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Should ESG Funds Buy "Bad" Companies?

Sectors like oil and tobacco are excluded from sustainable funds for obvious reasons, but investors may miss out if they are too strict with their ethical criteria

James Gard 20 June, 2019 | 9:15AM

Cigarettes

Is it better for sustainable fund managers to own oil, tobacco and defence firms in their portfolios or try to exclude them entirely? Many investors may feel strongly that if they are investing in an ESG or impact fund then it should exclude certain “unethical” sectors.

But companies in controversial areas, such as BP (BP.) and Philip Morris (PM), are investing billions in improving their public image and trying to “future-proof” their business against inevitable change. Investors who shun such firms may miss out if these efforts pay off in the long-term.

The issue is not clear cut, says Morningstar’s global head of sustainability research Jon Hale in a recent article: “Wouldn't another investor come along to take the place of the ‘responsible’ investor? And if enough investors shun a company's stock, it could become undervalued and end up outperforming for those who don't have any problem investing in it.”

Hale argues that the point of environmental, social and governance (ESG) based investing is not to sort the “responsible” from the “irresponsible” companies from each other, but to “identify companies that are more effectively addressing the significant ESG issues they face today”. The point is to use ESG to “enhance the financial value” of the stocks you own rather than to find a perfect mirror of your values.

On the flipside, however, avoiding seemingly “harmful” companies may be effective in driving change; firms are more worried than ever about their reputations and how they are perceived. Avoidance can also be a pure financial call too, as you are refusing to back companies which are likely to underperform in a sustainable future environment.

“It's okay to use exclusions to avoid companies in which you would rather not invest – and it can make a difference,” Hale concludes. But he cautions investors not to expect ESG fund managers to follow the same criteria – their priority is finding “sustainable high-quality companies” rather than those that exactly match an individual’s ethics. This is a fundamental difference between ESG funds and traditional ethical funds which have taken a negative screening approach. 

Activist Approach

Legal & General Investment Management’s director of corporate governance, Sacha Sadan, believes an activist approach often works to turn around companies. LGIM looked at 84 companies it invests in and found that eight were doing a paticularly poor job on climate change: “Where we could, we have divested those companies. I prefer not to divest but you do need a carrot and stick.”

He also believes that investment firms should be working together to put pressure on firms, as some issues can be large for just one fund manager to tackle alone. 

The managers of the recently launched UBP Positive Impact Equity fund draw a line between ESG investing and the “impact approach”. Co-manager Victoria Leggett says it boils down to a simple formula: “Are the products or services these companies sell doing harm or good?”

She uses the example of defence manufacturer BAE Systems (BA.): the company will score highly on the “S” and the “G” parts of ESG, for example in its treatment of employees, but investors would expect a company in this sector to be excluded from an impact fund.

“These companies are very well run but they cannot alter their structural DNA,” she says.

Leggett's criteria for selecting stocks in the fund includes what she call “intentionality”, ie. a company’s direction of travel. If a company has “legacy” issues it is trying to address – say an electricity generator that is phasing out its coal plants and replacing them with wind farms – then it should be given the benefit of the doubt.

“There are very few large companies where it is completely black and white in terms of impact investing,” Leggett adds.

“It’s not about excluding everybody else. It’s all about promotion of the companies that do better,” agrees co-manager Rupert Welchman.

Oil Firms Can Change

Tobacco and oil companies are another group which have traditionally been excluded from impact funds. But cigarette maker Philip Morris says it is “designing a smoke-free future”. Leggett points out that if vaping fully replaces tobacco smoking, and it is found to be less harmful, then one could make an investment case for including a tobacco firm. But, she adds, it’s still probably a “no”.

Leggett says: “We are picking companies that are fixing problems … in whatever form Philip Morris morphs into, the company is not fixing a societal problem.”

Welchman wouldn’t rule out oil firms being included in an impact fund if they stop drilling for oil and commit 100% to renewables. The energy industry is in a transition phase, he argues, but there is not the political will to enforce change on these companies. Consumers are the most likely to drive “impact” changes on big oil producers, he argues.

As Morningstar’s Jon Hale suggests, very few industries and services can be considered immune from public pressure to do better: “Strong ESG performance is becoming a hallmark of what it means to be a quality company in the 21st century.” 

 

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

Securities Mentioned in Article

Security NamePriceChange (%)Morningstar
Rating
BAE Systems PLC556.37 GBX0.14
BP PLC489.50 GBX-0.14
Philip Morris International Inc78.32 USD0.37

About Author

James Gard  is content editor for Morningstar.co.uk

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