What are “ESG Funds”?

ESG funds are collective investments that integrate Environmental, Social, and Governance factors into their investment philosophy and process. This would typically result in a rigorous assessment of the sustainability characteristics of a company (being equity or bond) – those with strong credentials represent potential investment opportunities, where poor sustainability records may lead to the company being avoided by ESG strategies. Unlike traditional funds that seek to generate financial return, ESG portfolios also aim to create non-financial benefits such as promoting more sustainable sources of energy and tackling climate change, improving social imbalance, promoting fair working conditions and remuneration, etc.

Key Learning Points

  • ESG funds integrate Environmental, Social, and Governance factors into their investment philosophy and process, which depending on the style of the fund may lead to avoiding certain areas of the market such as oil & gas or mining
  • The primary objective of traditional funds is to deliver above-market returns to their investors, ESG funds also seek to generate non-financial benefits for all stakeholders
  • The demand for ESG funds has grown rapidly over the recent years. According to data from Morningstar, global sustainable fund assets reached $2.24 trillion in June 2021
  • Although many variations exist, there are two major approaches to ESG investing – exclusionary where “bad” companies are screened out and best in class where companies operating in non-ESG sectors which demonstrate good sustainable practices are included in the portfolio

 

How Does It Work?

ESG Funds could be either active or passive. In the first instance, an investment professional (or a team) will construct a portfolio of hand-picked companies with good sustainability credentials, wherein the second fund will closely track an index of sustainable companies. Navigating the investment universe would typically take two forms – dark green funds will avoid investing in and exclude companies operating in controversial sectors such as oil & gas, gambling, alcoholic beverages and tobacco, arms, and others. There are also light green funds that will take a more secular route. They can still make a decision to invest in companies from those “bad” sectors of the economy but will consider only those that can demonstrate the desire and better plans to improve than their peers.

 

What Are the Criteria?

When building their portfolio, ESG fund managers look at both financial and non-financial characteristics such as:

Environmental

This area captures a very broad view of the issues linked to the use of energy and the transition toward renewable sources, waste and pollution, climate change, biodiversity, and the treatment of animals, water resources, and many others. Managers will assess how a company manages any environmental risks that it might face.

Social

Here all relationships with stakeholders are evaluated. That includes all companies within the supply chain, as well as employees and local communities. Some of the points examined will be the working conditions and wages that the company offers, its contribution to the local society (that could be through encouraging volunteering or donations), and in general, any issues that may arise from a social perspective.

Governance

Here, all management practices will be reviewed. That may include transparency and engagement with shareholders (through voting), avoiding excessive executive pay, and board diversity. Avoiding conflicts of interest and in fact aligning company interest with that of the stakeholders is key.

Below is a multiple-choice question to test your knowledge, download the accompanying excel exercise sheet for a full explanation of the correct answer.

ESG Funds