What are the different approaches to sustainable investing?

Over the last few years, there has been an increasing number of avenues for investors to align both their financial goals and their sustainability preferences – whether they want to factor in environmental, social and governance (ESG) risks, capture opportunities or help finance the transition to a more sustainable and inclusive economy. Below, we look at some of the most common approaches.

ESG integration is not a sustainable investment approach in itself, but instead is a component of many traditional investment strategies today. The term refers to the systematic assessment of financially material ESG factors that can affect a company’s bottom line in the investment analysis and decision-making process. ESG integration, however, does not change a strategy’s investment objective, exclude specific types of companies or constrain a strategy’s investable universe.

The growing use of ESG integration reflects the increasingly widespread understanding that ESG factors, such as climate risk, natural resources use, human capital management and business conduct, can have significant implications for a company’s long-term financial health, alongside more traditional factors, such as product demand. Investors who do not want to invest in sustainable strategies but do want managers to have a process that enables them to assess ESG risks in their investment processes, with the goals of managing risk and improving long-term returns, may wish to choose an ESG integrated approach.

Exclusionary strategies were the earliest approach to sustainable investing, emerging from religious investment approaches that required the exclusion of prohibited investments, such as gambling and alcohol stocks.

Today, many funds include restrictions on the ability of a fund manager to buy assets related to certain industries, such as weapons, tobacco, thermal coal extraction, unconventional oil and gas extraction, alcohol, and adult entertainment. These restrictions may be aligned with international norms that establish minimum standards of business practice, or may reflect the values of individual investors or groups of investors.

Some investment strategies use exclusions alone to reflect investors’ sustainability preferences. However, exclusions are also frequently just one component of approaches that seek to invest in companies with strong ESG practices or capitalise on sustainable opportunities, rather than only mitigating ESG risks or avoiding the worst offenders.

Positive tilt strategies include a larger allocation within their portfolios to stocks with higher ESG scores, typically seeking to maintain an ESG score that is above a defined threshold. The way asset managers determine their ESG scores varies, with some using scores from external providers and others using qualitative and/or quantitative scoring systems developed in house by investment professionals or by a dedicated sustainable investing team.

Best-in-class strategies rank companies in the investment universe within their sectors and then select the most sustainable companies within each sector. This process allows investors to build a portfolio of ESG leaders, while also avoiding large skews toward sectors more associated with strong ESG practices or better disclosure, thereby maintaining greater diversification.

Thematic strategies are designed to align with specific environmental and/or social objectives, predominantly investing in companies whose products and services address specific themes within these areas. Examples include strategies investing in companies providing climate change solutions or offering products that address inequality.

Impact strategies have a dual objective: to generate financial return and to achieve environmental and/or social impact. Such strategies set and report against specific impact metrics – for example, a climate change impact fund could track the reduction in greenhouse gas emissions resulting from the use of portfolio companies’ products and services.

These descriptions of the main approaches to sustainable investing are intended only as an introduction. Within each category, there are wide variations, and the way that sustainable investment solutions are categorised is not standardised across the industry, so it is vital to look at individual approaches more closely before making an investment decision.

To help you understand which approach is right for you and how it might fit with existing investments in your portfolio, please speak to a financial adviser.