Tips to understand ethical investing screens

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Managed funds and ETFs adopt four basic strategies to create an ESG portfolio.

They screen for “good” companies or sectors (a “positive screen”) and screen out “bad” companies or sectors (a “negative screen”). So they may knock out all thermal coal and tobacco companies and include renewable energy companies. Those may be easy examples to understand, but defining “good” or “bad” for most companies and sectors can lead to stark subjective disagreements.

They may also adopt an “impact investing” approach, seeking not only a market return on investments but also a targeted impact on social or environmental issues they prioritise (for example, microfinance or sustainable agriculture).

Using an ESG integration approach, a fund manager collects ESG information from all public announcements and disclosures. They also send out voluntary ESG questionnaires to hundreds of companies in the hope they will honestly answer and return them. While this approach sounds rigorous, it involves a lot of subjectivity to create and maintain an ESG rating process. In addition, they typically don’t provide full and real-time transparency for investors on their resulting “proprietary” ESG screen.

Lastly, fund managers can focus on the G (governance) part of ESG by using their active ownership of the company’s shares to positively influence corporate behaviour (such as advocating for gender equality on boards).

Before investing, investors are advised to have a good look under the bonnet of potential investments to better align the ESG methodology with their values. A combination of these four basic strategies is likely, but they’re invariably explained in complex, technical terms.

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Given the lack of any uniform ESG standards, product providers try to gain investors’ trust by accrediting their ESG product with various organisations. But in the unregulated alphabet soup world of ESG, what real value is ESG accreditation if everyone is seemingly accredited by someone?

When evaluating companies on traditional financial metrics, investors can rely on standardised financial disclosures set by international accounting rules (with fraud an obvious exception). If all companies follow the same rules, investors can compare, analyse and make sound investing decisions.

The lack of standardised ESG rules and regulatory rigour increases the risk of “greenwashing”. This is when companies or fund managers market themselves as adhering to the best ESG principles but exaggerate their claims and fall short of targets. Most investors struggle to differentiate green from greenwash.

In a positive development at the recent COP26 conference, the International Financial Reporting Standards (IFRS) Foundation, the body that sets international accounting standards, announced the creation of the International Sustainability Standards Board (ISSB).

It may take some years, but the ISSB will develop harmonised and transparent global reporting standards for ESG disclosures. This will allow SMSF investors to invest based on globally standardised ESG information backed by regulatory rigour. Until then, get under the bonnet and do your ESG research.