What does sustainable investing actually mean?

More of us are adjusting our lifestyles to consider our moral principles or concerns about the environment; in fact, over 60s care more about environmental issues and are far better at recycling than younger generations. 

That trend is now extending into how we invest our money: interest in ‘sustainable investing’ has soared in recent years, and according to a report from Morgan Stanley, 77% of individual investors are now interested in placing their money in businesses that are delivering either a positive social or environmental outcome. 

This could be businesses that are actively involved in areas such as decarbonisation or tackling climate change, as well as those firms that demonstrate high levels of social responsibility. 

In hard figures, more than £5 billion was put into sustainable investment funds in 2022 – so whether you’re an established investor, or dipping your toe into the stock market for the first time, sustainable investing could be an option to marry your ethical values without compromising on returns. 

What is sustainable investing? 

Sustainable investing can broadly be explained as investments that take environmental, social and governance issues into account – often referred to as ESG. You might also hear about some investments referred to as responsible funds or impact investing funds. 

Investing in a fund made up of shares in multiple companies can reduce the risk investors face by increasing diversification.  

This can mean a lower chance of sharp swings in price, as it is less likely that all the shares in the fund will lose value at the same time. By contrast, a portfolio you’ve made yourself, composed of just a few different shares, will be riskier. 

“ESG investing can mean investing in businesses that follow specific environmental standards or are registered as a B-Corporate, for example, and have committed to being a sustainable business environmentally and socially,” explains Ed Crowther, Founder of My Square Metre, a consultancy that helps businesses manage their carbon footprints. 

“The area has grown significantly over recent years with numerous new funds starting up and more banks and funds switching to sustainable investing.”

However Ben Yearsley, Investment Consultant at Fairview Investing, points out there's currently a big issue with trying to put your money into ESG-focused companies: “The problem with sustainable investing is that there is no real standard definition.” 

As a result, some companies can easily engage in ‘greenwashing’, where they make small gestures towards things like lowering a carbon footprint and then claim to be sustainable. This means you’ll need to do your research to establish if the companies you’re investing in match with your own definition of sustainability. 

To tackle this problem, City regulator the Financial Conduct Authority (FCA) has announced a scheme that applies one of four labels to investment funds, indicating how they approach their sustainability goals. This is due to come into effect in July 2024. 

In the meantime, the onus is very much on investors to get to know their chosen investments before they part with their cash. 

As a rough guide, funds now will typically fall into one of three categories: 

• Positive screening: investing in companies that are having a positive impact on society or the environment, for example through renewable energy or having a best-in-class employment policy.
• Negative screening: excluding companies that are considered to have a damaging impact on society or the environment, for example oil exploration, arms, gambling, tobacco or child labour.
• Engagement: here funds invest in businesses with a view to using their powers as shareholders to improve their policies and work practices. 

Even when the labels do come into use, sustainable investing is still a highly subjective area. One person's environmental or ethical priorities will invariably be different to the next, so use the guidance as a starting point for your research.

This is especially important as only 70% of the companies in a fund will need to meet the criteria (although funds will need to disclose what the other 30% of investments are made of).

What impact can sustainable investing have on returns? 

Historically there’s been a belief that sustainable or ethical funds lag behind their rivals because they were more limited in terms of where they can invest, or they may require higher costs to implement good ESG practices. 

While any investment in the stock market is not guaranteed to bring positive returns, the mindset that ESG funds can be limiting is shifting. 

“It may have been the case in the past that sustainability meant settling for lower growth because it was so prescriptive,” says Yearsley.  

“But today, possibly the opposite is true. The thing to bear in mind is that companies that score well on ESG criteria tend to be growth stocks.” 

There’s also the argument that businesses that score well for sustainability are more resilient and better placed to manage risks like climate change or regulatory changes.  

Crowther adds: “Sustainability can also mean more stable returns because of lower internal staff turnover and better relationships with suppliers, especially international ones – so there is a lower chance of nasty surprises like key suppliers going bust.” 

Whether sustainable, or ESG, investing offers better returns than its ‘normal’ counterpart is tricky to demonstrate – it can depend on how the investor or analyst defines sustainability in companies or funds. 

For instance, Morningstar research in 2022 showed investments that took ESG into account were more likely to outperform those that didn’t over five-year periods. 

In 2023, research from the Morgan Stanley Institute for Sustainable Investing also found that, globally, sustainable funds delivered close to 50% more than traditional investment funds, on average. 

However, ESG investment performance has been far from immune to market conditions, so it’s important to consider your priorities when it comes to deciding where to invest your money, and take professional advice if you’re unsure. 

How to invest sustainably 

It’s easier than ever to buy shares in specific companies that meet your own sustainability criteria. Most listed businesses now publish detailed information in their annual reports about their ESG credentials and goals, allowing you to do your own research on their claims. 

Investment companies also publish information about the strategies and goals of each fund, as well as details of the shares held.  

The previously-mentioned FCA’s labelling scheme should also help investors make informed decisions when it comes into effect later this year, as well as help companies improve their practices and make it clearer how they’re increasing their sustainability. 

Furthermore, if you invest through an online platform, they’ll often provide novice investors with lots of information about sustainable investing and include lists of recommended sustainable funds.  

If you're unsure where to start or want to invest larger amounts sustainably – whether in a stocks and shares ISA or a pension – it makes sense to get professional advice to help you understand what practices a company is undertaking.