Ethical investing

Types of ethical investing

Anyone labelling an investment as sustainable or suggesting it has ethical features must be able to provide evidence to back up their claims. Active investment fund managers follow certain approaches to achieve this. 

Keep in mind that some funds will combine two or more approaches. This goes to show that even with rules in place to make ethical claims easier to understand, you still need to roll your sleeves up and do a bit of homework to ensure your fund ticks the right ESG boxes for you.

Stewardship

The stewardship approach to ethical investing means looking after the investments you manage from the point of view of the environment, society, or the economy at large.

At the weakest level, this would mean voting on proposals made by the company. At the strongest, it would mean lobbying the company – either in private or in public – for change. It’s probably hard to find any actively managed investment fund that wouldn’t claim to engage in some form of stewardship, so it’s a broad church.

Stewardship can be an important component of ESG investing, but it’s probably not enough on its own to warrant the ESG tag.

ESG integration

ESG integration means considering ESG factors when making investment decisions. The effect that ESG integration has on a portfolio can be minimal, or quite substantive.

For instance, a fund manager could simply factor in a stock’s ESG rating, alongside other financial information, when making their investment decision. In this case, ESG integration would have a very small effect on the portfolio.

At the other end of spectrum, ESG integration can be much more robust. For instance, an investment manager might decide not to invest in a company based just on its poor ESG score. But this is still a judgement call made by the fund manager – unlike in an exclusionary fund (see below), where certain sectors are explicitly off limits.

Green investing

Green investing is an approach favoured by customers concerned about the environment. Green investors look to hold only environmentally friendly investments, and exclude companies which might be damaging to the environment.

Tilting

Tilting is when a fund uses ESG scores to ‘tilt’ their portfolio away from companies with poor ratings, and towards companies with good ratings.

When you choose this type of fund, some of your money may still be invested in companies and industries which you’re not keen on – but there’ll be a significantly lower amount of them compared to the market. So tilting strikes a balance between ethics and pragmatism.

Best in class

Similar to tilting, best in class allows investment across a range of industries, even carbon intensive ones. But it picks a portfolio of companies that lead their sector in terms of their ESG credentials.

The benefit of this approach is it’s easier to produce a balanced portfolio, so may suit investors who believe the likes of BP and Shell are critical to the transition to cleaner energy.

Exclusions

One straightforward way to invest ethically is to exclude certain industries from your fund portfolio. Typical examples are tobacco, oil and gas, gambling and defence companies.

This approach might suit you if you don’t mind too much where you invest – as long as your money isn’t held in companies you believe are doing harm. As well as being a traditional way of investing ethically, it’s also easy to understand and implement.

Positive impact investing

Some funds go a step further. Positive impact investing involves seeking out companies working towards solving the ESG problems facing the world – whether that’s climate change, financial inclusion, or poverty.

These funds can be more risky, often because they invest in fairly specialist areas. Two examples are renewable energy investing and social impact investing. Renewable energy investing is where funds invest in businesses that produce renewable energy, such as wind or solar farms. And social impact investing is where funds invest in projects with a positive social effect, often on disadvantage communities.

What are examples of responsible investments?

What makes an investment ethical is very much in the eye of the beholder. For some, holding an oil company like Shell, which makes money from oil and gas production, is simply unethical. For others, the commitment oil companies have made to transitioning towards renewable energy makes them part of the solution as well as the problem. So they don’t believe investing in oil companies transgresses any ethical boundaries.

Some ethical investors choose companies that are making a positive contribution to the world, such as the Danish renewable energy firm Orsted. Alternatively, they might pick stocks that aren’t doing much harm – Microsoft and Alphabet, for instance, are quite common in funds that invest in ethical companies.

When you're researching your funds, you can find the Morningstar sustainability rating, which will give you a score out of 5 for each of our funds available for investment.

What are ESG fund labels and what do they mean?

In a bid to improve consumer communications, the Financial Conduct Authority (FCA) introduced a series of reforms over the course of 2024, known as the Sustainability Disclosure Requirements (SDR).

One of these is an ‘anti-greenwashing rule’. This stops fund providers making claims about the ESG characteristics of their fund that don’t actually match up with what’s going on in the portfolio.

To help investors make more informed decisions, the FCA also introduced four new investment labels that you might see on fund literature. Each label corresponds to one of four different approaches to ESG investing set out by the FCA. To use the labels, a fund needs to have an explicitly stated sustainability objective, with at least 70% of its assets invested in that way.

The four labels are:

What else do I need to know about ethical investing?

The FCA says the sustainability characteristics of a fund must conform to a robust, evidence-based standard that is an absolute measure of environmental and/or social sustainability. In some cases, fund providers themselves may develop their own standards, but it seems likely many will defer to existing frameworks to define the standard for their funds. In either case, the intention is to get funds to show they’re actually delivering on ESG promises, rather than simply having good intentions.

Fund providers need to monitor their funds to ensure they comply with these labels, as well as to undergo an independent assessment to judge if they’re meeting the right standard. They’ll also need to keep investors informed of their ESG activities.

Passive funds aren’t exempt from these rules. They’re included in the labelling regime, even though they don’t normally control the composition of the index they’re tracking. While the FCA seems to afford them some leeway here, it says they’re still expected to take reasonable steps to make sure their fund maintains the ESG standards laid out to investors. This would include communicating with index providers if it looks like there’s a mismatch between the components of the index and the sustainability objective of the fund.

Keep in mind that ESG funds labels won't cover every fund with ESG leanings. Some funds that apply an ESG lens to their portfolio won’t qualify for any of these labels – and won’t be able to use one. They also won’t be able to use the words ‘sustainable’, ‘sustainability’, and ‘impact’ in their names. But that still leaves other, related names they could use, such as ‘responsible’, ‘ethical’ or ‘stewardship’. The FCA has also issued rules on how these funds are marketed to investors and the disclosures they need to make – again, as a barrier to funds talking the ESG talk but not walking the walk.