Earth Week: plotting a path to more responsible investing

There are more opportunities than ever to build a ‘responsible’ portfolio of ethical investments without sacrificing returns

The world marks this year’s Earth Day with remarkably clear skies, amid a global shutdown aimed at fighting the COVID-19 pandemic.

Fortunately though, for investors wanting a greener planet after the coronavirus, there are more opportunities than ever to build a “responsible” portfolio of ethical investments without sacrificing returns.

Ethical investing: A definition

First, some definitions. Ethical investing is described as an investment strategy which considers both financial returns and environmental, social and governance (ESG) criteria, with the integration of ESG factors used to enhance traditional analysis.

Another approach, known as “socially responsible investing” (SRI) often goes a step further by actively eliminating or selecting investments based on specific criteria. However, responsible investing is a generic term, with a wide range of approaches towards ESG.

"These days, many sustainable funds take a more integrative approach to building a portfolio," Morningstar's Karen Wallace wrote earlier this year in an explainer, ESG and sustainable investing: a guide.

"The emphasis is on identifying stocks that have best-in-class practices when it comes to addressing ESG issues relevant to that particular company. It tilts the portfolio toward companies that are better at managing ESG issues and therefore less likely to face financial risks such as fines, lawsuits, and reputational damage."

Crucially, research suggests that investing ethically does not mean sacrificing returns.

The Responsible Investment Association Australasia (RIAA), which champions responsible investing, highlighted in its 2019 annual report that responsible investment (RI) funds outperformed most mainstream Australian and international funds across one, five and 10-year horizons.

The report showed an average return for RI funds of 6.43 per cent over five years and 12.39 per cent over 10 years, compared with returns of 5.6 per cent and 8.9 per cent, respectively for the benchmark S&P/ASX 300 total return index.

Australia’s RI market has shown continued growth, reaching nearly $1 trillion in assets, up 13 per cent on the previous year.

The amount of assets being managed in accordance with RI principles represented 44 per cent of the nation’s $2.24 trillion in professionally managed assets. This compared with just $178 billion invested in RI funds at the end of 2013.

“The exponential growth in responsible investing recognises the integral role it now plays in decision making around fund allocations,” said RIAA chief executive Simon O’Connor.

The report also showed growing inflows into retail funds, aligning with RIAA’s consumer research showing nine in 10 Australians “expect their superannuation and other investments to be invested responsibly and ethically”.

International research also suggests the benefit of ESG investing.

According to Harvard Business Review, some 90 per cent of 200 academic studies on sustainability and corporate governance found that good ESG standards lower the cost of capital; 88 per cent showed better operational performance; and 80 per cent showed a positive correlation between stock price performance and sustainability practices.

‘Greenwashing’

However, investors are also cautioned against being overly reliant on marketing claims.

Only 28 per cent of the 120 investment managers assessed by the RIAA in its 2019 report used “best practice” approaches to ESG integration. Just 13 per cent employed negative screening to exclude so-called “sin stocks,” while 1 per cent used positive screening to identify the top ESG performers.

Separating the genuine responsible funds from their less ethical competitors can also be challenging.

“There is potential for greenwashing from funds that are marketed as sustainable investments yet in reality have limited ESG capabilities or sector screening. The risk is investors pay higher fees for funds that have basic responsible-investing filters that do not add much value,” an anonymous expert told the Australian Financial Review in a 11 January report.

ETF offerings

Nevertheless, rising interest in ethical investing has seen a response from the industry, including exchange-traded funds (ETFs).

Among them, the BetaShares Global Sustainability Leaders ETF (ASX:ETHI) and the BetaShares Australian Sustainability Leaders ETF (ASX:FAIR), account for the majority of listed sustainable assets, according to Morningstar’s “ETF Investor” report for the December quarter 2019.

BetaShares also caters for fixed income investors, with its BetaShares Sustainability Leaders Diversified Bond ETF – Currency Hedged (ASX:GBND). At least half of the fund’s portfolio comprises “green bonds” issued to finance environmentally friendly projects, as certified by the Climate Bonds Initiative.

Other such funds include the InvestSMART Ethical Share Fund (ASX:INES), the Russell Investments Australian Responsible Investment ETF (ASX:RARI), the UBS IQ MSCI Australia Ethical ETF (ASX:UBA) and the VanEck Vectors MSCI Australian Sustainable Equity ETF (ASX:GRNV).

In a December 2018 research note on ETHI, which Morningstar’s Alexander Prineas rated as “neutral,” he noted the “ESG label can denote wildly varying approaches”.

“For example, mining stocks may feature prominently in some ESG portfolios but be excluded entirely from others. There is no universally agreed-upon definition of what constitutes ESG best practice. We therefore suggest digesting a fund’s ESG approach before investing, and choosing a vehicle that suits individual needs,” he said.

Will the ESG trend continue? The RIAA points to research showing younger investors, particularly “Gen Z” and “Millennials” overwhelmingly prefer their money to “make a positive difference”.

With Australia’s recent bushfire crisis followed by COVID-19, there are plenty of reasons for investors to think ethically as the world marks its annual demonstration of support for environmental protection on 22 April.