The performance of funds with an ESG (environmental, social and governance) focus has taken a bit of a turn for the worse of late.

The average global ESG fund has returned 6.6% over the last 12 months to 5 April, compared to 8.7% from the typical non-ESG fund, according to data from Morningstar.

That’s partly because some of the technology and growth stocks that tend to populate ESG portfolios have struggled a bit this year, and partly because oil and gas stocks, which don’t often feature in environmentally-friendly funds, have had a revival thanks to rising energy prices.

The list of top 10 stocks held in global ESG portfolios shows the popularity of US technology stocks in these types of funds.

Longer term performance for ESG funds is still superior though. These investments have returned 66.4% over the last five years, compared to 60.6% from their non-ethical counterparts.

Some of that probably comes down to exposure to the tech sector again, which has performed much better over this longer time period.

While performance is important, it isn’t the only reason people invest in ESG funds. Some would like their money to make a positive contribution to climate or social issues, while others simply don’t want their money going to companies which may have poor practices. So how do investors go about choosing which fund is right for them?

As things stand, there are different approaches to investing ethically which investors might think of under the banners of light green, medium green and dark green.

Below is a summary of the various approaches, and while some people may disagree with the precise colour coding, it is only intended as a helpful grouping. Unfortunately, the fund industry has yet to apply such labels to make it easier to find what you want.

LIGHT GREEN APPROACHES

Stewardship

Stewardship means looking after the investments you manage from the point of view of the environment, society or the economy at large.

At its weakest level this would mean simply voting on proposals made by the company, at the strongest it would mean lobbying the company for change, either in private or in public. It’s probably hard to find an active fund that wouldn’t claim to engage in some form of stewardship, so it’s a broad church. Stewardship can be an important component of ESG investing, but it’s probably not enough on its own to warrant the ESG tag.

ESG integration

In this approach, ESG factors are considered when making investment decisions. The effect ESG integration has on a portfolio can be minimal or quite substantive.

For instance, a fund manager could simply receive an ESG rating for each stock, alongside other financial information which informs their investment decision. The ESG rating may therefore be a very small part of the overall decision-making process, and hardly reflected in the portfolio.

It’s easy to see why accusations of greenwashing might be hurled at this approach, and there is quite rightly a question mark over whether such funds qualify as an ESG investment.

At the other end of the spectrum, ESG integration can mean a more robust approach. For instance, an investment manager might withhold investment from a company under consideration based on its ESG score, though this is still a judgement call, unlike exclusionary funds where certain sectors are explicitly off limits (see below).

MEDIUM GREEN APPROACHES

Tilting

Some funds use ESG scores to tilt their portfolio away from companies with poor ratings, and towards companies with good ratings.

This approach clearly means that some of your money may still be invested in companies and industries which you’re not keen on, but you’ll
have a significantly lower amount of them in your fund compared to the market, so it strikes a balance between ethics and pragmatism.

Best in class

This is a similar approach which permits investment across a range of industries, even carbon intensive ones, but picks a portfolio of companies which are leading their sector in terms of their ESG credentials.

The benefit of this approach is that it’s easier to produce a balanced portfolio, and probably suits those people who believe the likes of BP (BP) and Shell (SHEL) are critical to the transition to cleaner energy.

DARK GREEN APPROACHES

Exclusions

One way to invest ethically is to exclude certain industries from your fund portfolio. Typical examples would be tobacco, oil and gas, gambling and defence companies.

This might suit investors who don’t mind too much where they invest, so long as their money isn’t held in companies which they believe are doing harm. This is a traditional way of investing ethically, and it’s also straightforward to understand and implement.

Positive impact

Some funds go a step further and seek out companies that are working towards solving some of the ESG problems facing the world, whether that be climate change, financial inclusion or poverty.

These funds can be riskier, often because they can invest in fairly specialist areas. Included in this category are funds which target investment in specific themes, such as renewable energy or clean water, and which may therefore have a very focused portfolio.

Some funds will combine a number of these different approaches, which just goes to show that if you do wish to invest ethically, you need to roll your sleeves up and do a bit of homework if you want your fund to be ticking all the right ESG boxes.

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