UK News Ethical vs traditional funds - which have the performance edge?
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Ethical funds have lagged traditional investments in performance of late but money is set to keep flowing into products tagged 'ESG', says an financial expert.
UK and global funds with 'environment, social and governance' goals have underperformed recently because growth stocks have floundered and rising energy prices have boosted oil and gas stocks, he explains.
But 'genuine' consumer demand, the fund industry's embrace of responsible investing and pending regulatory changes will drive the popularity of this sector in future, says AJ Bell's head of investment analysis Laith Khalaf.
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Over the past year, non-ESG global funds have returned 8.7 per cent and ESG ones 6.6 per cent, while non-ESG UK funds have put on 5.9 per cent and ESG ones 2.2 per cent.
But global ESG funds outperformed over three and five years, and the outcome was much closer among UK funds over a longer time frame too - see the table below.
'Longer term performance of ESG funds compares favourably to more traditional offerings, especially in the global fund sector,' says Khalaf.
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He believes money will keep flowing into responsible funds due to the following factors.
- Investor demand is there, and the investment industry has 'sunk a lot of marketing dollars' into launching new funds and rebranding existing ones to ESG.
- The Financial Conduct Authority iswhich should 'add much needed clarity' to what ESG vocabulary means in practice.
Khalaf notes that greater disclosure requirements under an EU classification scheme introduced in spring 2021 mean that 42 per cent of European fund assets now sit in ESG funds.
'The widescale adoption of regulated ESG classifications in Europe suggests that the endgame is likely to see the majority of funds incorporating some kind of ethical framework into their investment process, especially those offered by large investment houses.'
- Rules on how financial advisers should support clients' ESG preferences are on the way, which will also encourage fund managers to incorporate responsible investing in even more of their funds, he adds.
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What are the most widely held shares in UK ethical funds?
'Investors looking to put money into ethical funds, or indeed those looking for individual stock ideas, might well be interested in the most popular holdings within ESG funds,' says Khalaf.
'What’s most notable about the most popular holdings in UK ESG funds is the number of financial services firms in the top ten.
'This sector tends to score well on ESG metrics, as it isn’t a heavy industry that needs to consume lots of carbon to conduct its daily activities.'
Khalaf says the inclusion of Lloyds might raise an eyebrow or two 'seeing as the bank is still mopping up after past misdemeanours, and had to set aside £1.3billion in the last financial year for customer remediation'.
But he notes that pharma stocks are a bit of a shoo-in for UK ESG funds because their core business results in better health outcomes for society at large.
What are the most widely held shares in global ethical funds?
'Within global funds, the top ten most popular holdings have a distinctly technological flavour,' says Khalaf.
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'That is perhaps unsurprising given the extent to which technology stocks feature in the world index at large, but also underlines these companies do tend to score well on ESG factors too.
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'That’s despite the fact that some of them face questions around anti-competitive behaviour and the levels of tax paid in certain jurisdictions.'
What are the best performing UK ethical funds over the past five years?
What are the best performing global ethical funds over the past five years?
What does ethical investing jargon mean?
Investors face a bit of a maze because there are lots of words and phrases flying around which can have different interpretations, says Khalaf.
He expects this to improve, especially when the FCA introduces proposals for a green labelling regime which are due soon.
'If you do wish to invest ethically, you do need to roll your sleeves up and look under the bonnet of prospective funds if you want your fund to be ticking a lot of the right ESG boxes,' he says.
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Mystified by green investing jargon?
As more go 'ethical' with their money, find a full A-Z of what you need to know
Below, Khalaf explains six approaches to investing ethically, although he cautions that some funds combine them and within each there will be a spectrum of activity, from weak to strong.
This basically means looking after the investments you manage from the point of view of the environment, society, or the economy at large, he says.
'At its weakest level this would mean simply voting on proposals made by portfolio companies, at its strongest it would mean lobbying investee companies for change, either in private or in public, or both.
'It’s probably hard to find an active fund that couldn’t claim to engage in some form of stewardship, so it’s a pretty broad church. Stewardship is an important component of responsible investing, but in ESG funds it would normally be supplemented by further measures.'
2. ESG integration
ESG factors are considered when making investment decisions, but the impact on a portfolio can be minimal or quite substantive, explains Khalaf.
'A fund manager could simply receive an ESG rating for each stock, alongside other financial information which informs their investment decision.
'It’s therefore easy to see why accusations of greenwashing might arise around ESG integration. At the other end of the spectrum, ESG integration can mean a more robust approach.
'For instance, a fund may decline investment in companies which don’t carry a minimum ESG rating, no matter how appealing their other characteristics.'
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'Some funds use ESG scores to tilt their portfolio away from companies with poor ratings, and towards companies with good ratings,' says Khalaf.
'This approach clearly means that some of your money may still be invested in some companies and industries which you might take issue with, but you’ll have a significantly lower exposure than the market, so it strikes a balance between ethics and pragmatism.'
4. Best in class
'This approach 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,' says Khalaf.
'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 and Shell are critical to the transition to cleaner energy, and so might still merit investment.'
Some funds simply avoid investing in certain industries, such as tobacco, oil and gas, gambling and defence, explains Khalaf.
'This might suit investors who don’t mind too much where they invest, as 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.'
6. Positive impact
Other funds go a step further and actively seek out companies working on solving some of the problems facing the world, like climate change, financial inclusion, or poverty.
'These funds can be more risky, often because they can invest in fairly specialist areas,' says Khalaf.
'Indeed, 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.'
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