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Responsible Investing: SRI Investing, Funds & ESG

At Moneyfarm, we’re always looking for ways better to align our portfolios with our customers’ attitudes. It’s the reason we suggest a risk level to each individual investor and rebalance our portfolios where necessary to ensure they remain fit for purpose. It’s also the reason we talk to our investors daily to hear their insight into our products. 

One thing we’ve increasingly been discussing with our clients is the introduction of a solution built with sustainability and social responsibility at its core. So, after taking the time to build portfolios we know our investors will love, we’re ready to launch Moneyfarm’s new Socially Responsible Investing. 

The fundamental tenets of ESG investing are relatively straightforward. These focus on environmental sustainability, awareness of social issues, and sound governance.

Getting socially responsible investing right takes time. SRI investing, for example, excluding polluting industries or companies of questionable morality – these are a part of the process, but ensuring that the investments themselves are effective while maintaining sound ESG principles is a complex balancing act. 

In this article, we’ll explain responsible investing, the types of responsible investing, how we put together our Socially Responsible Investing portfolios and what makes them up, as well as explain how the Moneyfarm Engagement Layer separates our ESG offering from the rest.

What is meant by responsible investing?

Responsible investing is a broad-based investment approach that takes into account not just financial performance but also social, governance, and environmental issues when making and managing investments. 

Responsible investing creates long-term value for society, the environment, and the economy. Investments that create long-term value can be interpreted as investments that create financial and non-financial values.

With responsible investing, investors should take into account the impact of their investments over time by investing in strategies that seek to align corporate practices with environmental, social and governance factors. 

For example, companies should be environmentally friendly, pay workers fairly and treat people well. This means that you avoid investing in companies that pollute the environment, exploit employees, or mistreat customers.

Types of responsible investing

There are different investment approaches to incorporate responsible investing. The most common approaches include ethical investing, socially responsible investing, ESG integration, thematic investing, impact investing, sustainable investing, best in class ESG, and shareholder agreement. We are going to discuss six approaches to responsible investing.

Ethical Investing

Ethical investing is an investment strategy that uses an investor’s ethics, moral principles or international laws, treaty or agreements to guide investment decisions. Ethical investing allows individuals to invest in companies whose practices and values are aligned with their own beliefs. These beliefs can be based on political, religious, and environmental principles. 

The typical ethical investment exclusion means filtering out some types of companies and sectors – usually sin stocks like weapons manufacturers, tobacco companies, etc. Religious exclusions include avoiding contraceptive manufacturers or companies violating sharia law. Companies that violate agreements such as human rights law and good practice guidelines can also be avoided. 

However, investing ethically and eliminating sin stocks doesn’t guarantee good financial returns. Some ethical investors might avoid certain strong financial performers because their values don’t align with their personal beliefs (e.g. nuclear power).

Examples of ethical investing include iShares MSCI Emerging Markets ETF (EMXC), which excludes Chinese companies, Parnassus Endeavor Fund (PRBLX), which is a weapons-free fund, and Vanguard FTSE Social Index Fund (VFTAX), which excludes sin companies.

SRI Investing

SRI, also known as socially responsible investing, is an investment strategy that uses specific ethical guidelines when selecting investments. How does SRI investing work? It works by using ESG factors when screening and excluding companies. SRI investing avoids investments that violate social and environmental factors or principles. For instance, companies that manufacture addictive substances or engage in socially irresponsible activities.

Examples of social factors include labour disputes, ​​occupational health and safety, and employment and wage discrimination, while environmental factors may include environmental and waste management, greenhouse gas emission and natural resources exploitation. Therefore, SRI investments are made in companies that have a positive social impact, such as social justice, green energy, environmental conservation, etc.

SRI investors use a chosen criteria to screen companies or sectors before creating investment portfolios based on financial performance. Investors can find SRI investments in the stock markets, and ETFs and mutual funds are used to gain exposure to SRI investing as a single investment can cut across multiple companies and multiple industry sectors.

Examples of socially responsible investing SRI EFTs include SPDR SSGA Gender Diversity Index (SHE), which invests in gender diversity companies, Invesco Taxable Municipal Bond (BAB), which invests in environmentally friendly projects, and iShares Global Clean Energy UCITS (INRG), which invests in renewable energy.

Sustainable Investing

Sustainable investing is about improving the world, and it is an investment approach that takes into account environmental, social and governance factors. Sustainability investing can also be interpreted as a strategy that screens out investments deemed to be detrimental to long-term environmental or social sustainability. It can also be seen as a mixture of the thematic and ESG integration approaches.

It promotes better corporate responsibility and long term financial return. It looks for companies that can grow while positively impacting society and the environment. For example, companies with goals aimed at reducing inequality, providing job security and advancement opportunities for employees. At the same time, it is screening out non-fossil energy-based companies and too-big-to-fail financial institutions.

ESG Investing

ESG stands for environmental, social, and governance. ESG investing is an investment strategy that focuses on a company’s environmental, social, and governance risks and practices. In addition, the investment approach focuses on how companies do business, such as company stakeholders, identity, and decision-making. 

ESG investing aims to maximise financial returns and uses ESG factors to help identify risks and opportunities. Some ESG factors include pollution, carbon management, human rights, transparency and disclosure, and climate change.

By incorporating the risk assessment of long term environmental, social and governance issues into their investment decisions, ESG investors look beyond short-term financial returns. ESG investing can be seen as an alternative to SRI investing.

The key difference with ESG investing is that it uses criteria, metrics and data to measure and assess a company’s risk beyond the traditional financial framework. 

Thematic Investing

Thematic investing is an investment strategy that involves researching long-term trends and new opportunities instead of individual companies and stocks. These trends are grouped into relevant themes that align with personal interests and values. 

Thematic investments factor in beliefs, values, long-term trends, ideas, and disruption. For example, a value-based investment strategy theme might be investing in women-run companies. A theme can cut across several sectors, such as the Workforce Diversity Leaders theme that includes tech, retail, gaming, and hospitality companies. 

The thematic investment approach is based on positive impacts that are beneficial to society or the environment. The three major themes include climate change, disruptive technology innovation and changing demographics. Other themes include rapid urbanization, health care, space economy, genomics, agriculture, and cybersecurity.

ETFs and mutual funds create easy access to these themes. Examples of thematic ETFs include Global X FinTech ETF (FINX), which invests in Fintech companies, and iShares Global Clean Energy ETF (IClN), which invests in renewable energy companies.

Impact Investing

Impact investments look at a company’s positive impact on a particular ESG issue while making a profit. It uses ESG metrics and methodologies and has a measurable environmental and/or social return. 

The primary objective of impact investing is not financial returns but to seek a specific social or environmental objective. Such objectives can include community employment, sustainable agriculture, minority-owned business support, employment-based recovery services, and charity. 

If an investor is looking for transparency about the specific ways their capital is being used, impact investing might be the best option instead of ESG or SRI. Impact investments are mostly private market investments, but ETFs and mutual funds are available.

Examples of impact investments include the Gates Foundation, a charity foundation that fights global poverty, disease, and inequity, Soros Economic Development Fund, which invests in emerging countries and tackles societal issues, and iShares MSCI Global Impact ETF, which invests in companies that address at least one United Nations Sustainable Development Goal.

How we build our ESG portfolios

With Moneyfarm’s standard portfolios, ESG considerations are applied ex-post. This means that we build our portfolios before we comb them for social laggards. However, in our new Socially Responsible Investing portfolios, the process is ESG-focused from the ground up. 

When we build our socially responsible portfolios, we use only best-in-class ETFs that actively optimise for ESG risk, CO2 intensity, and any controversies that might affect a business’ social impact. In addition, we select funds that score highly on ESG factors, and those that consider the investor’s role as owner and creditor.

We also apply negative screening alongside the best-in-class approach to provide another layer of protection against companies that engage in controversial practices or companies our investors would not want to be associated with. As you can imagine, some key areas we avoid are the arms trade and gambling, to name just a couple. 

For more information on how we build our ESG portfolios, please take a look at our Socially Responsible Investing page, which covers everything from structure to impact.

ESG Portfolios: Financial and Non-Financial Risk

Let’s look at what actually goes into one of our Socially Responsible Investing portfolios. The first thing to note is that, just as with our regular investment portfolios, our ESG range will have seven different risk levels, each tailored to suit a particular kind of investor with a specific attitude to risk. 

As you can see from the chart below, the greater the portfolio’s risk level, the more it will be made up of equities. At the other end of the spectrum, less risky portfolios tend to be made up more heavily of bonds, with all risk levels holding a small amount of cash. But, again, this is very similar in structure to our regular portfolios.

Geographically, the differences between risk levels are less stark. As you can see from the chart below, United Kingdom assets hold less weight as the risk levels increase, while exposure in the US and emerging markets (excluding China) grows. Chinese assets range from none in our lowest risk portfolio to slightly more prominent in higher risk portfolios. 

The chart below details the changes in currency exposure as the risk levels of the portfolios increase. As the risk level increases, exposure to GBP is reduced while exposure to USD, emerging markets, Euros, Japanese Yen and others increases. This is because higher risk levels can afford more elevated levels of volatility and because for higher levels of risk, currencies like USD and Yen can work as a safe haven in volatile periods.

Measuring the impact of the portfolios

Anyone investing in a Socially Responsible portfolio will undoubtedly want their money to make a difference. Of course, there are legitimate financial reasons for opting to invest in ESG, but we expect the majority will be guided (at least in part) by a desire to align their wealth with their beliefs. 

It’s important, then, that we are able to measure the impact of the portfolios across a few different metrics. Below are arguably the key details – our ESG portfolios invest in companies that are less CO2 intensive (42% reduction on average) than the non-ESG ones.

Importantly, our Socially Responsible Investing portfolios are 100% United Nations Global Compact compliant. This is an initiative that encourages businesses to behave responsibly, covering a broad range of social and environmental factors from working conditions to climate responsibility. 

Finally, our portfolios will only use ESG funds that are 100% compliant with international labour laws. This covers everything from unfair discriminatory practices to the absolute avoidance of forced labour. This is something every portfolio will take into account, but it’s vital that an ESG proposition is hypervigilant in these kinds of areas. 

In terms of fundamentals, this means there are a few notable metrics we can highlight. The overall MSCI ESG Risk Rating level of our portfolios increases significantly, and all portfolios have a rating between A and AAA. The number of ESG laggards (companies highly exposed to ESG risks) decreases significantly. The Weighted Average Carbon Intensity is significantly reduced, while the fund sustainable impact involvement increases by up to 50% more (12% to 18%). 

The Moneyfarm Engagement Layer

A core feature that separates our ESG proposition from others is the Moneyfarm Engagement Layer. Put simply, this is a set of principles that guide our approach to socially responsible investing, key pillars we want the funds and businesses we invest in to align with. These are:

  1. How ETF issuers vote
  2. Asset manager engagement on environmental topics
  3. Alignment of the fund to the Paris Agreement’s goals
  4. Asset Manager policies and structure for proxy voting and engagement
  5. Pledges signed

What this means is that we are not simply interested in the assets that make up any given fund. It’s also extremely relevant how those asset managers behave and how involved they are in environmental issues. It also places the funds themselves within the wider context of the Paris Agreement and international sustainability targets. 

The Moneyfarm Engagement Layer will not only inform our decision-making process broadly but will be specifically called upon in instances where two funds appear similar on other metrics. When all previous conditions are met equally, preferential selection applies to ETFs that have a higher engagement score. This framework also allows us to maintain continuous engagement with ETF issuers, which can ultimately result in influencing their activism with investee companies.

A note on performance

When people open a Socially Responsible Investing portfolio, a large part of the decision will be driven by a desire to protect and grow their wealth over time. This is, after all, the primary reason anyone invests, and it’s important that ESG propositions can, at the very least, keep pace with regular investment portfolios. 

The chart above is a simulation, a backtested performance projection to give us an idea of how our new Socially Responsible Investing portfolios would have performed across five and a half years. Much like our regular portfolios, valuations took a hit at the beginning of the Covid-19 crisis, while generally rising over the period. 

Of course, simulated past performance is no indication of future returns. Investors should be prepared for their portfolios to dip in value as well as grow and may get back less than what was invested. However, it is becoming increasingly clear that socially responsible portfolios have the potential to perform alongside regular ones. We recently produced a deeper dive into the potential performance of ESG portfolios and the factors that make the difference, which you can read here.

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