The ethical fund industry is expanding to accommodate the growing number of investors seeking to put their money in companies they feel do the right thing.

For these investors, the days of investing in so-called sin stocks—guns, booze and gambling—are over.

In fact, the list of areas where investors can make a difference has expanded to include climate change, pollution, and the way companies treat their workers.

Almost 50 per cent of investors say they now choose funds or companies to invest in according to ESG considerations, according to the Legg Mason Global Investment Survey 2018.

In this year's first quarter alone, 73 funds added environmental, social, and governance criteria to their investment processes, according to Morningstar's global head of sustainability research Jon Hale.

But the growth of ethical funds has led to a proliferation of labels and acronyms as managers struggle to provide clear definitions for what they do.

Sustainable, ethical, ESG, socially responsible investing, or SRI, green, impact, responsible investing: these terms are often used interchangeably but they don’t all mean the same thing, making this area a potential minefield for investors.

In this article we'll examine the ways you can invest ethically and make investment decisions that align with your values.

Matching ethics to investment

According to the Responsible Investment Association of Australia, ESG investing is the explicit inclusion of environmental, social and governance factors into traditional financial analysis and investment decision-making.

Environmental factors can include the contribution a company makes to climate change and carbon emissions, to air and water pollution, how they manage waste, or whether they contribute to deforestation.

Social factors can include a company's commitment to gender and diversity, how they treat their staff, how they interact with the community, whether their customers are satisfied, and their stance on human rights.

Governance refers to the way a company governs itself – its board composition, how much it pays its executives, whether it has proper processes for auditing and review, or whether it engages in bribery and corruption.

For a fund, this means the portfolio manager will use ESG factors to inform their view on a company's fundamental value, long-term risk, competitive advantage and return prospects.

Morningstar European director or passive strategies and sustainability research Hortense Bioy says an increasing number of asset managers are incorporating ESG factors into their investment process.

"This is what is expected to become the new normal," she says. "So eventually, every professional investor will integrate sustainability in their investment decisions."

Check the label

However, Hale warns investors to check the label thoroughly. Some funds, he says, are guilty of “greenwashing” – in short, adding a token line in their prospectus about ESG considerations, with little substance or tangible commitment to ethical investing.

esg ethical investing impact

SRI funds use exclusionary screens to remove companies with significant business activities involving tobacco and alcohol

"Though these funds are not being rebranded or marketed as sustainable funds (at least not yet), the fact that they now consider ESG could be a way to sell them to consultants and advisers looking for ESG funds, allowing them to grab some of the growing ESG market share and stem the tide of outflows from these actively managed funds," he says.

"Indeed, there is a clear distinction to be made between these ESG consideration funds and those with a more fulsome commitment to sustainable investing."

How to screen for ethical investments

Socially responsible investment (SRI) funds — or ethical investment funds — typically use exclusionary screens to ensure a portfolio reflects the values of investors. For example, the Vanguard Ethically Conscious International Shares Index ETF (VESG) excludes companies with significant business activities involving fossil fuels, alcohol, tobacco, gambling, military weapons and civilian firearms, nuclear power and adult entertainment.

SRI funds can also choose to apply positive or best-in-class screens, which helps them make investments in companies or industries with superior ESG performance or make investments based on a theme such as clean energy or water technology. For example, Nanuk’s New World Fund (41749) positively screens in favour of companies with sustainable practices, and negatively screens to avoid companies involved in things that hurt the environment.

It's crucial to establish whether the ethics of an SRI fund match yours. Sure, a fund may say it uses environmental screens, but are those screens stringent enough for you? Once you decide what's important to you as an investor, check the funds website, prospectuses and annual reports, which should carry basic information about the types of social screens the funds use. And also examine a recent portfolio of any SRI fund you're seriously considering.

Also worth noting is that some socially responsible and ESG funds are involved in shareholder activism. It's highly unlikely that any corporation will clear all socially responsible hurdles. A company may have an excellent environmental record, but it may not provide the best working conditions for its minority employees. If SRI funds demanded perfection from every company they owned, they would never buy anything. So, some fund families use shareholder activism to challenge the policies of some of those companies they do own. Because shareholders own the company, they can push for change. Other times, funds simply engage the firm in a discussion, quietly pressuring management to alter policies it considers unpalatable.

Impact investing

Whereas SRI products tend to focus on screening out companies they consider negative, impact funds on the whole use positive screens.

These funds invest in assets that deliver measurable social or environmental impacts alongside their financial returns. This can include investing in communities where capital is specifically directed to traditionally underserved people or providing financing to businesses that have a clear societal purpose.

Many impact fund managers use as a benchmark the United Nations’ 17 Sustainable Development Goals, which address poverty, inequality, climate, environmental degradation, prosperity, and peace and justice.

It’s worth noting that while most responsible investments target market-rate financial returns, RIAA says some impact investments will intentionally deliver below market-rate returns in order to maximise the social or environmental impact.

RIAA's responsible and ethical investment spectrum

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RIAA Responsible investing

Note: this Spectrum is only intended as a guide to understanding different responsible investment approaches and their features and that the boundaries defining each strategy are not set in stone, open to varying definitions, interpretations and executions. [Source: Responsible Investment Association Australasia]