Commentary: 4 key questions to help investors avoid greenwashing

With the sharply rising interest in sustainable investing around the world, and the proliferation of sustainable funds, investors face a serious challenge. How do they determine a fund is truly managed according to responsible criteria vs. one whose sustainability principles are superficial, inconsistent or poorly construed — a situation known as "greenwashing?"

The Global Sustainable Investment Alliance estimates sustainable assets under management in key regions have grown 34% during the past two years, reaching $30.7 trillion in 2018. To capture this demand, investment managers have launched more than 100 sustainable funds in the U.S. alone during the past three years.

Despite — or perhaps because of — its growing popularity among institutional and retail investors, sustainable investing can be defined in many different ways. Also called socially responsible investing, it can encompass impact investing; the application of environmental, social and governance criteria; negative screening; and other strategies. There are more than 150 providers of research, ratings, rankings, indexes and labels used to determine whether specific investments qualify as sustainable. Accordingly, SRI ratings of investments can be inconsistent due to differences in data collection, analysis and reporting.

We believe investors should consider four key questions to cut through the sustainable investing confusion and avoid greenwashing.

We believe a strategy can be sustainable only if it is well integrated into a manager's entire investment process, and not segregated to SRI portfolios alone. ESG investing no longer is as simple as reducing an investment universe to the "best-scoring" names. It means thinking about how sustainability affects all companies and investment strategies. Fund managers should ask how long-term ESG trends and external costs, such as climate change, loss of biodiversity and rising inequality, are reflected in a company's business model.

Such integrated thinking requires rigorous analysis and the ability to "look under the hood" of potential investments. For example, in comparing the carbon footprint of two mobile phone companies, imagine that one company has outsourced all of its operations, while the other is vertically integrated. The first company would thus appear to have a lower carbon footprint than the second, even though making a mobile phone creates more or less the same carbon footprint. This is not visible in the data, but requires knowledge and judgment to see what is there. If a fund has no resources committed to looking at this, and analysts do not have access to in-depth research or an understanding of these issues, the manager will not be able to structurally integrate sustainability.

Assets managers must look beyond ratings and labels, and actively engage with the companies in which they invest. The most effective engagement process takes place over many years, allowing analysts to track and measure the progress of companies over time.

For example, Robeco and other institutional investors engaged with a leading international oil and gas company, which had already expressed a willingness to reduce the net carbon footprint of its energy products. Following its engagement with the investor group, the company went further and agreed to several specific commitments, including, among other things, setting three- to five-year net carbon footprint targets, aligning executive remuneration with energy transition practices, and seeking third-party assessment of its efforts.

Even if a fund manager offers a selection of SRI funds, it is important to determine whether the manager credibly applies sustainable principles in its own business. Investors should examine how a manager describes its mission, work environment, employment practices and approach to the community, and decide whether this is truly consistent with sustainable investing. As noted earlier, voting behavior is also a major clue to a manager's level of commitment to sustainability.

One way a manager can "walk the talk" of sustainable principles is through its voting behavior. Larger passive investors often vote with a board's recommendation, even on shareholder proposals relating to environmental and social issues. Managers should be willing to support shareholder proposals relating to ESG issues.

While SRI labels provided by private or government entities might offer a stamp of approval for a fund, label standards vary from provider to provider, and from country to country. The SRI label established by the French Finance Ministry assesses factors such as a fund's ESG analysis methodology, engagement and transparency. It is externally verified (including an analysis of regulatory filings), so a fund must demonstrate that it has the necessary data, processes and procedures to obtain the French label. The Belgian label, on the other hand, is much more prescriptive, specifically on what not to invest in. The Morningstar Sustainability Rating uses a historical holdings-based calculation factoring in company-level ESG analytics. The MSCI ESG Fund Quality Score measures the ESG characteristics of portfolio holdings and ranks funds based on such factors as sustainable impact, values alignment and ESG risks.

Although such labels attempt to independently certify a fund's SRI principles and practices, the variety of methodologies makes it hard for investors to really know the nature of the funds in which they are investing. Thus, asset managers need to be transparent and clearly show what is — and what is not — part of the strategy of their funds.

Today, investing sustainably is a difficult and demanding process. Past approaches — based on excluding tobacco, gambling, alcohol, fossil fuel or defense industry stocks — are overly simplistic. Ratings and labels are helpful but are not a substitute for independent analysis by investors. The market is now distinguishing among different ways of defining and implementing sustainability. To avoid greenwashing, investors must do the same — by asking the right questions and reaching their own conclusions.

Masja Zandbergen is head of ESG integration at Robeco, Rotterdam, Netherlands. This content represents the views of the author. It was submitted and edited under Pensions & Investments guidelines, but is not a product of P&I's editorial team.