How investors can guard against ESG fund greenwashing

As funds with ‘values’ become more popular, investors need to watch out for potential ESG fund greenwashing. We explain what to look out for. 

You can have any colour you like as long it is green. That appears to be the message from the modern-day Henry Fords of fund management, who have realised that in a post-pandemic, climate change-aware world, environmentalism sells.

Across Europe, funds investing according to environmental, social and governance (ESG) factors raised €151 billion in the first nine months of last year alone, according to Morningstar - a 79% increase on 2019. Consultancy PwC thinks ESG funds might outnumber their non-ESG peers by 2025.

But just how ESG are those funds? There is growing concern that at least part of the ESG industry is a triumph of style over substance – that fund managers are paying lip service to the principles of sustainable investment in the rush to cash in.

Investors who look beneath the bonnet of such funds might be surprised to discover where their money is going. An investigation by the Financial Times published earlier this month found that some of the world’s largest ESG funds have holdings in large oil and energy companies – exactly the kind of fossil fuel businesses that most ESG investors would expect to avoid.

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Welcome to the world of ‘greenwashing’, where fund managers hope a quick coat of sustainability paint will give their products shine, despite the cracks that remain underneath. “The more that fund managers see this as a growth opportunity, the more funds we’ll see in this space,” warns Mike Appleby, head of the sustainable investment team at Liontrust. “That inevitably increases the risk that you’re invested in a fund that isn’t very different to a fund that doesn’t have green in its name,” adds Appleby, who has spent nearly 20 years in sustainable investment roles.

Regulators are stepping in to tackle greenwashing issue

Regulators have watched the growth of greenwashing with alarm. In the European Union, new rules came into force on 10 March specifically to tackle the issue. The Sustainable Finance Disclosure regulations require, for the first time, fund managers to provide information about the ESG risks in their portfolios; this will effectively mean that funds are categorised as sustainable or non-sustainable.

In the UK, where funds are now beyond the reach of EU regulation – unless fund firms wish to sell them in the EU – the government has promised to “match the ambition” of these regulations, although campaigners are frustrated by the slow pace of reform. The Financial Conduct Authority (FCA) is currently working on rules that would mirror the EU approach.

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To be fair to fund managers, the issue of greenwashing is not entirely of their own making. One problem is that investors themselves mean different things when they say they want to invest sustainably, just as the constituency of people concerned about meat consumption ranges from flexitarians to vegans

Maze of different ‘investing for good’ options

For some investors, an ESG fund should avoid any business involved in activities of which they disapprove – from poor environmental performance to questionable labour market practices. Others say they actively want their fund managers to remain invested in such businesses, so that they can use their power as shareholders to engage with management and encourage positive change. Then there are impact investors, who want their funds to seek out investments in enterprises regarded as a force for good; in some cases, these investors may not even regard financial return as their first priority.

Clearly, fund managers need to explain where their products sit on the ESG spectrum, but there is inevitably scope for missteps. “It’s 50 shades of green out there right now,” warns David Macdonald, founder of The Path, an independent financial adviser set up to help clients combat climate change. “No wonder investors are starting to get confused over what is real and what is too good to be true.”

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Another problem is that the guides that investors – and fund managers themselves – might expect to steer them through the maze can also point people in the wrong direction. While there are a string of ESG benchmarks produced by ratings agencies and other specialist analysts, these standards are inconsistent and often surprising for what they include and what they don’t. It doesn’t help that laws on corporate reporting in most jurisdictions do not yet require companies to disclose all the data that standard setters need in order to rate them on ESG criteria.

In any case, these benchmarks are backward looking and may not capture what is currently going in a business. Last year, for example, after the fast fashion retailer Boohoo (LSE:BOO) was embroiled in a scandal involving labour practices in factories that make its clothes, it emerged that leading UK ESG funds held shares in the business. That reflected the high ESG ratings previously awarded to the company by benchmark providers such as MSCI. Only after the controversy did MSCI and peers such as Sustainalytics and Vigeo Eiris downgrade their reports on Boohoo.

Fund managers need to take responsibility

However, Philippa Gee, the managing director of Philippa Gee Wealth Management and a long-standing specialist on advising clients on ethical and environmental investment, says that despite such issues, fund managers need to take responsibility. “Any fund manager worth their salt in the ESG world should be carrying out significant due diligence, well beyond a simple glance at a company’s brand and marketing material,” she says.

Equally, Gee believes investors need to carry out their own checks. “There are two different routes,” she suggests. “One option is to stick to fund managers with a proven history in the ESG market and a pedigree of experience and performance; this is evidence they are not just offering ‘me-too’ products. Second, if you have continuing concerns, you need to ask each potential manager to supply details of the due diligence they carry out on any potential holding, so that you can see how they select holdings, what criteria they use to monitor those holdings and what would change the decision from a buy to a sell.”

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Dzmitry Lipski, head of funds research at interactive investor, believes investors are entitled to make use of benchmarks and recommendations – he points to interactive investor’s own ethical longlist and ACE 40 list as a good starting point for ethical and ESG fund ideas. But he also thinks that investors need to be clear about what they are looking for, and to be prepared to get their hands dirty.

“Ethical investment has always had tensions that are not always easily reconciled, so it is crucial to accept that it can be subjective. At what point a company starts to become ethical is hugely open to debate and personal opinion,” Lipski says. “As always, investors should do their own research and scrutinise all the available data and fund information.”

Warning signs of potential greenwashing

If that sound challenging, in practice, there are lots of warning signs that might alert you to the possibility that a fund manager is engaged in greenwashing. Be sceptical about launches from managers with no experience in the ESG field, particularly if they do not appear to be investing significant resources in new ventures.

In addition, be mistrustful where managers cannot point to evidence of their activism – where have they engaged meaningfully with companies, for example, and how often have they been prepared to vote against the board in controversial situations?

Above all, transparency is vital. Look for detailed information on how fund managers are pursuing their ESG goals, rather than generic slogans. How do they make investment decisions and what are their ESG criteria? Are they prepared to publish their entire portfolios of fund holdings, so you can scrutinise these, rather than just top 10 lists?

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“Some fund managers only claim to get over a very low bar, such as the United Nations Principles for Responsible Investment, which can look appealing but, if this is the only commitment that managers can make, they should be treated with caution,” says Macdonald.

“You can also find tell-tale clues that things might not be as they seem in the reporting. If a fund does not disclose its carbon footprint, you would have to ask why. And if it is reporting Scope 1 and 2 emissions, but avoiding the more rigorous Scope 3, what is it hiding? To me, that is the equivalent of someone trying to sell the health benefits of butter by selling it as ‘19% fat-free’.”