4 strategies for ethical super investing

In part two of our series on ethical super, we look at the different ways an ethical super fund may find its investments.

How do ethical super funds go about deciding where to invest? The more you look into this seemingly simple question, the more complex it becomes. 

And it’s important. How your super fund chooses what to invest in impacts on returns – something we’ll cover in more detail later in this series.

There are four main strategies used to identify the ethical credentials of an investment opportunity:

1. Environmental, social and governance (ESG) screening
2. Negative screening
3. Positive screening
4. Engagement

We explain these four strategies below, but the key takeaway is to find a fund that aligns with your values so you know it’s making investment choices you agree with.

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4 strategies for ethical super investment

ESG screening: A super fund considers a company’s environmental, social and governance risk

Negative screening / divestment: A super fund ‘screens out’ or sells their shares in companies that are engaged in activities at odds with their values

Positive screening: The super fund invests in companies for their returns but also their positive impact on society

Engagement: The super fund uses its role as a shareholder to help change the behaviour of a company

1. ESG screening

The most common way super funds consider the ethical values of a company is through assessing its environmental, social and governance (ESG) risk. 

The idea is that companies whose activities harm the environment, cause detriment to their broader community, or are likely to run into problems with the law, are more of a long-term risk for investors. 

On the other hand, companies that are run well with environmentally sustainable and socially responsible practices are more likely to be good long-term investments.

How an investment manager uses ESG screening

Sybil Dixon is a senior investment analyst at UniSuper. She says that companies with poor ESG practices are more likely to be fined or sued.

“We’re unlikely to have large positions [or investments] in companies that aren’t interested in improving with respect to ESG,” Dixon says. “That doesn’t mean [UniSuper] won’t have large positions in companies that are involved in contentious areas. But the higher the ESG risk is in a particular sector, the better we expect that company to be in managing those risks.”

Some questions a fund manager applying an ESG filter to their portfolio might ask include:

• If a resources company is going to run out of minerals to extract in a decade, how is it managing the risk of becoming obsolete?
• If a construction company doesn’t have strong safety procedures in place, could this end up costing the company? (For example, a company that has workplace accidents may have to pay fines or compensation and find it difficult to recruit good staff in future.)
• If a tech company has a culture of letting sexual harassment go unchecked, could this hurt how it’s perceived by the market?

ESG screening has its critics

Prominent ethical super fund Australian Ethical has criticised ESG as not actually being a type of ethical investment strategy. This is because ESG only considers the ethical worth of a company to the extent it poses some kind of risk to the company’s financial value. 

Advocates for more radical approaches, such as Will Van De Pol from nonprofit organisation Market Forces, still sees ESG screening becoming a feature of mainstream investment as a good thing. 

“I think the more understanding funds have of the ESG risks within their portfolios the better,” he says.

44% of all total assets under professional management in Australia incorporate ESG criteria

The growing prominence of ESG means that these considerations are now baked into the investment choices of many mainstream fund managers. In its 2019 report, the Responsible Investment Association Australasia (RIAA) found that 44% of all total assets under professional management in Australia incorporate ESG criteria. This number represents a 13% growth in a single year.

Even the super funds not applying an ESG screen will invest in companies seen as socially responsible, sustainable and environmentally sound if they see these companies are likely to provide them with the best returns.

Some ethical super products will steer clear of so-called ‘sin stocks’ – defence companies, alcohol and gambling.

2. Negative screening and divestment

Another common approach is to exclude, or apply a ‘negative screen’, to companies or even entire industries that are viewed as unethical or undesirable. This approach is essentially about taking investment options off the table.

A related tactic is divestment, where a super fund sells off its ownership of a certain company’s shares.

If a fund divests from a company on ethical grounds, this can draw attention to the company’s bad conduct and reduce its legitimacy. It’s a way of saying: “I don’t want to be involved in this”.

A decision to divest can seem like a neat and straightforward way to make an ethical statement. You don’t like what a company is doing, so you get rid of any stock you hold in it. But some investment experts contend that divestment is not the most impactful way to make companies change their behaviour. 

Divestment runs the risk of shifting those objectionable activities to owners that don’t careSybil Dixon, UniSuper

Divestment is simply a transfer of ownership. Another investor can snap up the stock. “Divestment runs the risk of shifting those objectionable activities to owners that don’t care,” explains Dixon. 

Vitium Global (formerly the Vice Fund) has made a business of buying up so-called ‘sin stocks’. It focuses on alcohol, gambling and defence companies and many of its options have beaten the market historically. 

As long as investors like Vitium exist the ability of divestment strategies to change the behaviour of companies may be limited. 

With divestment, there’s also the possibility that other investors will profit when you sell your shares.

3. Positive screening

Some super products go a step further than negative screening and aim to actively steer funds into companies that offer a net benefit to society or the environment. This is using a ‘positive screen’. Examples could be investing in renewable energy, healthcare or education. 

While ethical super is sometimes presented as a completely new and different way of looking after your retirement savings, it’s difficult to find a fund that would consider investing in a socially responsible or green company that doesn’t also offer strong returns for members.

Impact investing is a type of positive screening – it seeks both competitive returns and social impact. Impact Investing Australia defines this as investing in “organisations, projects or funds with the intention of generating measurable social and environmental outcomes, alongside a financial return”.

Some products aim to actively steer funds into companies that offer a net benefit to society or the environment

Emma Herd of industry group Investor Group on Climate Change says that impact investing is an exciting trend. “It brings together the financial and environmental, and the social, in terms of really quantifying the impact of what your dollar is invested in,” she says.

Yet, as the table below shows, impact investment is generally a small part of an ethical fund’s investment strategy.

This picture is muddied, however, by what the RIAA has termed “classificational ambiguity” – meaning that impact investing and positive screening can be overlapping terms that are hard to untangle.

Super fund	Commitments on impact investing
Australian Ethical	Favours ethical investing and doesn’t set particular targets for impact investing. CIO David Macri says: “No investment should be considered purely on its positive impact potential, but nor should it be solely on corporate profits alone.”
Christian Super	Says “around 10%” of its investments are in “projects that have a measurable social or environmental impact as well as a financial return”.
Future Super	Different options have different goals for investment in green industries. Renewables Plus has the highest target; it aims to invest 20% of the portfolio in renewable energy projects.
Local Government Super	Doesn’t set specific targets for impact investing. “Our philosophy is that each investment has to be financially attractive and stand on its own merits … we won’t sacrifice returns to meet impact goals,” says the fund’s CIO.

Another variant of positive screening is ‘best in class’, where the investor will look for companies that lead their particular industry in sustainability practices.

4. Engagement

A completely different approach is engagement, where an investor keeps shares in the company despite having misgivings about its activities. Instead of selling their shares, they take action as a shareholder to try to steer the company in a preferred direction. 

This idea might not appeal to super fund members who’ve specifically moved their super to an ethical or sustainable fund because they don’t want to have any investment in companies or industries that don’t align with their values. 

The argument for engagement is that it lets the investor ‘get a seat at the table’, which can sometimes mean voting rights. 

An investor takes action as a shareholder to try to steer the company in a preferred direction

In many cases, super funds can only acquire a tiny percentage of the available shares and will have to work together with like-minded investors to have any impact. This is where groups like Climate Action 100+ and Investor Group on Climate Change come in.

These bodies bring together institutional investors, including a number of Australian super funds (both certified ethical and large mainstream funds), in a bid to address climate change risks in a way that benefits super fund members in the long term.

As with ESG, more and more super funds, including mainstream funds, are engaging with the companies they invest in. In a 2018 report, the RIAA found 43% of super funds were involved in some type of direct company engagement, up from 30% two years earlier.

In part one of our ethical investment series, we looked at how Australians are increasingly interested in ethical investment, and learned that only a small percentage of super funds and options presenting themselves as broadly ethical or socially responsible are certified.

Takeaways on investment strategies

• ESG screening, which involves considering the environmental impact, sustainability and governance risk of a company, is a fast-growing field. Many of the biggest mainstream funds now use this approach to some extent.
• Some products aim to steer funds into companies that offer a net benefit to society. This is using a ‘positive screen’. A subset of positive screening is impact investing, though this is generally a small part of an ethical fund’s investment strategy.
• Despite seemingly being two totally different approaches, most advocates of engagement see some role for divestment. Similarly, most investors involved in engagement see divestment as necessary for certain industries. But if you’re set on divesting from companies you don’t agree with, you could still end up in an ethical fund that holds shares in contentious companies it hopes to engage with. Similarly, if you want to work with companies to improve their practices, a fund with a divestment approach might not suit your needs. Check with the fund or look at its investment portfolio to make sure it’s a good fit with your values.