While the pandemic has thrown many of the certainties we hold to be self evident into the abyss, one of the trends that has emerged in markets is a sharp uptick in interest in responsible investing.
Clients surveying the economy after Covid will be conscious of the negative impact on industries such as aviation, and natural resources, which are usually avoided by Responsible investment funds.
Technology has made the many locked down lives easier, with many of those new businesses operating in a way that meets the criteria sought by ESG funds.
And the regulatory landscape is changing, with ESG questions now embedded in the suitability questions advisers must ask clients.
In this report we examine the trends driving the current growth in demand for responsible investment funds, and the key questions for advisers to consider in the years to come.
Responsible investing: the new normal
Words: David Thorpe
The Covid-19 pandemic is likely to mean an acceleration of changes that had already begun to percolate through society; structural changes which, when combined with an altered regulatory environment means the outlook for responsible investment funds has permanently changed.
A raft of regulatory changes introduced in recent years is placing environmental social and governance (ESG) funds at the centre of the advice process, according to Steve Kenny, commercial director at Square Mile Research.
There have been a raft of new regulations, mostly coming from EU level, and they leave the US and Australia playing catch up.
He says changes to the suitability rules mean advisers will have to ask a client about ESG investment preferences, whereas in the past, the topic only tended to be broached when the client mentioned it.
Mr Kenny adds that broader governance rules and obligations around environmental policies are also likely to mean more companies that do not take ESG obligations seriously, will suffer in terms of profitability and share price, increasing the appeal of ESG funds that are able to pick the winners in that changed world.
Ryan Medlock, senior investment development and technical manager at Royal London, says: “There have been a raft of new regulations, mostly coming from EU level, and they leave the US and Australia playing catch up. The regulations have come at EU level, but also at UK level.”
“In 2018 there were 180 regulatory measures proposed globally. Central to the EU plan is a classification system for economic activity that is ESG compliant.
"And that will improve disclosure and transparency. It could well lead to a scoring of ESG funds, and that opens up certain challenges, for example, it is much easier to score negative screening.”
Funds that negatively screen are those which only exclude certain investments on the basis of how they conduct business, rather than actively seek out companies which may be viewed as making a positive contribution.
Mr Kenny says: “There is a lot of confusion among advisers around ESG and the terminology used.
"Lots of terms in this space are used interchangeably, which doesn’t help, and there is no agreed definition around what each of the terms mean.
"But I think the changes coming will help with that and sustainable investing will come to the forefront of an adviser's mind over both the short and the longer term.”
Mr Medlock adds that within the UK there has been an increase in the obligations upon pension fund trustees in terms of ensuring the investment objectives are reviewed.
Such a discussion may lead to more such funds switching to ESG mandates, something which is likely to be positive for the sector.
ESG fund outperformance
There is a lot of confusion among advisers around ESG and the terminology used.
Responsible investment funds strongly outperformed, relative to more mainstream assets during the period in March and April, when turmoil ravaged portfolios.
There are a variety of reasons why socially responsible funds held up so well, according to Lorna Blyth, head of investment solutions at Royal London.
Ms Blyth says: “Data from Morningstar shows that 65 per cent of ESG large cap focused funds beat global tackers in March, while here at Royal London, our own ESG fund range beat the multi-asset funds we have.
"I think the reasons for the outperformance are that responsible investing [...] portfolios tend to be more concentrated and have little exposure, if any, to sectors such as fossil fuels and airlines, which suffered in the sell-off.
"In contrast, these funds have higher exposure to sectors that have done well to tech and pharma. These funds tend to invest in companies that are well governed”
Ms Blyth expects this to develop into a longer term trend as deep societal changes take effect.
Adrian Lowcock, head of personal investing at Willis Owen, agrees that the fall in oil prices and problems faced by airlines were “the starting points” for why ESG funds performed so well.
He says: "This has been a very humanitarian recession, something that other recessions have not had, and I think companies that have been seen to try to bend the rules have suffered in share price terms, while those that have been seen to be helping, or wanting to help, have benefited.
"That is really about the 'G' - governance - in ESG. I think this will be a big factor in how companies are viewed after the pandemic as well. Good governance and strong management was rewarded.”
Mr Lowcock expects consumer habits to change, with some demand not returning. He believes travel will be one of the industries that bounces back, while fashion retail could be altered for ever.
Ms Blyth says the experience has been true may mean client preferences change for the long-term, and that this will drive demand from end clients for ESG funds.
She adds: “Our own experience is that a lot more advisers and end clients are asking questions about responsible investing funds.”
On the Willis Owen platform, Mr Lowcock says the experience has been that lots of older investors have begun to invest in ESG funds.
He adds: “The momentum has been building slowly, but I think it is something that will continue into the future.”
Picking the right ESG fund for your clent
This has been a very humanitarian recession, something that other recessions have not had.
The range of responsible investment funds available to advisers has exploded in recent years as the sector has moved from the niche to fashionable.
Responsible investment funds are presently embarking on a journey which is typical of an emerging asset class, evolving from being single strategy focused to having multiple themes and investment styles.
Minesh Patel, a chartered financial planner at EA Financial Solutions in London says: “The universe of ESG funds into which you can invest has improved, you can access multi-asset funds, or bond funds or equity funds.
"I also think that awareness among clients of the different types of sustainable investment funds has also improved.
"I think it is now clear in the market that that fund houses now view sustainability as integral to what they do, rather than something you add in later.
"You can choose multi-asset funds, or equity funds and can mix and match.”
He adds that if a client wants to invest responsibly and has a low risk profile, then he tends to choose multi-asset funds.
If the client has a higher risk profile, then he tends to mix and match ethical bonds and ethical funds to create the right risk profile.
Mr Medlock says it is possible to build a diversified portfolio, as even though the sector is still in its infancy, there are a lot of solutions out there.
Mr Medlock says: "If we think about ESG integration in general, it's much easier to do in equities. With fixed income it's more about engagement and analysis.
"Obviously there are a wide variety of approaches different managers can take. It’s not the case for example that all managers would exclude the same stocks.
An increasing number of managers are incorporating ESG into mainstream funds they run, so it is not a case of one size fits all for ESG funds anymore.
"It used to be that most funds just used exclusions, that is leaving certain stocks out, but there is more than that on offer now," Mr Medlock adds.
“There has been a number of third party ESG fund rating tools that have come onto the market, and those will play an increasingly important role in the future, as part of the advisers attitude to risk profiling.”
The universe of ESG funds into which you can invest has improved, you can access multi-asset funds, or bond funds or equity funds.
Using ESG funds to invest in technology
The Covid-19 pandemic has shaken up the world economy and created opportunities for investors in responsible investment funds through the adaption of new technology.
The disruption caused by the pandemic has been filled with rapid adaptation of new technology, or wider use of existing, but greener, technology.
This has included reduced use of public transport as meetings are conducted via Zoom.
The number of people cycling and walking has increased, while online grocery shopping and banking also increased, reducing the amount of carbon used in the everyday economy.
We have included AI and robotics. AI is helping with more efficient harvesting. We are also looking at medical advances, and investments that deal with food and water shortages.
Ashley Hamilton Claxton, head of responsible investing at Royal London Asset Management, says: “The themes around technological change are something that we are constantly monitoring in our sustainable investment fund range.
"This is a range of funds where we look to invest in the companies that are improving the world.”
"And with the pandemic, some of those themes that we have been looking at have a greater focus, such as experimental medicines, automation and logistics and how that fits into supply chains, and also tracing apps.”
Tom Sparke, investment director at GDIM, a discretionary fund management firm in Cambridge, adds: “Technology is very much a moveable feast and we monitor our technology exposure across all our funds, including our responsible investing funds.
"We have included AI and robotics. AI is helping with more efficient harvesting. We are also looking at medical advances, and investments that deal with food and water shortages.”
Mr Sparke says he expects there to be more clarity in the years to come around how funds that are labelled ESG, including how they screen stocks and whether the fund complies with UN sustainable development goals.
Ms Hamilton Claxton says avoiding “greenwashing”, that is, funds which claim to have responsible investment credentials, but actually do not, is a huge focus for her team.
She says: “It is very important to us. We think the industry in the UK should adopt a set of guidelines and definitions on this, and indeed not just the UK but in Europe as a whole."