Unpicking the jargon of sustainable investing

• As sustainable investing goes mainstream, investors now face bewildering choice – Morningstar reported that 111 sustainable funds were launched in the first three months of 2021 alone
• Too frequently, terms such as “ethical”, “ESG” and “SRI” are used haphazardly when discussing the topic
• But they have different implications, approaches and outcomes – which we demonstrate in the full article where we review three different “sustainable” funds
• Investors that can navigate these terms may avoid being caught up in potential bubbles and greenwashing – making investment selections to meet both their sustainability and financial objectives. 

While frequently treated as interchangeable, not all approaches to sustainable investing are identical. As it continues to gather momentum in the investment industry, and investors look to benefit from it, we pause here to clarify this critical point.

After hitting all-time highs during 2020, Morningstar noted that inflows into sustainable European funds broke the quarterly record again in the first three months of this year, attracting €120bn. In addition, 111 new sustainable funds were launched¹.

Unfortunately, most commentators, investors and marketers treat the underlying universe of investments as equivalent and unitary. The terms “ethical”, “sustainable”, “ESG”, “SRI” and the like continue to be used haphazardly when discussing the topic.

The EU Sustainable Finance Directive (SFDR) was intended to clarify the issue, reduce greenwashing and jargon. However, the initial reaction seems to have been to add three more descriptors – Article 6, Article 8 and Article 9 – to many writers’ bingo wheels.

Labels, labels everywhere…

The problem of not having a consistent, common language is typical of a rapidly evolving industry in its adolescence. A lack of universally accepted terminology may be an issue; but the greater one is the lack of consistent usage, or lack of effort to be specific.

This is a known and lamented industry challenge. But, it has implications for investors wanting their capital to generate positive outcomes alongside financial returns. This makes it important to explain the differences between the terms and their usage so that investors can make the best selection for their investment and sustainability objectives.

A sustainable thought exercise

To illustrate, let’s review a small selection of indices and associated exchange-traded funds (ETFs) that provide exposure to US equities relative to the S&P 500 and are intended to be “sustainable”. Importantly, the demonstration does not cover the full spectrum of sustainable products. Here we’re just reviewing sustainable investments that use ESG based on their labels and their prospectuses.

A few caveats first for the associated table. While similar, they do have differences; but for ease, we can assume that if you want to invest sustainably into the US mid-to- large cap market, you might pick any one of them. Also, use of these indices or associated funds here is neither an investment recommendation, nor advocacy or criticism for the approach taken by the index provider or manager.

You can’t judge a fund by its cover

First, let’s start simply with names (see table). Between the (A) MSCI USA SRI ETF, (B) MSCI USA ESG Screened ETF or the (C) MSCI USA ESG Select ETF, which one would you pick as the hypothetical investor? All three would be SFDR Article 8 funds. If you wanted the “most” sustainable one, which would it be? What positive outcome(s) would investing in any of them generate? Which actual investment approaches do they use?

Obviously this won’t be immediately clear from names, but it’s slightly more complex. For example, let’s look at (B), which is “ESG Screened”. Does that mean it is screened on ESG criteria? Would that be an overall ESG rating, or across each E, S and G rating? Is that on a best-in-class for each industry or to a minimum level across all industries? Or perhaps the overall score? Or is it first screened on an ethical basis and then uses ESG?

Appreciating these naming challenges starts to demonstrate that simply labelling or saying an investment product uses ESG does not mean they are all identical.

These may be easy criticisms, especially as there are limitations on fund names. But stepping back, when talking about the pros, or cons, of “ESG investing” it’s not immediately clear what that means.

Looking beneath the label

Second, what would you expect the underlying holdings of these “sustainable” indices to be?

Upon review of top 10 holdings in the table, investors newer to the field may be surprised to find such well-known companies, even though that was the segment of the market we had specified. As well, these may not be the firms that immediately come to mind as solving societal issues such as climate change or healthcare (even though some do have business lines addressing these issues).

Moreover, some investors may have strong personal views about how “sustainable” or “ethical” these companies are given their experience or what they see on the news.

But ESG is not primarily about making a moral judgement². It’s about incorporating the environmental, social and governance risks relevant to the sector and company into investment selection. Primarily it’s a risk mitigation tool.

So the selected US large or mid-cap companies are ones that, based on the underlying data providers and ratings, are better at managing the ESG risks, or higher performers against their peers³.

Ultimately, ESG consideration can be applied to any company. It’s helpful to think about it as a look into the internal operating practices of an organisation. The aim is to get insight into how well-run is the organisation. This is distinct from considering the implications of the organisation’s goods and services externally, where the positive and negative outcomes are also considered.

Focusing too much on the label, not the practices

So even an illicit cocaine cartel could score well in some ESG criteria, hypothetically, if it had environmentally friendly growing practices, paid living wages and had streamlined and clear governance⁴.

As exaggerated as the above example is, it shows that investors shouldn’t think about investing in “ESG” as categorically generating societal benefits through their portfolio. As well, the reverse that simply because an organisation’s trying to “do good” through producing electric vehicles, addressing food waste, or providing education, does not mean this flows to the organisation’s operating practices.

Investors shouldn’t be surprised to find brand name companies in sustainable investing products where they prioritise ESG considerations. The primary aim is to find the well-run organisations, not necessarily the ones solving the most critical global problems.

This difference, and the rallying of most capital towards ESG, is why many of the field’s original advocates are understandably critical. There is a concern that simply by focusing on these ESG operating practices, and not actively putting capital towards solving our global problems, we may be generating a false sense of security or accomplishment.

Only the first step

As this brief case illustrates even with a criteria of investing sustainably for US exposure primarily incorporating ESG considerations (though some had ethical screens as well) can yield very different results. The difference in holdings and weightings will then flow to a divergence in investment performance too.

Notably, all are passive investment products which tend to be the more transparent and detailed about their investment process. Index methodologies are generally available to review. Given time and knowledge, it is possible to decipher how sustainability appears in their investment process and the result in terms of holdings.

With active managers, that process tends to be more opaque as either ESG ratings and/or underlying data is incorporated into discussions and decision-making with varying specificity (as explained further in the second half of our Outlook 2021 article on Material E, S, G factors in 2021).

If we added other sustainable investing funds into the mix, this would diverge even further. For example, these could be sector focused, such as renewable energy, circular economy or healthcare. Or indices or funds where, along with assessing operating practices, they explicitly target companies whose goods and services seek to solve societal problems. When collecting all these different approaches together, it becomes clear that loosely referring to “ESG”, “ethical” or “sustainable” funds does not help the industry. Nor investors.

Focus on the investors

While critical here, though primarily of commentators and marketing, the industry is making collective and considerable effort to address terminology issue.

Hopefully, highlighting these differences does not cause readers to throw up their hands up in disgust at the situation, but be more confident to ask for explanations – how does this investment incorporate sustainability? Where does it focus operating practices and/or goods and services? What techniques or approaches does it use? What are the implications?

These questions will help to diminish the risk of getting caught in potential bubbles and greenwashing. They will also help to avoid confusion that having a sustainable label is an indicator of quality, or competence of the underlying manager.

Finally, it’s important to note that the above illustration presents sustainable investing from a product perspective. In reality, it starts with investors’ financial and sustainability objectives, and only then navigates to investment opportunities. In this way, industry jargon is bypassed and the focus is on helping clients to generate financial returns and societal outcomes in the way that matters to them.