ESG funds – from niche to mainstream

Go back a few years and what were then known as ‘Ethical’ or ‘Green’ funds were seen as a sleepy backwater in the investment world. They were often focused more on companies’ environmental and moral credentials than their ability to make money, and all too often that was reflected in their performance. Their portfolio might have been green, but all too often performance was in the red.

Things have moved on since then. Funds are more commonly branded as Sustainable, Responsible or Impact, or with the wider label of ESG (Environmental, Social and Governance), all with different emphases. What they have in common is a belief that investing is about more than short-term financial success.

As well as the branding, something else has changed. More and more, we’re seeing these funds cropping up amongst the strongest performers in their sectors. So why have we seen this shift? And why should you consider ESG funds for your portfolio?

An explosion in funds

One reason for the greater success of ESG funds is that there are more of them. The number of funds available has more than doubled over the last 10 years, so the chances of success have also increased.

Much of that explosion has occurred in the last five years, so the newer funds haven’t yet had a chance to shine. Looking at the average performance for existing funds over those five years, ESG products have matched or even exceeded the returns of their mainstream counterparts across multiple sectors. And this despite having restrictions on what they can invest in.

Bad companies doing badly

Part of the reason for the rise of ESG funds is that ‘bad’ companies are increasingly delivering bad returns for investors.

In some cases it’s simply a case of a company doing something wrong, and getting found out. Of course corporate wrongdoing has always been around, but each scandal serves as a further reminder that dishonesty doesn’t always pay.

In 2018 German fintech company Wirecard soared into the DAX index, briefly becoming larger than Deutsche Bank, before collapsing in 2020 after longstanding allegations of fraud proved to be entirely correct. Also in 2020 Anglo-Australian mining giant Rio Tinto was hit by a wave of bad publicity after it destroyed caves in Australia considered sacred by the local aboriginal people. The scandal ultimately led to the resignation of its CEO.

It’s not just individual companies. More broadly we’re seeing whole industries performing badly – the oil, airlines and tobacco sectors have all suffered in recent years for a variety of reasons. And investors are increasingly uncomfortable with owning them, for both financial and moral reasons. Not only would this mean financing damaging activities now, there is also the question of whether for instance oil companies have a long-term future as the world transitions to renewable energy.

Whatever the reason, steering clear of these companies has helped ESG funds deliver better performance for investors.

Good companies performing well

The flipside to this is that ‘good’ companies are performing better. Most obviously, green energy has gone mainstream in recent years. In 2020 renewable energy soared past carbon to become the UK’s largest source of electricity, driven principally by our increasing stable of windfarms. Last year also saw the International Energy Agency proclaim that the world’s top solar plants now offer the cheapest electricity in history. Electric car sales rose 186%* in the UK in 2020, despite the collapse in car sales generally during the pandemic.

In Norway electric cars outsold petrol cars*.

Increasingly these trends are being reflected in stock-market performance (source: Morningstar). 2020 saw Tesla become the world’s most valuable car manufacturer, making founder and CEO Elon Musk run neck and neck with Jeff Bezos for the title of world’s richest man (source: BBC). Its value now exceeds that of all its major rivals put together.

ESG investing isn’t just about environmental stories. Technology is another area of focus. The sector has delivered outstanding returns in recent years, driven by familiar tailwinds such as the relocation of shopping from the high street to the internet and more recently the shift of work from office to home. However, less obvious is that tech companies also carry many of the traits prized by ESG funds.

From an environmental point of view they’re relatively clean, or at least they don’t come with factories belching smoke like industries of the past. They’re not without issues, such as power consumption by data centres, but companies like Google and Microsoft invest in renewable power and tidal cooling to minimise their carbon footprints. Another benefit is that the companies tend to have more meritocratic structures than traditional industries, favouring talent rather than which school you went to or who you know, leading to more diverse workforces. Put together, these characteristics are attractive from both an ESG standpoint and an investment standpoint.

A wider universe

Companies with sound ESG credentials can now be found in almost any part of the market. All sorts of businesses are becoming more focused on the wider impact of their operations. If they don’t, then their staff, or customers, or the government are likely to make them aware. The rise of social media and environmental awareness makes it harder for companies to gloss over their mistakes and easier for consumers to steer clear of them. In this world being kind to the environment has become a selling point.

This is particularly the case in the fashion industry, where companies are keen to keep on the right side of their typically younger, more environmentally-aware customers. A number of stores already offer boxes where you can drop off unwanted clothes for recycling, but Swedish retailer H&M has gone a step further. The company’s Stockholm store recently unveiled a machine that can convert the fibres from worn out clothes into new garments, a potentially vital breakthrough in an industry long criticised for environmentally unsound fast fashion.

Even the energy sector, long synonymous with oil companies and pollution, has a more environmental option: Finland’s Neste.

The company focuses on renewable energy and in particular low emission renewable diesel, a fuel made from waste vegetable oils from food and other industries. Neste has also moved into aviation fuel, making it an obvious beneficiary with airlines pledging to reduce their carbon footprints.

The ESG gold rush

The success of ESG funds has not gone unnoticed elsewhere in the industry – mainstream fund managers too are increasingly touting their ESG credentials. In many cases they’re simply smartening up processes they already carried out – the best fund managers have always looked at companies’ governance, preferring those whose management is incentivised to deliver for investors as well as themselves.

However, many have now moved beyond this to look at environmental and social factors as well. For fund managers who invest for the long term, considering the wider impact of a company is simply common sense. A business might be profitable today, but if its treatment of the environment threatens its future then buying its shares is as much playing pass the parcel as it is investing. And for fund managers who have resisted ESG, new EU legislation is increasingly forcing their hands.

As a result, in many cases ESG funds are converging with their mainstream equivalents. Fundsmith Sustainable Equity comes with a range of exclusions – mining, gambling and tobacco to name but three – but despite this 23 of its 26 stocks are the same as those in the mainstream Fundsmith Equity fund. Not surprisingly the two funds have delivered very similar returns.

In conclusion

ESG investing has moved out of the margins. Mainstream funds have grown more of a conscience, but at the same time ESG funds are increasingly delivering returns to match them. Investors no longer have to choose between their conscience and performance – there are a number of high quality funds available that deliver on both counts, and below we’ve highlighted three that do just that.

Bestinvest and ESG

We haven’t just jumped on the bandwagon when it comes to ethical investing. Bestinvest has been researching investments in this sector for a long time and has helped many people invest in line with their values for many years: Our Top-rated Funds features all our favourite ESG funds. With us you get competitive fees, a knowledgeable telephone team, an abundance of free investment research and control over your investments. It’s quick and easy to open an account with us. Please read the important information below and make sure you understand the risks before investing.

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The Ready-made solution 

If you feel like you don't have the time or knowledge to choose and look after your own investments, we also have an Ethical Ready-Made portfolio that comes with a collection of investments that’s ready for you to invest in. You can choose the Ethical Ready-made Portfolio in a Stocks & Shares ISA or an investment account.

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Speak to us

If you’re new to investing and want to understand the best way to start, please get in touch by calling our friendly telephone team on 020 7189 2400.

*New Scientist 7/1/2021

Important information

The value of investments, and the income derived from them, can go down as well as up and you can get back less than you originally invested. Different funds carry varying levels of risk depending on the geographical region and industry sector in which they invest. You should make yourself aware of these specific risks prior to investing. Please note that some ethical funds may, by definition, have a limited investment universe; this may affect performance. This article does not constitute personal advice.  If you are in doubt as to the suitability of an investment please contact a financial adviser .Past performance is not an indication of future performance.