While there may be few winners coming out of the current crisis, ESG investing is certainly one. Selecting investments on Environmental, Social and Governance criteria may not be anything particularly new; religious investors have been doing it for decades and momentum has been building powerfully ever since. Now, however, it is soaring in popularity amid a pandemic which has painfully underscored the interconnectedness of people and places, and the fragility of the systems upon which we all rely.

While there may be few winners coming out of the current crisis, ESG investing is certainly one.

The figures illustrate a boom bordering on frenzy: the latest (Q3) figures show net retail sales for UK responsible investment funds quadrupled from £1.9bn in 2019 to £7.1bn in 2020, while assets in sustainable funds hit a record £930bn globally. Taking all the various types of strategies and labels into account, it is thought that over $40trn in assets are now run along ESG lines – a figure which has doubled in just four years

Numerous factors have been driving the ESG trend, not least the power of social media to highlight issues and cultivate a sense of collective responsibility. But there is more than altruism at play. Whereas many used to believe that ESG was about trade-offs, it has long been widely accepted that investing ethically doesn’t necessarily entail taking a hit on returns. In fact, ESG investments have actually shown significant outperformance during the crisis: over the first three quarters of 2020 stocks with higher ESG ratings had better returns in every month except for April.

Risk reduction

One very important reason is risk management. As various meta-studies have shown, there is a strong positive correlation between high ESG standards and corporate financial performance. If a company avoids things like polluting practices and labour disputes (and all the negative press those bring) then it’s easy to see how their profits are more sustainable over the long term. Thus, the seemingly “fluffy” world of ESG is actually underpinned by hard-nosed business principles that those of all ethical leanings (or none) can get behind.

It also goes without saying that ESG credentials have become a real selling point for investment firms amid rising social consciousness and a corresponding desire among all sorts of people (and especially the younger generations) to put their capital to good use. This, however, is very much a double-edged sword.

There are real question marks about whether there are sufficient legitimate ESG opportunities to meet demand. The more hard-bitten among us might see that there is a lot of bandwagon-jumping going on, as well as companies and investment firms that really are walking the talk. Warnings about “greenwashing” – the practice of slapping green or other virtuous labels on instruments that don’t really warrant the name – have been coming thick and fast.

As with all investments, the maxim of buyer beware holds true – as does looking “under the bonnet” of your investments. On an individual stock level, this might mean looking right through a company’s supply chain to see if any nasties are lurking within. For instance, many people are now questioning how ethical battery power can be if manufacture involves conflict minerals that are often mined by children in war-torn states. We could also ask if an ostensibly ethical investment remains as such if this also boosts the economy of a repressive regime. Do environmental gains justify humanitarian costs or vice versa? Should we prioritise ethical concerns at the macro or micro level, and should we be thinking near or very long term?

Competing priorities

The truth is ESG investing is an absolute minefield of competing priorities and, I’m afraid to say, trade-offs of a very much deeper kind. While investors can certainly try to invest sustainably and in line with their values on their own, I would say this landscape is very often best navigated with professional help.  

The challenges are manifold. Investors have to decide whether they are screening out for bad, or screening in for good; they must also choose between investments that make a positive impact in and of themselves, or if they invest in fund managers which exert shareholder pressure to effect positive change. And of course, these needn’t be binary choices.

The broader issue is the difficulty of building a diversified ESG portfolio that will allow you to do good with your capital, while also doing well in risk-return terms. ESG bonds are becoming more prevalent, but still lag well behind funds, so you may suffer a fixed income gap in your portfolio if following too strict an approach. What’s more, many ethical products have only short track records, making it difficult to pick winners. Higher fees can then compound the issue of muted returns.

If all this sounds incredibly complex, that is because it really, really is. There is a reason that wealth managers have expert teams dedicated to ESG – and that firms specialising only in this area have sprung up to cater to demand.

It is great to see the world uniting to put capital to work in creating a better tomorrow. Yet it would be naïve to think that investors won’t have to make pragmatic and sometimes difficult decisions about what they can – and should – do when balancing ethical concerns against the health of their wealth in the difficult times ahead. This should be the start of a golden age for ESG investing, we just need to keep our eyes wide open too.

Gary Skovron
Gary Skovron

COO of ARQ Wealth