By Fong-Yee Chan, head of ESG strategy, Vanguard Europe.
Investors interested in environmental, social and governance (ESG) investing have a rapidly growing range of products to choose from, with the number available in the UK more than doubling over the past five years1.
With this expanding universe comes a growing need for advice on ESG options, with the topic coming up in roughly one in five conversations with advisers2.
There are many different ways to reflect ESG considerations through investment products and processes. These range from stewardship (the promotion of effective company governance through activities such as engagement and voting) and ESG integration (the inclusion of material ESG information in investment analysis and decision making), through to products with a formal ESG mandate or label.
Vanguard has developed a four-stage framework to help advisers navigate the ESG landscape and the first step – defining the client’s goals – can help you to assess the different ESG options and decide on an appropriate approach.
One way to determine a client’s ESG objectives – and therefore the best course of action for them – is to ask what they are trying to achieve by looking to address certain ESG issues.
Your client may have certain ethical, moral, religious, humanitarian, political and/or environmental beliefs, which may determine the ESG approach they wish to take. For example, a company may be conducting a legal business activity, but the investor may not want to co-profit from it because it is at odds with his or her values. This values preference may be so strong that the investor would be prepared to sacrifice a financial return.
Alternatively, the client may be seeking to generate a financial benefit, such as enhancing risk-adjusted return or reducing certain types of risk. For instance, an investor may want to invest in renewable energy companies because they believe they will benefit from the transition to a low-carbon economy.
They may want to bring about positive environmental, social or governance-related changes on one or more issues that concern them. For example, they may aspire to influence a change in working conditions for employees of certain companies or sectors.
Finally, the investor may have to follow certain ESG-related requirements, such as specific exclusions, set by an external party such as a regulator.
The client’s objectives may vary by different ESG issue and are not mutually exclusive – they may want to generate a financial benefit as well as bring about positive change, for example. There is no one-size-fits-all approach, which is why it is helpful to start the ESG conversation by establishing a client’s goals before deciding on a suitable approach.
Once you have understood your client’s goals, the following additional questions can help you understand which ESG options might be most appropriate:
There is an ongoing debate in the industry as to whether investors should divest from (or sell) certain companies because of their business activities, or continue to own them and engage with them on managing ESG risks. To a large extent, this will depend on what the investor is trying to achieve by incorporating ESG criteria into their investments.
If the investor is looking to align their investments with their personal values, then they may wish to divest – or, in other words, exclude certain sectors, securities or issuers – that are not in line with those values.
However, if the investor wants to influence positive change in the economy, in society or in the environment, they may feel it is more effective to own certain companies and – through their asset manager – have a seat at the table to engage with the company board and encourage better management of ESG issues.
Ahead of last year’s United Nations climate change conference (COP26) in Glasgow, MPs on the Work and Pensions Committee emphasised the importance of engagement over divestment to encourage the transition to a lower-carbon economy, saying “encouraging behaviour change in companies through good stewardship is more likely to be an effective approach to help the real economy transition to net zero” 3.
At Vanguard, we offer both approaches. As long-term owners of the companies in which our funds invest, our global stewardship team engages with companies on material ESG issues that can impact long-term value for investors.
For some investors, however, owning certain companies is not consistent with their values. That is why we also offer ESG index funds that allow investors to avoid certain ESG risks by screening out (or excluding) companies or sectors, based on specific criteria. These could be non-renewable energy companies, for example, or weapons or tobacco manufacturers.
Once you have defined your client’s ESG goals, you can assess the different ESG options and decide on an appropriate approach.
It is possible to take account of ESG considerations through both active and index strategies and the decision will ultimately depend on your client’s goals and attitude to risk.
Active managers can take account of ESG criteria in their investment research and stock-selection processes, even where they don’t have a specific ESG mandate. As stated above, index products can apply ESG criteria to either exclude securities from the universe or, conversely, select or over/underweight securities based on certain ESG criteria.
Importantly, both active and index managers can engage with the companies in their portfolios to encourage oversight of material risks, including ESG risks. For Vanguard’s externally managed equity and multi-asset funds, the managers have full proxy voting responsibilities for the funds they manage.
Ultimately, then, the question of whether an active or index fund is most appropriate comes down to the client’s objectives and risk tolerance. If they are looking for the potential to generate alpha, then an active product may be appropriate. If they prefer to track closely to the market, then an index product may be more suitable.
Some approaches to ESG investing apply across all products, even where they don’t have an ESG objective – for example, engagement and voting activities, as outlined above.
Similarly, ESG integration has long been used by the managers of non-ESG active funds. It does not necessarily preclude investment in a company, sector or country because of an undesirable activity, but considers ESG risks and opportunities alongside other factors when selecting investments. For example, an active equity manager might consider a financially material governance issue when evaluating a company's earnings growth prospects.
Nevertheless, some investors may prefer a product with a specific mandate if they want to emphasise certain ESG considerations. For example, Vanguard offers active multi-asset funds designed for investors who want to generate long-term growth, alongside the incorporation of sustainable investment criteria.
These questions can help advisers understand an investor’s motivation for incorporating ESG considerations. For more on our objective and practical framework for ESG decision-making, download our paper today.
1 The number of products on offer to UK investors more than doubled from 116 to 242 from 2017 to 2021. Source: Morningstar, as at 24 January 2022. Open-ended mutual funds domiciled in the UK classified in ‘sustainable funds – overall’ category; fund flows and AUM use oldest share class available.
2 Source: ESG Tracker Study Update, NextWealth, October 2021. ESG survey undertaken in July and August 2021.
3 Pension stewardship and COP26 – Report Summary, Work and Pensions Committee, 30 September 2021.
Investment risk information
The value of investments, and the income from them, may fall or rise and investors may get back less than they invested.
Important information
This document is directed at professional investors and should not be distributed to, or relied upon by retail investors.
This document is designed for use by, and is directed only at persons resident in the UK.
The information contained in this document is not to be regarded as an offer to buy or sell or the solicitation of any offer to buy or sell securities in any jurisdiction where such an offer or solicitation is against the law, or to anyone to whom it is unlawful to make such an offer or solicitation, or if the person making the offer or solicitation is not qualified to do so. The information in this document does not constitute legal, tax, or investment advice. You must not, therefore, rely on the content of this document when making any investment decisions.
Issued by Vanguard Asset Management Limited, which is authorised and regulated in the UK by the Financial Conduct Authority.
© 2022 Vanguard Asset Management Limited. All rights reserved.