Understanding sustainable and ESG investing

If a fund manager says they consider ESG, it means they have carried out additional research to understand the environmental, social and governance (ESG) risks presented by the companies they are looking to invest in. ESG is often referred to as ‘sustainable investing’. 

Examples of what ESG factors cover vary but they can include climate change, health and safety in the working environment and protecting the interests of shareholders.

Ethical investing involves choosing investments that avoid dealing with products and services that may be considered harmful or misalign with personal values, such as tobacco, adult entertainment and gambling. Many ethical funds will also screen for a wide range of environmental issues such as deforestation or negative social issues such as low labour standards.

Impact investing aims to generate positive, measurable influences on society and/or the environment, alongside a financial return. Some of the areas impact investing might aim to challenge include traditional (ie non-renewable) power generation and gender inequality.

This is an alternative term for a range of investment approaches including responsible, sustainable or ethical investing. It usually means that environmental, social and governance (ESG) factors and values have been integrated into the investment process. Some examples may include human rights and environmental sustainability.

An investment approach that considers environmental, social and governance (ESG) factors, with a focus on companies seeking to improve wellbeing and have a positive impact on society and the physical environment.

Faith-based investments align with the principles of certain religious groups. To create these funds, a negative screening process is typically used to rule out any issues that could be deemed unsuitable by religious standards (such as those involved with alcohol production and gambling). Funds should also actively engage with companies that prioritise sustainability, social responsibility and ethical practices.

Investing in companies that either explicitly focus on improving the environment or avoid those that damage it.

Different institutions and funds have different ways of looking at environmental, social, governance and ethical issues. These are explained to potential investors through criteria and policies (the main difference between the two being that policies are more detailed). Fund policies and criteria set out how a fund will deal with these issues, which in turn helps direct where a fund will and won’t invest.

Environmental issues (which should be explained in an investment fund's published ‘policies’ or ‘criteria’) consider a company’s impact on the planet and the risks posed by environmental factors, such as climate change, biodiversity loss and plastics.

Social criteria consider how a company manages its relationships with employees, suppliers and the communities it operates in, including its response to labour strikes, supply chain disruptions and negatively perceived labour practices.

Governance relates to company management and leadership and may focus on issues like executive pay, audits, internal controls and shareholder rights and responsibilities.

Many funds also consider ethical issues which relate to personal values and concerns, which do not easily fit within the groups above. These include issues like armaments, tobacco, gambling and animal welfare.

ESG reports disclose data which explains the influence a company has on environmental, social and governance (ESG) issues.

Also known as a ‘sustainability report’, shareholders can see a performance analysis across the three key ESG areas. Through quantitative and qualitative data, the report will look at what the business has achieved and the impact it has on all ESG factors. And any future goals the business is working towards.

Although ESG reports are not compulsory, the rise of regulations in corporate ESG data means it’s often in the best interests of the business to communicate their strategy and consider transparency with shareholders.

The Financial Conduct Authority (FCA) introduced sustainability labels as part of a range of measures to provide clearer information and protect investors who are looking to invest in sustainable funds. 

Each of the four labels indicate the specific environmental and/or social goal of the fund.  

If a fund meets the general and label-specific criteria a fund manager can choose to use a label. They need to provide clear and simple information on the fund’s goal, how they'll achieve it and annual updates on its progress.

Learn more about the sustainability labels

Greenwashing is where fund managers (or others) mislead potential investors by making false or exaggerated claims about a company’s or fund’s environmental standards.

The Financial Conduct Authority (FCA) introduced sustainability labels as part of a range of measures to provide clearer information and protect investors who are looking to invest in sustainable funds. 

Each of the four labels indicate the specific environmental and/or social goal of the fund.

If a fund meets the general and label-specific criteria a fund manager can choose to use a label. They need to provide clear and simple information on the fund’s goal, how they'll achieve it and annual updates on its progress.

Where a fund does not have a sustainability label but still makes a sustainable claim, the best way to guard against most aspects of greenwashing is to look closely at what the fund is designed to do. Funds that say they exclude a particular area, such as tobacco or oil companies, can be expected to do exactly that. Funds that say they will invest in line with named themes, such as renewable energy or healthcare, are more complex to monitor but can be expected to invest in companies that align to those themes. Funds that say nothing on these topics, or are unclear in their communications, cannot be expected to invest in any particular way and their views about particular issues may be different from your own.

Funds also have different positions on stewardship (engaging with companies to encourage them to adopt higher standards), which can lead to different investment decisions. Funds that rely substantially on stewardship activity may hold more controversial companies to account with the aim of encouraging them to change. So, if you are keen to avoid potentially controversial companies you may prefer to consider funds with stricter exclusions or a stronger focus on positive themes - such as good environmental, social and governance (ESG) practices.

It’s also important to remember that many listed companies are very large and complex. Most have both positive and negative features - so where one fund manager may see problems another may see a useful service or valued employment opportunities.

Ultimately, guarding against unwelcome surprises comes down to carrying out your own due diligence as strategies vary. You should start by looking online and even visit the fund manager’s own website, to understand what an individual fund sets out to do, its purpose and where it will and won’t invest.

The design of investment funds is always a combination of what a fund manager (or fund management company) believes makes sense and what they think their customers will want to invest in.

For funds that specifically focus on environmental, social, governance and ethical issues there is an additional layer of planning required.  Designing their strategies often involves weighing up lots of different issues, considering what people want today and where the investment risks and opportunities lie.

Some fund managers take the decision to focus on a specific industry, like water, or issue, such as climate change. Whereas others choose to have far broader remits, like sustainability funds and ethical funds.

There are also many different approaches that investment funds can take - from avoiding companies with poor standards (exclusions), to investing in companies that are providing useful services (positive stock selection) and encouraging companies to change (stewardship activity).

Climate change is a good example of this. Some people – and therefore some funds - will simply want to avoid coal, oil and gas companies. Others will want to focus on investing in renewable energy companies. And some will want to encourage oil companies to change their ways and become renewable energy companies.  Some will also care about supply chains, employee relations and management practices. Others may not. Different fund strategies reflect each of these variations – and much more.

And when unforeseen challenges arise - such as when a company behaves in a way the fund manager did not expect or an accident occurs - some fund managers may continue to invest in a company so that they can encourage senior management to change their ways, whereas others will make a swift exit. There is no magic formula… but the good news is that fund managers are increasingly focusing on such things.