The most contentious shares held by ESG funds

The holding of fast fashion retailer Boohoo in some ESG funds raised eyebrows, but there are other controversial shares and sectors. Jeff Salway reports.

Boohoo (LSE:BOO)hit the headlines in July when a Leicester factory making clothes for the fashion retailer was placed at the centre of the city’s spike in coronavirus infections.

It then emerged that staff had been told to come into work during lockdown, were paid well below the minimum wage and subjected to poor working conditions. The news was not only shocking, but for those environmental, social and governance (ESG) funds investing in the retailer it was also somewhat embarrassing.  

The episode raised new questions as to how ESG fund investors could be confident that their money was in companies that met their own idea of investing ethically and sustainably. 

The flows into UK funds focusing on ESG issues leapt from £3 billion to £10 billion last year and the amount of money in such funds is reaching new highs all the time. 

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But as more people divert their money into what is a very broad sector, many will invariably find that they are investing in firms they might not consider ethical or responsible.

“Like snowflakes, no two ethical funds are the same because ethical investing is inherently subjective by nature,” notes Myron Jobson, personal finance campaigner at interactive investor.

He groups ethical funds into three categories: those that focus on excluding companies and sectors that don’t meet their criteria; those that invest in companies active in delivering positive social and/or environmental outcomes; and funds that consider a range of ESG issues or themes when balancing positive or negative factors. 

There are also funds that mix-and-match the three styles, while engagement-focused funds invest in companies that might not meet certain criteria, but which they seek to influence positively.

“ESG is a risk-analysis process,” explains Julian Parrott, partner at Edinburgh-based advisers Ethical Futures. “It identifies potential risk to profitability of a business from ESG factors – it does not mean that funds are managing and selecting holdings to meet a wider remit reflecting positivity in any of these areas.”

Ultimately, different investors have different views as to what constitutes ethical and responsible. Some issues also contain inherently grey areas.

“The point at which a company stops being unethical and starts to become ethical is down to personal opinion,” says Jobson. “And that’s why ethical funds can look distinctly different from each other.”

Some sectors and stocks are particularly contentious, however, dividing opinion among fund managers and investors as to their ESG merits.

Boohoo and fast fashion

The company’s prominence in ESG funds was due partly to the high scores it was given by ratings providers.

“It’s a top holding for lots of ESG funds, but it clearly wasn’t a suitable investment if you care about sustainability,” says Ketan Patel, manager of EdenTree Investments’ Amity UK Fund. 

“Fast fashion is cheap and disposable - two things [that] don’t fit with being sustainable.”

Parrott agrees, noting the wider sustainability concerns around fast fashion that should have set alarm bells ringing for ESG investors.“These high turnover, low-cost retailers may often have issues to consider around labour and supply chain standards,” he notes. 

Energy and an ethical conundrum

Investors might also be surprised by the regularity with which certain oil and gas companies appear in ethical and ESG portfolios. But while oil is a long way away from what many would define as ethical, many are investing heavily in clean energy.

Any tracker fund following the up and down movements of the FTSE4Good index would have exposure to oil and gas. “The inclusion of companies like Shell (LSE:RDSB) in the FTSE4Good UK 50 index may raise an eyebrow,” says Jobson. “But some investors argue that the company boosts ‘green’ credentials because of its renewable energy division as part of plans to become a net-zero emissions energy business by 2050.”

The Trojan Ethical Income, which features on interactive investor’s ACE 30 rated list of ethical funds, excludes all companies with material exposure to revenues from fossil fuels, including oil companies. In contrast, several UK ethical funds count the likes of Royal Dutch Shell and mining company Rio Tinto (LSE:RIO) among their biggest holdings, despite seemingly obvious reservations from an environmental perspective.

Cars and cleanliness

While this may be a historical case, the emissions scandal that erupted in 2015 and 2016 was embarrassing for the many ESG funds with exposure to companies including Volkswagen (XETRA:VOW), Fiat-Chrysler (MTA:FCA) and Renault (EURONEXT:RNO). The scandal, which continues to make its way through the courts, emerged when VW was found to have manipulated vehicles so that when tested they appeared to have much lower emissions than they really did. Other companies were soon dragged into the same spotlight, including some that were prominent in ESG portfolios and given strong ratings by ESG researchers. 

Some ESG funds had disinvested from VW in the months prior, citing governance concerns. Similarly, the index provider MSCI “noted a deterioration of VW’s corporate governance practices” in early 2015, removing the company from its ACWI ESG index. Other organisations missed the warning signs, however, often owing to an emphasis on environmental and social factors - where VW scored well - while overlooking the governance aspects of the ESG formula.

Tech and transparency

Governance is also the main talking point when it comes to the ESG shortfalls of the FAANG stocks - Facebook (NASDAQ:FB), Amazon (NASDAQ:AMZN), Apple (NASDAQ:AAPL), Netflix (NASDAQ:NFLX) and Google’s parent Alphabet (NASDAQ:GOOGL). “These stocks are often subject to investor concerns, but they are still widely held,” says Parrott. “Amazon is the most controversial on the basis of issues such as labour and tax, yet you will still find it in ESG-based sustainable funds.”

There are serious and growing concerns over privacy, social justice and governance in Google, Facebook and Amazon in particular. Yet eight of the 10 best performing large-cap US funds using ESG metrics as part of their selection process had either Apple, Amazon or Microsoft (NASDAQ:MSFT) as their biggest holding in the year to the end of July, according to Morningstar.

“Governance gets least coverage, but if you don’t have a good G then the E and S won’t follow,” says Patel at EdenTree. “The G becomes a real issue when you look at global companies such as the FAANGs.”

He points out that the likes of Facebook and Amazon have ownership structures where the power lies with one or two dominant individuals and other shareholders have little real influence. Patel adds: “We engage a lot, but when it comes to the management structure and voting rights I don’t see how you can force change in these companies.”

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Grey areas

There are numerous other sectors in which the lines will seem more blurred to ESG investors. In banking, pharma and nuclear power, for example, there will often be marked inconsistencies, with the ESG merits of companies open to interpretation or not clear at first glance.

“We tend to find companies where their impact ‘is not immediately obvious’ yet where we believe that their products are having a significant impact in reducing inequalities and promoting social inclusion,” says Rosie Rankin, a product specialist on the Baillie Gifford Positive Change fund. 

For example, Taiwanese electronics giant Taiwan Semiconductor Manufacturing Company (NYSE:TSM) - a key Apple supplier - has attracted attention for continuing to rely on non-renewable sources for its power. But the company also plays a vital role in lowering the cost of semiconductors, according to Rankin.

“TSMC’s ability to produce higher-performing semi-conductors at ever-lower cost has played a critical role in the spread of mobile computing to developing countries, enhancing the ability of billions of people to connect and communicate with each other.”

So it’s rarely clear-cut. As Parrott points out, “one man’s acceptable company may be anathema to another”. While some funds are guilty of jumping on the bandwagon and investing in companies many ESG investors wouldn’t touch with the proverbial bargepole, other instances are more subjective. 

A look at any fund’s top 10 holdings will tell you much of what you need to know about its approach to ESG and how it fits with your own views.

“It all goes to show that investors need to look under the bonnet of each proposition marked ethical to ensure it marries up to their ethical stance before committing their cash,” says Jobson.