Refusing to own stocks for ESG reasons is little different to avoiding them for financial reasons, fund managers argue, although some investors are reluctant to embrace such an approach.
In 2019, net retail sales into responsible investment funds amounted to £3.2bn – with £1.3bn of this coming in the final quarter of the year alone. Figures from the Investment Association show 1.5 per cent of total industry assets were in responsible funds at the start of the year, but this had climbed to 2.1 per cent by its end.
Scott Spencer, a manager in the multi-manager people team at BMO Global Asset Management, expects this type of sales momentum to continue in responsible investing and to see more fund groups launching ethical solutions.
Active fund flows into responsible investments in 2019
Source: Investment Association
Focusing on environmental, social and governance factors, an ESG approach aims to avoid companies that perform poorly in these areas while rewarding those that score highly. This means that some companies or sectors – such as oil, arms or tobacco – are excluded from ESG portfolios.
However, some critics of this approach argue that divesting on ESG reasons leads to a restricted investment universe and the potential to miss out on returns if those areas that are being avoided rally.
But Spencer believes that there is another, less limiting way to look at this issue.
“If you have a strong negative view on certain sectors, then your universe will always be limited – as will be the case it you want funds to help solve a problem,” he explained.
“But if you want funds that are aware of the importance of environmental issues, social issues and good governance then your potential universe if probably wider then you thought and is growing.”
BMO’s multi-manager people team looked at the open-ended funds in their portfolios and found that, out of the 65 active managers they spoke with, 40 per cent will rule out stocks purely on an ESG basis. Furthermore, 63 per cent expect to increase their ESG focus in the past few years.
But why is divestment so contentious for some, when investors make constantly make sell decisions on other factors? 
Neville White, (pictured) head of responsible investment policy and research at EdenTree Investment Management said: “Fund managers make choices every day on stocks they hold and divest from on financial grounds. It seems strange then that divestment on ESG grounds has become so contentious.
“Choosing not to allocate capital to companies exhibiting poor overall environmental, human rights and business ethics credentials is a perfectly valid risk-adjusted approach to ESG analysis and oversight.
“There is a growing voice among asset managers that argues by avoiding unethical companies, we leave ownership and therefore governance to investors uninhibited by ethical considerations.”
White highlights two occasions when EdenTree has divested away from companies because of their ESG requirements.
The first example is Deutsche Bank, which the firm sold out off when it was implicated in multiple financial scandals.
“Due to poor internal controls, the company saw ballooning contingent liabilities. However, our concerns centred around operational integrity, and culture became severely challenged by the ongoing failure to restore trust,” he explained.
“Finally, a severe misconduct crisis, which included Libor rigging, mis-selling and money laundering – with serious implications for the long-term prospects of the company – prompted our decision to divest.”
EdenTree’s other example given of selling a stock on ESG concerns was British multinational security services company G4S after it became involved in multiple ethical challenges over “care and protection, including assault, use of non-approved restraint and more serious torture allegations in South Africa”.
“Operating in a high-risk environment, there was mounting evidence G4S was failing to provide adequate care and custody. Our decision to divest was ultimately prompted by allegations of abuse at the Medway young offender unit,” White said.
He added that there are several catalysts that can prompt divestment in a company for ESG reasons, including failure to make progress in improving their performance in key areas such as climate change or having particularly poor records in fines, incidents, high health & safety accident rates or pollution.
“These factors reduce a company’s ability to achieve superior long-term performance, thus justifying divestment,” said White.
Ultimately the goal of investing is to produce returns, so arguably ESG is just another way to determine whether or not a company is likely to succeed over the long term.
One of the most successful ESG divestment themes was the 2010 fossil fuel sell-off campaign. This originated on US college campuses and is still one of the key divestment cases today but, as White’s examples show, divestment isn’t always because of environmental reasons.
He added: “At a time when financial services are suffering from high levels of mistrust, investment managers are under pressure to demonstrate active principles alongside wider ESG credentials.
“We believe divestment, deployed wisely, sits comfortably within a balanced strategy of focused engagement and research.”
And White is not the only investor to think this, with Lazard Asset Management co-head of sustainable investment and ESG Jennifer Anderson agreeing.
“We don’t think not investing on ESG grounds is contentious when this is based on sound, proprietary company research and analysis,” she said.
“We believe that material ESG issues can and do impact a company’s long-term performance and so they should be part of the overall financial analysis that ultimately informs our buy and sell decisions.”
Anderson pointed out that one of the main barriers to ESG forming part of an investment process is the definitions surrounding the three elements, saying that there is a lot of confusion about exactly what ESG is. Indeed, the industry to working to set common definitions when it comes to ESG.
Yet this is not dulling investor demand for responsible investment, White said, and a growing number of investors now expect the implementation of ESG into a fund’s process in some way.
“Investors increasingly want fund managers to set investment ethical red lines,” he said. “Extensive recent dialogue with our clients has shown investors are in favour of processes and engagement backed-up with the ultimate sanction of divestment.”