TALKING ESG WITH CLIENTS
SUSTAINABILITY is topping the political agenda. Last year, we saw the UK become the first major economy in the world to legislate for net zero greenhouse gas emissions by 2050, for example. It’s also become a key priority for regulators. By October 2020, DC schemes will have to publish reports setting out how they implemented their policies on integrating sustainability risks in their investment decision-making process.¹
And sustainable investing has grown exponentially, with new funds coming to market at pace. According to Morningstar, there are now more than 2,405 sustainable funds domiciled in Europe, with 305 fund launches in 2018 and 360 last year. And the most recent figures show almost 170 launches in the first half of last year.²
Evidence would suggest, then, that sustainable investing is rapidly moving into the mainstream. Yet many financial advisers aren’t engaging with their clients on the topic, and it doesn’t form part of their standard review process. A recent poll of IFAs by FT Adviser found that that one-third of those surveyed would never consider ESG funds.
BUT THIS IS LIKELY TO CHANGE FOR TWO REASONS:
First, regulation. MiFID II and Insurance Distribution Directive amendments are planned which will make it mandatory for advisers to introduce ESG considerations into their suitability assessments. This will go beyond simply asking clients if they have any ethical considerations. Under current proposals, advisers will have to determine and document clients’ ESG preferences and recommend investment products and services that are suitable on that basis ³.
Second, demand is coming from clients themselves. With news headlines unremittingly highlighting the big challenges we face - such as climate change, natural resource scarcity, inequality and modern slavery (to name just a few) - ensuring a sustainable future is front of mind.
Consumers are making sustainable choices every day, from avoiding single use plastics, picking local produce over air-freighted goods, to using public transport instead of cars. And they’re beginning to turn their attention to how their money is being used to impact the world around us. This trend is being influenced by Millennials, but numerous studies show that other generational groups are also showing an interest.
According to Schroders’ 2019 Global Investor Study of more than 25,000 people globally, 60% believe their individual investment choices can make a difference to building a more sustainable world. And a recent investor survey by Allianz showed 83% of UK-based respondents say they are very interested in sustainability in general and 70% say they would invest in funds with sustainability goals. But despite that, just 20% of investors have discussed the topic with their adviser, and only 26% say they had been offered a sustainable investment after raising the topic with their adviser ⁴.
REGULATORY DIRECTION OF TRAVEL FOR ADVISERS
Under MiFID II and IDD amendments, ESG preferences are defined as choices as to whether and how environmentally sustainable investments, social investments or good governance investments are integrated into a client’s investment strategy. Advisers will have to take each client’s ESG preferences into account when explaining how their investment objectives are met. This will apply to both new and existing clients, but for the latter ESG preferences can be determined as part of the ongoing regular review process.
The FCA has indicated that it will be implementing these rules and making the required changes to COBS irrespective of Brexit. It is also worth noting that current European Securities and Markets Authority (ESMA) guidelines on suitability requirements, published in May 2019, already state that it is “good practice for firms to consider nonfinancial elements when gathering information on the client’s investment objectives and collect information on the client’s preferences on environmental, social and governance factors”.
PERCIEVED ESG PERFORMANCE TRADE-OFF?
The struggle to reconcile the perceived trade-off between performance and social and environmental impact is often cited as a barrier for advisers. However, there is growing body of research showing there is a positive link between material ESG considerations and a company’s financial performance - investing in companies built for the future naturally promotes sustainable long-term returns. Indeed, recent research found 41 of the 56 (73%) Morningstar ESG indices have outperformed their non-ESG equivalents since their inception ⁵. Interactive investor analysis revealed that funds taking ESG factors into account have performed better than their non-ESG sister funds ⁵. So an ESG strategy is not the deterrent to performance as may once have been thought.
So why are advisers not more regularly considering ESG in their financial planning recommendations?
PROLIFERATION OF FUNDS AND APPROACHES?
There are now more than 700 sustainable funds in the UK alone, according to Morningstar, and the sheer proliferation of different approaches being taken can make it difficult to work out exactly the positions that different funds might take. And, more importantly, whether that aligns to a client’s objectives.
Some funds that describe themselves as ‘ethical’ may invest in companies that people wouldn’t immediately think of as such. That could be because their approach is not to exclude companies with poor practices, but to use their shareholdings to try and influence them to change for the better – hoping to improve their financial performance over the longer-term.
Advisers are also wary of ‘greenwashing’. This is where a group aims to capture some of the interest and inflows by badging a fund as ‘sustainable’ to appear more serious about ESG than they might actually be.
Vanguard dropped nearly 30 stocks from two of its high-profile ESG funds as it was hit by reports that they were not actually ESG-friendly ⁶. A recent report from wealth manager SCM Direct found widespread examples of “misclassification and mis-selling” of ethical investments ⁷. And results from FCA diagnostic work to gauge whether there is evidence of greenwashing, showed that “the ‘sustainable’ label is applied to a very wide range of products where, on the face of it, some of these do not appear to have materially different exposures to products that do not have such a label” ⁸.
The regulator has said it will challenge firms where it sees potential greenwashing, and will take appropriate action to prevent consumers being misled. But the onus is currently on advisers to dig into what the fund manager is actually doing to incorporate ESG into portfolio selection.
CONFUSING TERMINOLOGY? BUT HELP IS ON THE WAY
The industry has been dogged with a confusing array of terminology for sustainable investment approaches that has been used interchangeably. This lack of consistency in the way groups ‘label’ their funds has made it hard for advisers to compare like-with-like.
But help is on its way. The Investment Association (IA) has launched an industry-wide common language for responsible investment with definitions and a framework for fund categorisation which is a major step forward towards bringing clarity and consistency. More than 40 investment management firms, representing £5trn of assets, took part in this consultation on the framework.
UNDERSTANDING THE LINGO
An important first step towards making an informed sustainable investment choice is understanding the language that is used. These definitions have been developed by the Investment Association as an industry-wide common language for responsible investment and a framework for fund categorisation.
Stewardship is 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 society.
The systematic and explicit inclusion of material ESG factors into investment analysis and investment decisions. ESG is an acronym for the three factors which are ‘Environmental’, ‘Social’ and ‘Governance’.
Exclusions prohibit certain investments from a firm, fund or portfolio. Exclusions may be applied on a variety of issues, including to align with client expectations. They may be applied at the level of sector; business activity, products or revenue stream; a company; or jurisdictions/countries. One common form of an exclusionary approach is Ethical Investing, where companies that don’t conform to the personal values of the customer / investor base are excluded.
Investment approaches that select and include investments on the basis of their fulfilling certain sustainability criteria and/or delivering on specific and measurable sustainability outcome(s). Investments are chosen on the basis of their economic activities (what they produce/what services they deliver) and on their business conduct (how they deliver their products and services).
Investments made with the intention to generate positive, measurable social and environmental impact alongside a financial return.
The IA is currently exploring a new UK fund label to help people make informed decisions and will be asking its members to identify which funds should be classified as having responsible investment characteristics. It will publish statistics on these funds later this year.
Pressure is also mounting on investment managers to provide easy-to-understand and straightforward data, and for information providers to adapt their databases to include additional fields.
LIMITED PASSIVE OPTIONS?
Most ESG funds on offer are actively managed. Some cost-conscious advisers only work with passive funds, so their sustainable options are reduced. However, new passive offerings are on the increase, with 49 new sustainable index funds coming to market in Europe in 2019, according to Morningstar’s European Sustainable Funds Landscape. In the fourth quarter of last year, passive sustainable funds accounted for 27% of total flows and currently represent 21% of European sustainable fund assets. The S&P Dow Jones and MSCI each launched a range of ESG indices in 2019 too.
HOW TO TALK ESG
Advisers need to work out what sustainability means to them – perhaps even develop an ‘elevator pitch’ and use terminology that resonates to ensure they come across authentically when talking on the topic. Those who don't believe ESG factors should be part of a client’s portfolio should back this belief with statistics or other evidence of why ESG should be excluded.
The first step is to understand where clients stand on the topic of sustainable investing. Some may already be knowledgeable and know exactly what they want but others may need advice about whether to take this approach at all. This is where advisers can showcase their value-add.
It may be a good idea to spend time exploring what’s motivating a client’s interests and educating them about the range of possibilities and how they could fit in with their longer-term investment needs. Advisers may want to think about a client’s key objective to narrow the focus and shape priorities. Is it:
- Avoiding or reducing ESG risks?
- Generating higher investment returns?
- Seeking a measurable impact?
It may, of course, be a combination of all three. In some cases, a single fund may not cater for all of their needs. However, multiple ESG strategies can be combined in a single investment vehicle.
Advisers will need to select the degree to which they integrate ESG into a client’s portfolio and will likely need to optimise ESG investment opportunities across a range of asset classes and the risk spectrum. But they’ll also need to assess the broader asset allocation to ensure it is properly balanced, avoiding introducing sector or style biases.
THE BENEFITS OF DISCUSSING ESG WITH CLIENTS
Interest in sustainability is an opportunity to attract and retain clients, especially women and the younger generation, where demand is reportedly the greatest. Although, as has already been covered, interest is growing among most generational groups.
It can also be a more interesting conversation to have with clients. Rather than being performance-focused, discussions can shift to what impact clients want to have with their investments: what sort of legacy they want to leave, how they’re impacting their community, the positive change on lives or the planet that their investments are able to provide. These deeper conversations can lead to more robust, ‘stickier’ relationships.
Advisers who choose to build a specialty in this area may increasingly find themselves at a competitive advantage.