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ESG Focus: Care Needed In Ethical Investment

ESG Focus | Jun 02 2023

This story features AUSTRALIAN ETHICAL INVESTMENT LIMITED, and other companies. For more info SHARE ANALYSIS: AEF

FNArena's dedicated ESG Focus news section zooms in on matters Environmental, Social & Governance (ESG) that are increasingly guiding investors preferences and decisions globally. For more news updates, past and future:

Care Needed In Ethical Investment

Tim Boreham warns not all so-called ethical or ESG funds and ETFs are what they seem.

By Tim Boreham

‘Do The Right Thing’ is the long-term catch-cry of Keep Australia Beautiful’s anti-littering campaign and is also the title of the 1989 Spike Lee-directed comedy-drama that examines racial and social inequities in New York.

Increasingly, though, Do The Right Thing is the guiding principle of retail investors, who are happy to forego monetary gain to invest in companies that do not go out of their way to stuff up the planet.

Or perhaps they both want decent returns and a warm, inner glow (see below).

While Doing The Right Thing should be self-evident, definitions quickly get blurred and investors need to be on high alert for greenwashing tactics.

As one green group rep put it a while back: a best-in-sector player still could be a coal miner that “blows the top off mountains, pollutes rivers and destroys the landscape, but in a more friendly way than their competitors.”

On the simplest of delineations, actively-screened funds include only companies that effect positive change, such as renewable energy developers or recyclers.

The more common approach is to steer clear of the usual suspects such as tobacco, alcohol or armaments, but apart from those vice stocks the definitions become more blurred than the bottom line of an optometrist’s chart.

The banks, for example – good or bad? They might lend to fossil fuel companies and almost certainly to grocers that sell alcohol and tobacco. But they are also actively developing products such as green bonds and trying to Do The Right Thing for customers.

The miners? Thermal coal is friendless, but there’s an argument that coking coal supports the production of the steel used in renewable industry infrastructure such as wind turbines.

Producers of an expanding list of battery metals – lithium, cobalt, graphite, copper and the like – can only be good, can’t they. They are polluters and exploiters of non-renewable minerals but if we don’t produce these materials there are no EVs and no chance of meeting the Paris net zero 2050 carbon reduction target.

The growth of the sector is reflected in a slew of exchange traded funds (ETFs), under the banner of ‘sustainable’ or ESG (environmental, social and governance) investments.

Typically passive funds, the ETFs track an underlying sustainability index which can have some surprising inclusions.

For instance, the $2 billion under Betashares’ Global Sustainability Leaders Fund ((EFHI)) tracks the Nasdaq Future Sustainable Leaders index.

With a name like that, one might think the fund invested in wind farms or organic orchards. In fact, its biggest holdings are in Apple, Home Depot (hardware), Visa and Mastercard.

Are these companies changing the world? Yeah nah … sorta. But billion-dollar funds need to invest in such traditional stocks because there aren’t enough investible ethical plays to go around and they do need to produce a decent return.

Other selection parameters of the Nasdaq index seem a bit random: for instance, no companies are allowed if they produce a drop of alcohol, but may sneak in if 5% or less of revenue derives from distributing the demon drink.

Producing pornography is verboten, not surprisingly. But once again, a company deriving 5% or less of revenue from distributing the naughty images could well be okay.

Your columnist isn’t accusing anyone of greenwashing, but investors do need to look under the bonnet to ensure their Prius of an investment does not turn out to be a petrol-guzzling Hummer.

With assets of $8.5 billion, Australian Ethical ((AEF)) remains the biggest pure-play listed ethical funds by a wide margin.

Australian Ethical chief John McMurdo is well aware of the need to avoid the greenwashing threat, as well as the need for financially sustainable investing.

The company uses a two-stage process, by which all investment propositions have to pass muster of both an ethical committee and a finance committee.

“We have been doing this for 36 years,” McMurdo says. “We have seen these situations before and are very proud of our long-term record and growth trajectory.”

For those seeking a more active ethical stance, perhaps the better option is to invest in an unlisted ‘impact’ funds with a definitive charter of doing good.

For a more single-minded approach, ETFs offer specific exposures to ESG themes (albeit with a renewable energy and low carbon bias).

For instance, Global X offers the Battery Technology and Lithium ETF ((ACDC)) and hopefully a diversion on the Highway to Hell of climate change.

Then there’s a wide field of tech-oriented companies (not funds) in sectors such as hydrogen, battery recycling and of course wind and solar farms.

In the biotech sector, dozens of companies are developing drugs, devices and diagnostics to tackle both common and rare diseases.

The odds aren’t in their favour, but some succeed as spectacularly as Neuren ((NEU)), which has won US approval for its drug to trat the rare diseases Rett Syndrome.

Perennial runs the $260 million Perennial Better Future Trust, which invests in a rota of 25 to 50 small to mid-cap stock (pretty much anything outside of the top 50 stocks).

A variant, Perennial’s listed ETF Einvest Better Future Fund ((IMPQ)) replicates this investment approach.

The managers’ firmly include any involvement in the ‘usual suspects’, which means that Metcash is on the outer because it distributes booze and smokes.

The firm also selects companies actively doing good, choosing stocks with ESG scores better than benchmark.

An examples is Calix ((CXL)), which is developing technologies to abate emissions in the difficult cement and lime sector and improve crop and water quality.

Another inclusion is the somewhat unloved Sims Metal Management ((SGM)), a metal recycler that benefits from the adoption of electric arc furnaces that use scrap steel rather than coking coal.

Meanwhile diversified fund manager Pengana Capital Group ((PCG)) offers the Axion International Ethical Fund, which seeks to invest in a “portfolio of dynamic and growing companies undergoing positive change with a robust ethical framework.”

As with all listed investment managers the question is whether to invest directly in the funds, or become a shareholder and clip the ticket on the management fees.

Australian Ethical shares have doubled over the last five years, delivering total shareholder returns (including dividends and as of December 2022) of 120%.

Over that period the company’s flagship Australian shares fund has delivered a 6.6% average annual gain, against 6.1% for the ASX 300 Accumulation Index.

Perennial’s Better Future Fund also shows that you can have your cake and feel good about it, too: a 12.9% annual return since inception (excluding fees), compared to the benchmark 8.3% gain.

The ETF has been less spectacular, gaining 29% since listing in difficult conditions in mid-2019.

Still, the returns show that Doing the Right Thing should be more than doable investment-wise – and no harder than putting an ice cream wrapper in the bin.

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