ESG and sustainable investing

Sustainable investing has grown rapidly and encompasses approaches so different that the shared label conceals more than it reveals.

The approaches

Which are genuinely distinct.

Exclusionary screening: removing sectors — tobacco, weapons, fossil fuels, gambling — from an otherwise conventional portfolio.

The oldest approach and the simplest to understand.

ESG integration: incorporating environmental, social and governance factors into conventional financial analysis, on the basis that they are financially material.

This is a risk analysis approach rather than an ethical one.

Best-in-class selection: holding the highest-rated companies within each sector, which means an oil company can be held if it rates well relative to peers.

Thematic investing: targeting specific areas such as renewable energy or water.

Impact investing: aiming to produce measurable positive outcomes alongside financial return, generally in private markets.

And stewardship: holding companies and using voting and engagement to influence behaviour.

A fund labelled sustainable may be doing any of these, which is why reading the methodology matters more than the label.

What the ratings measure

A common misunderstanding.

Most ESG ratings assess the financial materiality of environmental, social and governance risks to the company — how much climate change might affect its business, for instance — rather than the company's impact on the world.

Which means a high ESG rating does not mean a company is doing good; it means the rating agency considers it well managed relative to these risks.

Ratings from different providers correlate poorly with each other, which is a well-documented finding and which undermines their use as an objective measure.

And methodologies are proprietary and change.

The returns question

Where the evidence is mixed.

Studies have produced results ranging from slight outperformance to slight underperformance, with much depending on the period examined, the definition used and the sectors excluded.

Excluding sectors reduces diversification, which theory suggests should reduce risk-adjusted returns.

Governance factors specifically have some evidence of financial relevance.

Periods when excluded sectors performed strongly — energy during commodity price spikes — produced substantial relative underperformance for excluding funds.

The honest position: sustainable investing does not reliably improve or reduce returns, and choosing it primarily for return reasons is not well supported.

The impact question

Which is separate and important.

Buying shares in the secondary market transfers ownership between investors and provides no capital to the company, which limits the direct impact of divestment.

The proposed mechanisms for impact are: raising the cost of capital for excluded companies over time; signalling and social pressure; and stewardship through voting and engagement.

Evidence for the first is debated and probably modest at current scale.

Evidence for stewardship producing changes in corporate behaviour is somewhat stronger and depends on the investor's willingness to actually vote and engage.

Which means an investor primarily seeking impact might reasonably conclude that holding and engaging is more effective than excluding, which is the opposite of the intuitive position.

Greenwashing

A genuine and regulated problem.

Funds have been marketed as sustainable while holding portfolios substantially similar to conventional ones.

Regulators in several jurisdictions have introduced fund labelling regimes, disclosure requirements and naming rules to address this, and have taken enforcement action.

Which means checking the actual holdings against the label is necessary rather than paranoid.

A fund excluding a small percentage of the index while charging a premium is a common pattern worth identifying.

What to check

Practically.

The stated methodology: which approach is being used.

The actual holdings, particularly the top ten, compared against a conventional index.

What proportion of the parent index is excluded.

The cost premium over a conventional equivalent.

The tracking difference against a conventional benchmark, which shows how different the outcome has been.

The voting and engagement record, if stewardship matters to you.

And any regulatory label the fund carries under the local regime.

Deciding what you want

The question that determines everything.

If you want to avoid profiting from specific activities, exclusionary screening does that regardless of the impact question.

If you want better risk-adjusted returns, the evidence does not clearly support this as a reason.

If you want to influence corporate behaviour, stewardship and engagement have more support than divestment.

If you want measurable impact, private market impact investing is the relevant category and is largely inaccessible to retail investors.

And if you want to reduce your own contribution to a problem, actions outside a portfolio — consumption, energy, voting, donations — are frequently more effective per unit of effort.

The reasonable position

Which is not a dismissal.

Aligning a portfolio with your values is legitimate and does not require justification on return grounds.

It should be done knowingly, with an understanding of what the fund actually does, at a cost you accept, and without expecting either superior returns or substantial impact from the exclusion itself.

And a broadly diversified sustainable fund at a reasonable cost is a considerably better option than a narrow thematic one launched after a theme performed well.

General information only, not investment advice. Investments can fall in value and past performance does not indicate future returns. Consult a regulated financial adviser.