time of plenty

Canaccord Genuity Wealth Management’s Patrick Thomas takes a simpler view. He says: “The way to assess whether a fund or company is ESG compliant is to ask whether the business being invested in makes the world a better place.

"There are of course subjective considerations as to what some people think is ethical or not, but I think there are some areas, such as water supply, where there isn’t really a dispute, and we focus on those.”