Interest in environmental, social and governance (ESG) investing continues to grow as increasing numbers of investors seek to balance financial goals with their personal values.
The growing popularity of ESG investing is reflected in the assets that global sustainable funds have attracted, with flows topping $134 billion in the third quarter of 20211. The latest Morningstar report on sustainable investing found that over 6,147 sustainable fund and ETF products are available in Europe as product issuers continue to cater to client demand.
But as awareness around sustainable investing has grown—and the range of ESG funds in the market has proliferated—so too has the confusion. Many investors want to know what options are available to help them align their investments with their values – particularly as ESG risks and opportunities can mean different things to different people.
There are a number of different ways to approach ESG investing, including exclusionary portfolio screening (which excludes companies based on their products or business activities), inclusionary portfolio screening (which invests in companies or sectors based on ESG criteria) and impact investing (targeted investments with the dual objective of generating some financial return in addition to some positive environmental or social impact).
There are other approaches that an investment firm can implement across all types of funds such as stewardship (the responsible allocation, management and oversight of capital to create long-term value for clients and beneficiaries, leading to sustainable benefits for the economy, the environment and society2) and ESG integration (systematic inclusion of material ESG information in investment analysis and decision making).
The rapidly evolving landscape of ESG investing is having a profound impact on how advisers are thinking about it for clients. No longer the preoccupation of a committed few, the momentum behind ESG investing has been building in recent years.
We recognise that some investors will want products which incorporate ESG considerations to different degrees. At Vanguard, we currently incorporate ESG considerations into our product design and investment processes in a number of ways, which we categorise as “engage”, “allocate” and “avoid”.
Engage - As long-term owners of the companies in which our funds invest, we engage with companies on material ESG issues as we believe they can impact long-term value creation at those companies.
Allocate - Many of our active funds aim to allocate capital to companies based on how they manage ESG considerations, alongside other factors, when selecting investments – even where they don’t have an explicit ESG investment strategy. For example, they may consider how social and environmental factors might affect a company’s future earnings.
Avoid - We develop products that allow investors to avoid exposure to companies that are not aligned with their values, or to mitigate certain ESG risks.
These approaches are not mutually exclusive and portfolios could simultaneously apply more than one given that there are multiple ways to adopt an ESG approach to investing.
Our investment stewardship activities are the main way we can address material ESG issues within our broad-based equity index funds. We engage with the portfolio companies in our funds to promote effective company governance and encourage long-term value for investors.
Our dialogue with the management and boards of companies is a year-round process that goes beyond proxy voting at a company’s annual meeting. We represent the interests of our fund shareholders through public advocacy and ongoing engagement and dialogue with companies to understand their governance practices and long-term strategy. Vanguard expects companies to disclose significant risks to shareholders, such as its carbon emissions; set a goal and strategy for mitigating those risks; and report on progress.
We also recognise that some investors don’t want exposure to certain ESG risks or want to avoid companies that don’t align with their values. Vanguard currently offers several exclusionary ESG products across equity and fixed income that help investors to avoid certain ESG risks. These products use transparent exclusion measures to remove certain companies from the investment universe based upon ESG screening criteria.
Vanguard assesses ESG risks and opportunities in the context of their potential to affect long-term value for shareholders in our funds. We look to the managers of our active funds to assess companies’ ESG risks, even when a strategy does not have an explicit ESG objective. Incorporating ESG risk into security selection for active funds does not preclude the fund from investing in certain companies or sectors because of their business activities. Rather, it ensures ESG risks and opportunities are considered alongside other factors when selecting investments. Our approach differs for internally managed active funds and those managed externally.
ESG risk assessment is a core element of Vanguard Fixed Income Group’s bottom-up financial analysis for potential investments. Our team quantifies the financial materiality of ESG risk and assesses whether a security’s current valuation properly reflects that risk. Specifically, investments are assigned a proprietary ESG risk rating based on the probability and impact of an ESG event. Portfolio managers use these ratings, combined with other factors, as they allocate investor capital to the investments with the best return prospects.
This integration into our processes provides investors with more complete information for decision making, enabling them to allocate capital to companies that are best managing ESG risks and capturing ESG opportunities.
Most of Vanguard’s active equity and multi-asset funds are managed by external firms. This approach provides us with diversity of thought and broader access to top talent. Each firm has its own philosophy and process, and most consider ESG factors when selecting securities. We recognise that each manager is likely to have its own distinct approach for integrating ESG considerations into its research and decision-making. Many of our managers’ teams of analysts regularly consider how social and environmental factors might affect a company’s future earnings. Some use quantitative scoring models to screen their universe, while others leverage their in-depth engagements with management.
Additionally, our external managers have full proxy voting responsibilities for the portions of the funds they manage, enabling them to integrate their proxy voting activities and company engagements with their specific investment strategies.
The most important consideration in selecting an approach is likely to be unique to each investor. There is no one-size-fits-all approach and the importance of goals, balance, cost and discipline will remain key to building a portfolio. As we go into 2022, Vanguard will continue to evaluate ESG products while maintaining our considered approach to product development.
1 Source: Morningstar, Global Sustainable Fund Flows: Q3 2021 in Review. October 2021
2 Source: Financial Reporting Council. The UK Stewardship Code 2020.
Investment Risk Information
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Vanguard Group (Ireland) Limited has implemented the EU Sustainable Finance Disclosure Regulation (EU) 2019/2088 (“EU SFDR”), as appropriate. Vanguard has introduced an internal product classification framework that helps to identify whether certain Vanguard funds promote, among other characteristics, environmental and/or social characteristics, or whether a fund has sustainable investment as its objective. Vanguard also considers the degree to which sustainability risks are integrated into the investment decision making process. Statements explaining Vanguard’s approach to the integration of sustainability risk, including into its remuneration policy and a transition statement to support the consideration of Principal Adverse Indicators (this is the impact of its investment decisions on sustainability factors, commonly referred to PAI), will be available on the policy page of Vanguard’s global website.
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