Navigating ESG investing in an increasingly complex world

This article first appeared in Professional Adviser.

While ESG investing seems like a straightforward concept, factors such as geopolitics cannot be ignored. But investing in ‘unethical’ countries can produce long-term positive change.

Not too long ago, ‘ESG’ was just another investing buzzword, but the explosion of interest in sustainable investing strategies now cannot – nor should not – be ignored.

On the face of it, this method of investing seems like an obvious choice, allowing clients to grow their wealth while making the world a better place. But, as we all know, if something seems too good to be true, it probably is.

While ESG investing certainly has its benefits, it is not as straightforward as clients may think.

Balancing returns and volatility

Issues of sustainability have been prominent in headlines for several years, but the coronavirus pandemic was the first real acid test of ESG investing and, on the whole, it seems to have performed fairly well.

This is partly because a focus on sustainability makes stocks with a high ESG rating tend to be less prone to volatility. This meant that they struggled less when markets fell in 2020 due to the economic effects of the initial lockdown.

However, it’s important to scrutinise the Panglossian belief that “more virtue equals more money” as this isn’t always the case. While ESG stocks may have fallen less in the initial shock, they also rose less as markets recovered.

Avoiding ESG can have benefits

When clients are investing their wealth, they are almost certainly looking to grow it – and if growth is the absolute priority, ESG can pose a dilemma.

When clients consider ESG, it is typically expressed through a simple hypothetical like this: “You can choose to invest in a company which offers strong returns, but the company principally manufactures guns and rockets. Is the indirect impact of this company worth the financial gain you would make?”

Clients may find that easy to answer but the real world rarely reflects these simple hypotheticals. When you start to consider geopolitics, too, things are no longer so black and white.

An excellent example of this geopolitical dilemma is investing in China.

If clients had bought the iShares MSCI China ETF (MCHI) ten years ago, they would have doubled their money by now. The country’s transition in recent decades to a more free-market style economy has clearly resulted in strong growth.

However, investing in Chinese stocks has significant ethical implications – not least because of China’s very poor record on human rights. A cursory glance at recent headlines will quickly confirm this, with the genocide of ethnic minorities in Xinjiang and the arrest of pro-democracy activists, such as Jimmy Lai, in Hong Kong.

If you were investing according to strict ESG principles, you would surely have to avoid China – except the situation becomes even more complicated when you consider the bigger geopolitical picture.

Unethical investing for long-term change

China has come a long way in the last few decades, embracing capitalism and quickly becoming one of the best-performing emerging economies, which has drastically improved the standard of living.

According to the World Bank, there were about 750 million people living in poverty in China in 1990. But thanks to the growth of international trade, that number had fallen to just 7.2 million by 2016, improving the lives of ordinary people in real and tangible terms.

It’s an achievement that would have been delayed or prevented if the Western world – whilst taking a principled stand on China’s crimes – had also turned its back economically.

The same can be said when you consider certain African nations such as Mali, where the UK is a key source of foreign investment.

Like many post-colonial states, Mali has a poor record on human rights. State security forces have been widely accused of excessive violence against dissidents and the country still retains the death penalty despite international pressure.

However, poverty has been falling since 2015, partly due to an increase in international trade, with foreign investment enabling farmers to modernise agriculture.

Once again, there is a very real risk that removing this investment would hamper that progress, and undermining Mali’s economic growth could also derail its transition towards democracy.

It could therefore be argued that the interests of the investor and of the Malian people are now aligned. The investor receives strong returns on their investment, while the influx of foreign capital helps to combat poverty and improve people’s lives.

Think carefully

In this way, the dilemma over ESG investing is much more complicated than a simple question of ‘right’ versus ‘wrong’: that’s a false dichotomy.

Aligning a client’s investments with their principles can be very rewarding. But it’s often important to test those principles in order to avoid missed opportunities.