Much has been made of the boom in ethical investing as investors favour active and passive funds that exclude harmful sectors. Less considered is a more important trend: gaining exposure to companies with high Environmental, Social and Governance (ESG) ratings.
The media sometimes confuses ethical investing and ESG criteria. Ethical funds avoid harmful sectors, such as tobacco, weapons or fossil fuels. ESG, a more holistic approach, integrates ESG principles into portfolio decisions. ESG investing may not exclude harmful sectors. 
A fund that adopts ESG principles might invest in a coal company that is well governed and manages its environmental footprint. Most ethical funds exclude the fossil-fuel sector and have much stricter investment parameters than ESG-driven funds. 
ESG is a growing issue for institutional investors. About $557 billion in Australian assets under management is invested through broad responsible investment (ESG) strategies, according to the 2017 Responsible Investment Benchmark Report from the Responsible Investment Association Australasia (RIAA). About $65 billion is in core responsible (ethical) funds.
An entire industry of data providers, analysts and intermediaries assessing the ESG performance of large companies has emerged. ASX 200 company boards, the good ones at least, have ESG high on their agenda and spend more time meeting fund managers about it. 
Why the fuss? Two reasons. First, superannuation funds and other institutional investors are responding to demands from members for their money to be invested responsibly. Younger investors see their investment capital as a force for social good.
Second, academic and market research consistently shows companies with higher ESG ratings outperform the market. So much so that some investment banks are producing detailed studies of ESG comparisons to identify investment opportunities.
Macquarie Group published such a report this week. The study analysed the ESG ratings of 229 ASX-listed stocks, covering 92 per cent of market capitalisation. Macquarie found companies with higher ESG scores outperformed the market by 2.7 per cent annually since 2011. 
Also, high ESG ratings were a predictor of future company performance. It seems like a no-brainer that doing the right thing is good business, but it’s only been in the past few years that investment banks have started to move beyond financial data when assessing companies. 
Macquarie listed several companies that it rates highly on ESG criteria and that have favourable recommendations from its analysts. They included: Seek, Orora, Lend Lease Corporation, CSL, Qantas,, Challenger Dexus, GPT, RCR Tomlinson, Fortescue Metals Group, Amcor, AGL Energy, Charter Hall Group, BT Investment Management and Mantra Group.
Macquarie’s breakdown on ESG factors stood out. The G (governance) in ESG had the strongest relationship with firm performance – a reason why it pays to assess the quality of the organisation’s board before investing. Good governance is a driver of higher returns.
The S (social) in ESG is having greater effect on performance. Investors are showing more interest in the corporation’s human rights record, employee treatment and turnover, supply chain and its social licence to operate. Macquarie found higher social ratings were linked with higher performance in blue-chips, less so in small-caps, where this is not as big a focus.
The signal from the E in ESG is also strengthening as the market pays greater attention to blue-chips’ environment performance. Since 2011, Environmental leaders outperformed laggards by 23 per cent on a cumulative basis, Macquarie found. 
ESG, of course, is not failproof. A company with high ESG ratings can still be a dud investment. It’s possible some companies are focusing too much on non-financial issues, to boost their ESG ratings, at the expense of what matters most in valuations: corporate earnings.
But it’s clear that higher ESG ratings are, on balance, associated with outperforming companies, and vice versa. And that ESG deserves more consideration in investment decisions.
For all the benefits, gaining exposure to top-rated ESG companies is harder than it should be. Few active or passive funds for retail investors focus on ESG as their main criteria. More common is ethical managed funds or exchange-traded products that exclude sectors.
Russell Investment’s Australian Responsible Investments ETF is an option. It tracks a high dividend index that is weighted towards ASX-listed companies with higher ESG ratings, consistent with responsible investing parameters. The ETF has returned 13 per cent over one year to November 2017 and 11.1 per cent annualised over two years. 
Chart 1: Russell Investments Australian Responsible Investments ETFSource: The Bull
The Australian Governance Masters Index Fund is another option. The Listed Investment Company ranks governance in ASX 100 companies and invests in the best-governed ones. An annual management expense ratio of 19 basis points is competitive with most ETFs. 
The fund has a five-year annualised return of 11 per cent – an attractive outcome for long-term conservative investors who understand the effect of good governance in reducing investment risk, doing the right thing and ultimately enhancing firm performance.
Chart 2: Australian Governance Masters Index Fund
This is my last column for 2017. Many thanks to readers who commented and shared their investing insights this year. I wish you and your family and safe and happy holiday season. The column returns mid-January 2018.

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• Tony Featherstone is a former managing editor of BRW, Shares and Personal Investor magazines. The information in this article should not be considered personal advice. It has been prepared without considering your objectives, financial situation or needs. Before acting on information in this article you should consider the appropriateness and accuracy of the information, regarding your objectives, financial situation and needs. Do further research of your own and/or seek personal financial advice from a licensed adviser before making any financial or investment decisions based on this article. All prices and analysis at December 13, 2017.