What Are the Different Approaches to Responsible Investment?

KLOFinancial | 4 years ago

This is the first in our series of blog posts in which we will provide more detailed discussion in relation to responsible investment approaches and themes. Our blog posts will expand on information within our responsible investment brochure and discussions on our podcast, all of which can be accessed via our website.

In this first blog we intend to discuss differing approaches that can be taken within the responsible investment space. It is all too easy to get lost in the jargon and many different terms that are banded around in the investment industry. We aim to cut through these terms and give some explanations to the investment approaches used.

At a high level, this can be best demonstrated through a responsible investment ‘taxonomy’ which shows differing approaches and sub themes.

Ethical

Ethical investing refers to the practice of using an investor’s ethical principles as the primary filter for the selection of securities invested and depends on the investor’s views. Ethical investing is sometimes used interchangeably with socially conscious investing; however, socially conscious funds typically have one overarching set of guidelines that are used to select the portfolio, whereas ethical investing brings about a more personalised result.

Ethical investing gives the individual the power to allocate capital towards companies whose practices and values align with their personal beliefs. Some beliefs are rooted in environmental, religious, or political precepts. Some investors may choose to eliminate specific industries or over-allocate to other sectors that meet the individual’s ethical guidelines.

For example, some ethical investors avoid sin stocks, which are companies that are involved or primarily deal with traditionally unethical or immoral activities, such gambling, alcohol, or firearms. Choosing an investment based on ethical preferences is not indicative of the investment’s performance.

To begin, investors should carefully examine and document which investments to avoid and which are of interest.

Norms based investing

Norms-based screening is an established method of making an investment decision. The method investigates the compatibility of potential investments and global norms such as climate protection, human rights, working condition and action plans against corruption. Global norms are set out by international organisations like the UN or at national level. To formalise this process the custodians of capital often sign up to industry codes of practice such as the UK Stewardship Code. This outlines seven principles for institutional investors to follow, number one being to: “publicly disclose their policy on how they will discharge their stewardship responsibilities”.

Negative screening

Negative screening can also be referred to as value-based investing and involves the exclusion of companies that do not meet a prescribed ethical standard. For example, tobacco producers will be ineligible for investment due to the negative impact cigarettes have on consumers’ health.

As a percentage of assets under management, negative screening remains the most significant style of sustainable investment. By showing commitment to best practice and industry leadership, companies can be singled out for investment and this can even include companies in sectors that you would not normally expect in an ‘ethical’ portfolio.

ESG

Environmental, Social and Governance-linked (ESG) investment strategies continue to dominate financial headlines. ESG is a set of standards seeking to reduce negligent corporate behaviour that may lead to:

Environmental degradation,
Armament sales,
Human rights violations,
Racial or sexual discrimination,
Harmful substances production,
Worker exploitation and corruption

ESG Integration

The benefits of investigating these areas are becoming better understood and the integration of ESG factors into investment decisions is currently a leading area of sustainable investment.

Some studies show that companies that score highly, or show improvement as judged by market participants, are outperforming peers over periods as short as one year.

The current popularity of sustainable investment could well result in a positive feedback loop through the power of fund flows.

At its heart, however, the inclusion of ESG factors are most suitable for long-term investors looking for fundamental drivers of company performance that are distinct from short-term actions like share buybacks.

Engagement and voting

Investors might start a dialogue with companies before the voting season in relation to particularly contentious items on remuneration, board structure or shareholder rights, and then start a more in-depth engagement to achieve a required change in corporate governance. In some markets, where engagement capacity is more limited, voting might be the only tool available to communicate with companies and raise concerns. In other circumstances, investors might vote against a management resolution as an escalation strategy and express dissatisfaction following unsuccessful engagement on ESG issues. More generally, engagement activities provide an opportunity to apply timely and nuanced factors within the voting decision-making process.

Board independence is a common governance factor where analysts look into the makeup of the board such as its diversity, independence, and experience. The assumption is that an independent board allows for stronger accountability of senior management and better outcomes for shareholders.

Positive screening for best in class

Investors who use positive screening to select investments concentrate their capital in industries, stocks, or projects that are considered “best-in-class” on specific environmental, social, and governance (ESG) metrics when compared to their peers. There are different ways to positively screen via ESG frameworks: some investors look for companies that are actively improving their scores, while others favour companies that have already established high scores.

Sustainable

Sustainable investing actively selects companies that have a positive impact on the world and the planet. This could be anything from green technology to social initiatives in developing countries. It is less restrictive than ethical investing as it allows for the fact that companies are often neither all good nor all bad, such as oil companies that invest in clean energy.

Sustainably themed

Sustainability themed investments cover a wide range of ‘themes’ from climate change and energy efficiency to forests and water. They aim to make a positive impact by investing in companies that support sustainable solutions. These investments are considered as being more ‘pioneering’ in their nature.

Impact investing

Impact investing refers to investments made into companies, organisations, and fundswith the intention to generate a measurable, beneficial, social or environmental impact alongside a financial return. Impact investments provide capital to address social and/or environmental issues. This can be anything from generating a specific amount of recycling or saving a certain amount of water.

The impact investing approach is still relatively new, but broadly speaking has two main aims:

To tackle global social and environmental challenges by investing in companies which, though their practices, products, or services, create a positive impact. This may be done through targeting specific outcomes, or by ensuring impact considerations play a key part of the investment process. Impact investments must measure and report their social and environmental performance or in other words, the non-financial impact they have.
To provide financial returns alongside the societal or environmental impact. It seeks to ensure that investors do not have to give up returns for their investments to have an impact, though this cannot be guaranteed, and investments can be made across many asset classes, sectors, and regions.

KLO Financial Services

If you want to find out more, listen to our fourth episode of KLO Talks, “The Importance of Responsible Investment”.

In this episode, Financial Planner Matt Booton discusses the importance of Ethical and Responsible Investment and the social impact it has across a wide range of current topics such as climate change and the coronavirus.

Matt cuts through the technical jargon to make ESGs more digestible and educates about the changes within this sector in regards to cost and risk.

If you’re looking for financial advice regarding responsible investments, talk to our financial advice team. Please call on 01926 492406 or email us at enquiries@klofinancialservices.com to make an appointment.