How to find well-run funds that look for well-run, responsible companies

In the end, most advisers and clients put capital at risk because they want a return that satisfies their personal needs and requirements. Some may do so because they want to make a difference and do good. Many more will be keen that their investments do no harm and thus avoid making a difference in a negative way.

This raises three key questions:

  • How can time-poor, information-rich advisers and clients keep track of which firms meet their ethical standards and live up to their personal values on the issue of sustainable investing?
  • Does ignoring certain stocks or industries on ethical, social or governance (ESG) grounds doom the adviser and client to underperformance or poor investment returns?
  • How can advisers and clients invest across a basket of securities which meet their requirements in a cost-effective way?

The good news is that there are now indices which run rigorous screens to identify stocks which meet exacting ESG criteria. MSCI is a prominent player here, although there are other index providers, such as FTSE, Dow Jones Global, S&P and Stoxx Europe, who between them offer ESG, SRI (socially responsible), Islamic, Sharia, Christian and even low-carbon indices.

In addition, Exchange-Traded Fund (ETF) providers are addressing the need for liquid access to cost-effective, tradeable instruments. UBS offers a range of ETFs which are designed to track, or mirror, the performance of a basket of securities (equities or bonds) which pass a number of ESG filters and screens, minus the running costs associated with the product. iShares and Amundi offer alternative options.

There is also a select number of actively managed funds working in this area to provide optimal risk-adjusted returns, notably Aberdeen Ethical World Equity, Kames Ethical Equity, Alliance Trust Sustainable Future Growth, Standard Life UK Ethical, while firms such as Legal & General Investment Management has a dedicated ESG team, led by Sacha Sadan.

Best performing ethical equity OEICs over the last three years

Source: Morningstar, for UK Flex-Cap Equity, GBP Aggressive Allocation and Global Flex-Cap Equity categories

Best performing SRI Exchange-Traded Funds (ETFs) over the last three years

Source: Morningstar for the US Large-Cap Blend Equity, Global Large-Cap Blend Equity, Asia Pacific inc. Japan Equity and Eurozone Large-Cap Equity categories

There are also a number of passive and active funds (OEICs and investment trusts) which specialise in ‘green’ areas such as renewable and alternative energy, for those advisers and clients who wish to take the ‘impact investing’ option.

Screen test

While ESG issues may sound fluffy and cuddly, they are nothing of the sort. In 2012 Deutsche Bank published a research report which asserted that companies with high ratings for corporate social responsibility and ESG factors enjoyed a lower cost of capital in terms of debt (loans and bonds) and equity.

In effect this implied the market viewed such firms as lower risk. By implications, companies with weak governance or who pay less attention to their social responsibilities were seen as higher risk and in an extreme example the penalties for poor practice can be enormous.

The BP Deepwater Horizon oil rig explosion in 2010 killed 11 men and polluted the Gulf of Mexico. The FTSE 100 company had to pay out billions of dollars in fines and compensation, cut its dividend and its share price plunged from levels to which it has never, ever threatened to return.

Safety failures dealt BP’s shares a blow from which they have struggled to recover

Source: Thomson Reuters Datastream

In November 2012, the US Environmental Protection Agency (EPA) even imposed a temporary ban on the award of new contracts to BP, to confirm the ultimate danger to any company if it is perceived to have behaved poorly – the loss of licence to operate, where stakeholders and shareholders lose out in equally disastrous measure.

No adviser or client would have had the time to pore over BP’s Report & Accounts or attend its Annual General Meetings, to analyse the skills of its board and check out its ESG and SRI strategy.

This is the core of any active fund manager’s job, so a well-run collective can help here, but passive funds are also aware of the importance of governance and socially responsible practices. Neil Woodford, still working at Invesco Perpetual at the time, presciently sold dollops of BP shares before the Macondo incident, thus sparing his income-focussed funds the pain caused by a plunging share price and reduced dividend.

The UBS ETFs in this area track specially-constructed MSCI indices, which run several detailed screens. There is no ‘right’ way to run these filters, but there are two possible ways of doing so:

  • Negative screening, whereby certain industries are automatically excluded – gambling, tobacco, alcohol, adult entertainment, weapons manufacturing, for example (although allowances may be made in the case of distributors of these products and services, such as say hotels, airlines or broadcasters, depending on the rigour of the test).
  • Positive screening, which integrates ESG considerations into other factor analysis of a company.

ESG positive screen tests that can be applied to companies

Source: UBS

In the case of the MSCI benchmarks, the end product is a score for each company that is analysed, based on two factors:

  • An intangible value assessment (IVA) ranks a firm from AAA (the highest) to CCC (the lowest).
  • An impact monitor (ESG) rating that lies between 0 (the lowest) and 10 (the highest).

The minimum rating which qualifies a firm for inclusion in the indices is A4 – a metric which has intriguingly excluded no less a stock than Apple from the MSCI USA SRI benchmark. Apple only ranked A2, hindered by the furore over its refusal to co-operate with the FBI to unlock a gunman’s iPhone, as well as questions over labour rights in Asia and even its involvement in the defence and weapons industries via its development of microprocessors used in missile guidance systems.

Performance test

The exclusion of Apple raises the issue of performance. Research from MSCI and UBS shows that the World and US SRI indices underperformed relative to official benchmarks, and the meteoric share price rise of Apple – at one stage the world’s biggest stock by market cap – had a lot to do with that.

Exclusion of Apple has hurt SRI indices (but may be helping now)

Source: Thomson Reuters Datastream
NOTE: Past performance is not a guide to future performance and some investments need to be held for the long term.

Advisers and clients may be a little less edgy about missing out now Apple’s earnings and share price momentum may be waning, but in the end they want a risk-adjusted return on their money.

Reassuringly, the same dataset shows that it is only in those two areas that the SRI equity indices provided a total annualised net return that is inferior to the local benchmarks over a five-year period to the end of 2015.

Investing in a socially responsible way does not necessarily compromise performance, according to historic data

Source: MSCI, UBS Asset Management, as of 31 December 2015. Shows five-year annualised total net return in dollars.
NOTE: Past performance is not a guide to future performance and some investments need to be held for the long term.

This at least suggests advisers and clients can stick to their principles and not necessarily compromise on performance, despite the absence of stocks like Apple or sectors such as tobacco that have historically generated strong positive total returns.

There is also the potential to enhance performance over the very long term by gaining access to baskets of securities which could prove to be less risky and it could be worth advisers and clients keeping a track of SRI and ESG indices, and the instruments that track them, as they build a performance history.

AJ Bell Investment Director

Russ Mould’s long experience of the capital markets began in 1991 when he became a Fund Manager at a leading provider of life insurance, pensions and asset management services. In 1993 he joined a prestigious investment bank, working as an Equity Analyst covering the technology sector for 12 years. Russ eventually joined Shares magazine in November 2005 as Technology Correspondent and became Editor of the magazine in July 2008. Following the acquisition of Shares' parent company, MSM Media, by AJ Bell Group, he was appointed as AJ Bell’s Investment Director in summer 2013.