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Financial Times – ESG? SRI? Is your green portfolio really green?

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You decide to buy a car. You tell the dealer you want to be environmentally responsible and trust him to supply something appropriate. You had an electric car in mind but he supplies a hybrid. Not too bad, but when it arrives you find that the internal-combustion part of the power plant is a diesel supplied by a German maker caught lying about emissions. 

Things get worse. A couple of years on, the car is rusting and you discover there is no corrosion protection. Soon your car is heading for the scrapheap. Not very sustainable eh?

This experience should be familiar to most investors in so-called sustainable funds. Whichever term you use to describe them — green, sustainable, socially responsible investment (SRI) or environmental, social and governance (ESG) — the assets that investors entrusted to these strategies totalled more than $12tn for ESG funds in Europe last year. Sustainable investing sells, so it is hardly surprising. But what are investors getting?

You might assume that your sustainable fund would exclude sectors such as fossil fuels and “sin” stocks — arms, drinks and tobacco. It may come as a surprise that almost all sustainable funds do not have any hard sector exclusions. 

If they combine this with a peculiar application of sustainability analytics, which typically ranks companies within sectors, you get unexpected results. That’s because the funds using this approach can and do invest in many obviously questionable sectors, albeit they invest in the “best of a bad bunch”.

For example, the S&P Dow Jones Sustainability Indices are considered by many to be the best benchmark for ESG investing — but British American Tobacco is in the index. The same is true for funds. The Vanguard SRI European Stock Fund at the end of November had 6 per cent in oil and gas production. Is this what you expect from ESG/SRI investments? 

If you think of yourself as a responsible investor, such breaches are shocking. You will need to ask if your ESG/SRI fund or index owns any drinks, gaming, tobacco, oil, gas, mining, fossil-fuel burning utilities, or arms companies. 

There is a deeper problem. Your ESG/SRI fund manager may monitor your investments for the commonly collected statistics such as CO2 emissions, hazardous waste production, and the age and benefits of the labour force, but how many monitor fundamental business sustainability? Or how much a company spends on research & development? Or its capital expenditure? We have rarely found businesses that can prosper without renewing and expanding physical facilities. What return does a company get on its capital expenditure? If it is inadequate it will fail.

There are virtually no examples of sustainable funds monitoring these real-world sustainability measures. Without them your sustainable investment will simply fail no matter how low its CO2 emissions. It is the investing equivalent of the hybrid car that rusts away.

The results of this for investors are clear and not in a good way. 

The average five-year annualised return for ethical and sustainable equity funds in the Investment Association universe is 11.9 per cent. The equivalent for the MSCI World Index is 15.5 per cent. I would guess some investors may be willing to forgo performance in return for ensuring that their principles are adhered to. Given the lack of hard sector exclusions, though, they get the worst of both worlds — poor performance and a breach of their principles.

Terry Smith is chief executive of Fundsmith LLP