BP or not BP – that is the question

If someone asked me to build a balanced portfolio, but told me I couldn’t invest in technology stocks, emerging markets and property, I would tell them to expect the return to be lower or the risk to be higher than a portfolio built including those asset classes.

A key tenet to investing is diversification – holding securities that go up when others are going down allows a smoother ride without giving up return.


Put in the terms of modern portfolio theory, the more securities or asset classes at your disposal, the higher your efficient frontier.

Source: AJ Bell. Illustration purposes only.

You may ask what this has to do with ethical investing.

Ethical investing stretches back to the 18th century, with religion as the main motivation. The Quakers prohibited investments in anything related to the slave trade, the Methodists refrained from investing in industries ‘that harm one’s neighbour’ and Muslims avoided areas contradicting Sharia Law.

Although the restrictions differ from group to group, the one point in common is that early ethical investing was exclusionary in nature, avoiding securities or sectors that are deemed inappropriate.

This type of ethical investing is referred to as ‘negative screening’.

By shrinking the size of the investment universe you are, according to modern portfolio theory, lowering the expected long-term returns for a given level of risk.

This is perhaps why ethical investing has historically been a niche area, reserved for charities, religions and public corporations, where values and beliefs rank ahead of wealth maximisation.

However the balance of opinion is changing. A recent Morgan Stanley study shows that 75% of the population is interested in sustainable investing, and 86% of millennials show interest – the future inheritors of wealth. On the other hand, the study shows that only 38% of the population has moved to actually invest, highlighting the conception that ethical investing leads to lower returns. This figure is corroborated by the recent IA asset management study, showing 26% of assets in the UK have some sort of responsible approach.

In 2005, the term ‘ESG’ was coined as part of a landmark study entitled ‘Who Cares Wins’. This provided a pivot point for sustainable investing, challenging the concept that taking an ethical approach necessarily leads to lower returns.

‘ESG’ stands for environmental, social and governance. The idea is to move away from a pure negative screening approach, and instead focus on these three themes, the notion being companies that take a positive approach to managing these issues not only deliver better societal outcomes, but also returns that are at least as high as – if not higher than – those for companies with lower standards in these areas.

When investing in a company, the majority of its value lies in its future cash flows – you pay a price today to share in the future earnings of a company. For a company that takes a sensible, long-term approach to issues such as corporate governance, sustainability and delivering non-financial benefits, it is not an unreasonable assumption to make that its future cash flows are likely to be more steady, and less susceptible to regulatory change (such as gambling) or public opinion (environmental issues). Higher certainty in future cash flows is usually rewarded with higher share prices, and as such higher returns.

Already in this article I have used the terms ethical, sustainable and ESG interchangeably. As an emerging topic, we are still at a point where terminology is yet to be clarified, with each carrying a nuanced meaning. This is a big challenge within the space, because without a defined set of rules amongst investors, designing a product for the mass investment market could lead to confusion.

Many articles exist explaining the difference between terminology and different ESG scoring systems and methodologies. So rather than repeating here, I thought it would be useful to highlight the confusing nature within the passive ESG space through an example.

MSCI, a leading index provider in this space, runs four different ESG index families. These are:

  • ESG Leaders
  • ESG Focus
  • ESG Universal
  • ESG Select

From the name alone it is very hard to differentiate between the families. For example, the ESG Leaders family first screens out a small selection of companies involved in certain business activities such as alcohol or gambling. It then screens the remaining 50% of the parent MSCI index for companies with the highest ESG score and optimises the weightings, using these scores alongside traditional weighting methods, to design an index that respects the sector and regional breakdowns of the parent index.

On the other hand, the ESG Select index takes a very different approach. It still runs the same negative screen on certain business activities, however its approach to constructing the index is very different. Its focus is instead on working within a tracking error budget to the main index, whilst also aiming to maximise the overall ESG score and exclude companies with low ESG scores. The ESG Universal and ESG Focus index families integrate ESG in differing ways again, however both are fairly ‘light touch’ compared to the Select and Leaders ranges.

Source: MSCI

And this is just for one provider!

When looking at ESG scoring systems, different providers place a different onus on differing factors. As such, a company that scores well through one scoring system may actually score poorly with another.

For example, two of the main ESG scoring systems – RepRisk and Sustainalytics – rate the same company extremely differently, one giving Bank of America an above average score, and the other drawing the opposite conclusion.

Source: ACCF

This is not just a one-off case: CSRHub ran a regression of ESG scores from Sustainalytics and MSCI across 1200 global companies. Surprisingly the correlation between the two rating providers was just 32%.

Source: CSRHub

This brings us back to the question – does integrating ESG characteristics into your index or fund selection process enhance returns?

This is currently an impossible question to answer. With no consistency across the classifications, it is a data miners’ dream. It is easy to find an ESG index that points to consistent outperformance against its parent index. It is also as easy to find an ESG index that has perennially underperformed.

In addition to the raw performance side of things, it is also worth considering if following an ESG integration approach brings in any other unintended biases towards portfolio construction.

For instance, studies have shown that large companies with a quality bias tend to have higher ESG scores. European companies also tend to score better than US companies. Therefore, following an index rating by score will push you towards large-cap quality and an underweight to the US. In some markets this will serve you well and in other periods it may underperform. It is, however, hard to isolate if the ESG integration affected the performance, or whether it was due to the other unintended factor exposures.

The balance of research shows that limiting the amount of negative screening and instead focusing on integrating positive factors does not lead to underperformance against the parent index, however we are not yet ready to take the leap to concluding that it outperforms.

We often get asked if we will launch an ESG product at AJ Bell. It is something we continually review, but we believe it is important not to just jump on the bandwagon. Instead, if we decide to offer products here, we want to see further market developments in terms of consistency of implementation. It is clearly an emerging topic, but we want to make sure we end up choosing a VHS player and not Betamax!

Head of Passive Portfolios AJ Bell Investments

Matt is responsible for the day-to-day running of the AJ Bell Passive funds, working with our investment team to further grow the range of investment options. He joined us with over six years’ experience in financial services, having previously worked at a leading provider of wealth management services as a Senior Fund Manager and Head of Fixed Income Research, with specific responsibility for managing a discretionary fixed income fund. He also formed part of a four-person fund management team that ran the company’s multi-asset funds. Matt graduated from the University of York with a first class Masters degree in Mathematics, and is a CFA Charter holder.

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