What is ESG investing?
ESG investing is an investment strategy that seeks both financial return and positive social change
The growth of ESG (environmental, social and governance) investing began in January 2004 when former UN Secretary General Kofi Annan wrote to over 50 CEOs of major financial institutions, inviting them to participate in a joint initiative under the auspices of the UN Global Compact and with the support of the International Finance Corporation (IFC) and the Swiss Government. The goal of the initiative was to find ways to integrate ESG into capital markets. A year later this initiative produced a report entitled “Who Cares Wins”, with Ivo Knoepfel as the author. The report made the case that embedding environmental, social and governance factors in capital markets makes good business sense and leads to more sustainable markets and better outcomes for societies.
A short history of ESG
The first publicly available ethical fund was the Pax World Fund set up in 1971 in the US by two members of the United Methodist Church. Shortly after, in 1973, the investment arm of the Methodist Church in the UK put forward a proposal for the first UK ethical investment trust. By the end of the 1970s, ethical investment, underpinned by certain religious groups’ ethics, had become part of the investment landscape.
Through the mid to late twentieth century, two dominant themes started to emerge: concern about the effects of inequality in society and concern about the environmental effects of human activity. Environmental concerns took to the main stage in 1972 when the United Nations Environment Program was established. This was the precursor to several United Nations environmental initiatives, culminating in the 1997 Kyoto Protocol, which committed signatories to reducing greenhouse gas emissions. This was followed by the 2015 Paris Agreement, which set the target of global warming to no more than 2 degrees Celsius above pre-industrial levels.
What does ESG cover?
The three pillars of ESG cover a wide range of issues.
The following table summarises the main areas covered by each pillar.
|Climate change and emissions||Gender and diversity||Board composition|
|Air and water pollution||Human rights||Executive compensation|
|Energy efficiency||Labour standards||Audit committee structure|
|Waste management||Employee engagement||Bribery and corruption|
|Water scarcity||Customer satisfaction||Lobbying activities|
|Biodiversity and deforestation||Community relations||Political contribution|
Environmental issues cover how companies interact with the environment, Social issues cover companies’ conduct towards their internal and external communities, and Governance issues cover how companies behave in their business activities. All three pillars combine to define what most people would categorise as good business practice.
ESG investing can take several forms and, broadly speaking, these can be categorised into how diversified the resulting investment is:
Impact Investing: The most concentrated approach, this style usually takes the form of being goal-driven, for example investments in social housing projects to alleviate homelessness.
Inclusion-based: Here the approach is to identify companies that exceed a pre-determined level in one or more of the ESG categories. Companies that pass the screening criteria are eligible for investment.
Exclusion-based: As the name implies, this approach screens a universe of potential investments and seeks to exclude those companies that fail to reach certain minimum criteria in their ESG measurements.
ESG integration: The most diversified approach, this method seeks to integrate ESG concerns into a predefined investment strategy. There may be some companies that fail to qualify but the aim is to preserve the risk and return characteristics of the investment while taking ESG issues into account.
Approaches to ESG
What is screened out?
Each fund manager and index provider have their interpretation of what should be excluded when constructing ESG funds and benchmarks, with varying levels of scrutiny.
MSCI’s Enhanced benchmarks aim to excludes companies that are defined by the index provider as or deriving their revenues from:
- Being associated with controversial and nuclear weapons
- Producing tobacco
- Civilian firearms
- Oil sand
- Thermal coal
Companies that are classified as violating United Nations Global Compact principles or have not been assessed by the index provider for an ESG controversies score or an ESG rating, are also excluded from the Index.
GSI states that the Investment Manager will also bias the portfolio towards companies that are assessed to have higher scores with respect to environmental, social and governance (ESG) criteria in determining the weight of that company in the portfolio. The ESG criteria cover companies’ exposure to and management of the following: Environmental issues: such as climate change and carbon emissions, air and water pollution, and energy efficiency; Social issues: such as gender and diversity, human rights, and labour standards; Governance issues: such as board composition, executive compensation, and audit committee structure.
Studies show that ESG improves performance
It's a common misconception that for a portfolio to be ethical, you must sacrifice return, however, a variety of research has shown that it's not principles over performance.
The search for a relation between environmental, social, and governance (ESG) criteria and financial performance can be traced back to the beginning of the 1970s. Scholars and investors have published more than 2,000 empirical studies and several review studies on this relation since then. The findings of these studies contradict the common perception of many investors that screening out controversial securities and implementing ESG policies reduces performance, there is clearly a positive relation between ESG and corporate financial performance (Bassen, Busch and Friede, 2015).
A recent report by MSCI (Giese & Nagy, 2018) has shown that companies with improving ESG credentials have on average outperformed by 14.4% in emerging markets and 5.2% in developed markets over five years. The chart below compares a range of Morningstar Indexes to their ESG counterparts since their common inception (minimum 3 years to 31/10/2019). You can see that the ESG version of the index has outperformed in each asset class.
The below table is a comparison of traditional equity benchmarks and back tested ESG-focused The MSCI ESG Focus Indexes are designed to target companies with positive environmental, social and governance (ESG) characteristics while closely representing the risk and return profile of the underlying market. Each index is constructed through an optimisation process that aims to maximise its exposure to ESG, subject to a target tracking error and other constraints. counterparts by region, 2012–2018.
|U.S.||World ex-U.S.||Emerging markets|
|Traditional||ESG Focus||Traditional||ESG Focus||Traditional||ESG Focus|
|Max monthly drawdown||-13.9%||-13.9%||-23.3%||-22.7%||-35.2%||-33.1%|
|Number of stocks||621||313||1,012||453||855||300|
Past performance is not a reliable indicator of future results. The indexes used are the MSCI USA Index, MSCI World ex-U.S. Index, MSCI EM Index (“Traditional” columns) and MSCI’s ESG-focused derivations of each (MSCI USA ESG Focus Index, MSCI World ex-U.S. Focus Index and MSCI Emerging Markets ESG Focus Index).
ESG generates value through identifying many of the intangibles that will be drivers of business value in the long run and helping to reduce the risk of the cost of current externalities and future externalities.
Introducing Earth Portfolios by
Our ESG Journey
At EBI we believe that ethical investing is the future, we have carefully crafted a range of portfolios that seek to offer a premium on return while pursuing positive social and environmental change, founded on academic research.
EBI has been monitoring the ESG fund universe for several years, awaiting suitable funds to satisfy our evidence-based approach and engaging with fund providers to develop and launch a range of ESG funds.
In early 2019 EBI were approached by iShares to introduce their ESG Screened and Enhanced range of funds, which we assimilated into our World portfolios to create the foundation of EBI's Earth portfolios. Shortly after, EBI engaged with Global Sustainable Investments to provide additional factor exposure with ESG screening.
The current Earth portfolios have 46% of the equity element invested in sustainable funds. There are further ESG fund launches on the horizon that EBI will seed and incorporate to further increase the sustainability of the Earth portfolios.
However sustainable investing is never straightforward, with one asset class proving to be particularly difficult: sovereign bonds. Companies act in a world where right and wrong are (for the most part) clearly defined and the investors who provide the capital can exercise their judgement on those companies that act in a negative way. Approaches to issues such as corruption, pollution and human rights vary from country to country, with some exceeding internationally set standards and others falling below it. It’s far more difficult for the capital providers to intervene and change the behaviour of sovereign nations and EBI has yet to find a suitable ESG bond fund to replace the current bond element, but EBI will continue to monitor the bond fund universe.
EBI are proud to offer a range of ESG integrated
portfolios to suit your risk capacity, with a
Discretionary Investment Management fee of 0.12%.
Our portfolios' ESG-scores are a weighted average of the ESG scores available from Morningstar, and are applied to the equity proportion of the portfolio only.
How it's calculated and how well we perform
There are a variety of ESG measures in the fund marketplace, we have found Morningstar to provide the largest and most in-depth coverage and as such we have calculated our ESG scores using their ratings.
The Morningstar Sustainability Rating is a measure of how well the holdings in a portfolio are performing on environmental, social, and governance (ESG) issues relative to a portfolio’s peer group. The rating is a historical holdings-based calculation using company-level ESG analytics from Sustainalytics Sustainalytics is a company that rates the sustainability of listed companies based on their environmental, social and corporate governance (ESG) performance. , a leading provider of ESG research.
The Morningstar Sustainability Rating is the result of a three-step process. First, they calculate the
Morningstar Portfolio Sustainability Score
The Morningstar Portfolio Sustainability Score is an asset-weighted average of normalised company-level ESG scores with
deductions made for controversial incidents by the issuing companies, such as environmental accidents, fraud, or discriminatory
behavior. The Portfolio Sustainability Score is calculated as follows:
Portfolio Sustainability Score =
Portoflio ESG Score - Portfolio Controversy Deduction for every portfolio reported within the trailing 12 months. Second, they use these scores to calculate a portfolio's Morningstar Historical Portfolio Sustainability Score The Morningstar Historical Portfolio Sustainability Score is a weighted average of the trailing 12 months of Morningstar Portfolio Sustainability Scores. Historical portfolio scores are not equal-weighted; rather, more-recent portfolios are weighted more heavily than more-distant portfolios. . Third, they assign a Morningstar Sustainability Rating Based on their Morningstar Historical Portfolio Sustainability Score, funds are assigned absolute category ranks and percent ranks within their Morningstar Global Categories, provided that a category has at least 30 funds with Portfolio Sustainability Scores. A fund’s Morningstar Sustainability Rating is its normally distributed ordinal score and descriptive rank relative to the fund’s global category. In order for a fund to receive a Morningstar Sustainability Rating, its Morningstar Global Category must have at least 30 funds with Historical Portfolio Sustainability Scores. for a portfolio based on its Morningstar Historical Portfolio Sustainability Score relative to its Morningstar Global Category The Morningstar Global Category assignments were introduced in 2010 to help investors search for similar investments domiciled across the globe.
Morningstar supports global categories, which map into nine global broad category groups (Equity, Allocation, Convertibles, Alternative, Commodities, Fixed Income, Money Market, Property, and Miscellaneous).
Morningstar research teams use a mosaic approach when assigning Global categories. Click the link to see the methodology. . EBI take a weighted average of each fund's sustainability rating to calculate a portoflio sustainability score.
For the full methodology see here.