Can passive investing meet the ESG challenge?

What is the best approach to ethical investing?
Windmills in a field | Wealthify
Reading time: 5 mins

When it comes to ethical investing, it’s important to consider your investment strategy as it could have an impact on what gets included in your portfolio. You can either adopt an active approach or opt for a more passive form of investing. The popularity of passive investing has grown over the last years, and many people would naturally go for this option to build their ethical portfolio. But is it the most efficient approach? Here’s a short guide to help you choose the right investment strategy.

 

What is passive investing?
Despite what the name might suggest, passive investing isn’t about doing nothing. It’s about following the market wherever it goes. Put simply, with a passive approach to investing, you’ll track specific markets, like the FTSE 100 or the S&P 500, and your returns will depend on how these markets, as a whole, are performing. A good way to follow the market is to buy passive funds, also known as index tracker funds – think of them as pre-made hampers full of different investments. Some funds will track a specific market, whilst others will contain investments from multiple markets across the globe. The choice is up to you! The good thing about passive funds is that they allow you to diversify your portfolio. In other words, spreading your money across investment types, companies, and regions. For example, if you buy a fund tracking the FTSE 100, you’ll be invested in every company listed in this particular market, which should help you mitigate risk. And the more diversified your portfolio is, the more your risk will be spread, since one or two poorly performing markets may only affect a small portion of your invested money. Now, taking the passive route means that your investments will follow market movements and your returns will mirror the collective returns of the stock markets that you are following. If markets fall 10%, your investments will likely follow, and vice versa, if markets rise 10%, you could expect to see the value of your investments increase at the same pace.

If you decide to invest ethically, you could opt for the passive route. It’d work in a similar way, but instead of following the traditional markets, passive funds will track their ethical counterparts. For instance, it’s not always well-known, but the FTSE 100 has an ethical cousin, called FTSE4Good, and you’ll only find companies with excellent ethical standards there. So, if you were to invest ethically, you could potentially choose to follow markets like FTSE4Good with a passive fund. But how effective is it? Before answering this question, we need to have a look at ESG, a key concept in the world of ethical investing.

 

What is ESG?
ESG stands for ‘Environmental, Social, and Governance’ and it’s simply a list of criteria used by investment professionals, also known as fund managers, to measure the ethical impact of companies. Before including any organisation in their funds, fund managers will examine their practices and policies, using ESG. They’ll look at the environmental impact of each company: how much waste do they produce? How much energy do they use? Then, fund managers will take an interest in their social initiatives: what do they do to champion gender and race equality? Do they give back in any way to local communities? Finally, their corporate governance will be considered: what rights do they give their shareholders? How transparent are they when reporting to the public?

The work doesn’t stop there! Fund managers will conclude their investigation by giving an ESG rating to each company they examine. The better a company’s ethical standards are, the higher its ESG score will be and the more likely it’ll be to join the fund.

 

So, can passive investing meet the ESG test?
Passive ethical funds will use a fixed ESG score to screen companies and only the ‘best-of-breed’ organisations will be selected. So passive funds can meet the ESG challenge and be a good way to build an ethical fund. However, it’s not perfect and it’s important to understand the flaws that come with passive investing. Passive funds tend to see things in black and white and allow little flexibility. The ESG scoring system that they use can overlook companies that are working very hard to change their practices and improve their ESG standards. An example would be a fast food chain introducing healthier recipes in their menu. Also, companies in passive funds may not always be monitored on a regular basis and you may end up with a fund where companies have let their ethical standards slip over time. The other issue with passive funds is that they’re unable to exert their shareholder voting power to influence the overall business strategy of the companies they invest in.

 

What about active investing?
If you’re not convinced by the passive route to build your ethical plan, don’t worry, there’s another path. You could do the opposite of passive investing and take an active approach to ethical investing. What’s the difference, you ask? Well, with active investing, the aim is to outperform the market and the way to do this is to pick investments you think will do better than the market as a whole. Obviously, finding winners is no easy task and it can require time and expertise. Luckily, you don’t need to do the research yourself, you can purchase active funds where fund managers will pick potential winners, after analysing market data and researching companies. If you invest ethically, fund managers will focus their efforts on companies that are striving to do good. They will look at their activities and policies, and give each company an ESG score. Just like passive funds, actively managed funds will select the ‘best-of-breed’ companies, but they will also consider companies that are trying to improve their practices. Active ethical funds will also keep a close eye on the companies they include to ensure they maintain their high standards and keep up their efforts. And if fund managers hold enough shares in a company, they could push for change and influence ESG policies using their voting power. Since active funds involve a great amount of work, including constant monitoring, thorough research, and due diligence, they tend to cost a bit more compared to passive funds. So before taking the active route, make sure you’re happy paying slightly more to do your bit for the future.

At Wealthify, we use active funds because we believe it’s the only way to build plans that are truly ethical. We’ve also made it easy for you to invest ethically. All you need to do is choose how much to invest and the risk level that suits you. Then, simply switch the ethical toggle ‘on’ and we’ll do the rest, from picking your ethical funds, to managing your Plan on an ongoing basis.

 

The tax treatment depends on your individual circumstances and may be subject to change in the future.

 

Past performance is not a reliable indicator of future results

 

Please remember the value of your investments can go down as well as up, and you could get back less than invested.

 

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