Environmental, social, and governance: three factors that have become the focus of attention in the investment world. But where is the investment industry when it comes to incorporating the ESG factors into client portfolios?
“What we’re seeing at Natixis is that there’s a big disconnect between clients and advisers when it comes to ESG,” summarized Dave Goodsell, Executive Director of the Natixis Center for Investor Insight. “Eight in ten investors tell us that they want their assets to align with their personal values, yet only 9% of the advisers we spoke with in the U.S. this year said their clients are invested in ESG.”
Goodsell was speaking on December 2020 webinar sponsored by the Active Managers Council titled, “Getting Proactive on ESG: How Advisers Can Lead the Discussion with Clients.”
“There are so many different strategies, it’s hard to know which approach works for which clients and which needs,” Goodsell noted, kicking off a lively panel discussion on ESG implementation in wealth management practices.
The panel featured ESG experts Maria Lernerman, Consumer Discretionary and ESG Analyst at Harding Loevner, Mason Gregory. Senior Analyst for ESG and Sustainable Investing at MFS Solutions Group, and Jennifer Wu, Global Head of Sustainable investing at JP Morgan Asset Management.
The speakers explained how advisers can help their clients achieve “values alignment” in their investors. Here are their 5 top tips:
- Define the client’s goals
“The starting point should be, ‘What’s the intent?” stressed Jennifer Wu. “If the client is solely focused on financial returns, the best approach is ESG integrated,” which considers environmental, social and governance factors only if they are likely to affect company performance or security valuations.
On the other hand, “if the client’s intention is to go above and beyond financial return and pursue some social outcome,” they might consider other approaches, Wu continued. They could exclude companies with problematic practices from the portfolio, focus on a theme or industry that promotes positive environmental or social outcomes, or invest only in companies that are highly rated by ESG ratings services.
- Set expectations for returns
Another important consideration is the expectations for returns.
Almost half of the investors that Natixis surveyed want to make a values alignment, but not at the cost of return, noted Dave Goodsell. “So in our view, it’s a good thing its not an either-or choice, but it does mean some extra consideration when you’re selecting a strategy.”
Integrating ESG factors into a return-focused investment process can add long-term value for clients. “We have to understand the various risk and opportunities that companies face, and ESG is a huge part of that,” noted Mason Gregory. “ESG factors are extrafinancial externalities; however, they often impact the balance sheet over the course of the investment period.”
On the other hand, Jennifer Wu cautioned, “the more you shrink your investment universe, the higher the volatility, and there could be a return trade-off.” Investors will need to consider whether they are comfortable with that trade-off if they’re interested in exclusionary, thematic or other social outcome-oriented approaches.
- Understand the limitations of ESG ratings
The speakers cautioned against relying exclusively on ratings from ESG ratings services for implementing a values alignment for clients. While these ratings are a good starting point, they have significant limitations. As a result, passive approaches to ESG investing, which rely almost exclusively on these ratings for security selection, have those same limitations.
One major concern is that ESG ratings are backward looking. “Those ratings reflect past behavior,” explained Mason Gregory, and may not be a good indicator of future potential.
The ratings are also highly dependent on data availability, and “the data is a work in progress,” added Gregory. Larger companies tend to have better ESG ratings, simply because they disclose more data, noted Jennifer Wu, and “companies don’t have an incentive to disclose data that could work against them.”
- Take an active, future-oriented approach
Instead of dwelling on the past, investors need to think about “who will be in the winners in the future?” continued Wu.
That means having a thorough understanding of the company and its competitive position in its industry, explained Maria Lernerman, noting that active management is well-positioned to do this. By incorporating an analysis of ESG risks and opportunities into the analysis of other risks and opportunities, active managers can identify undervalued investments with potential for higher returns.
In short, Lernerman concluded, ESG investing is “inherently a better fit for active management.”
- Research the manager
Finding the right ESG manager is the final step in the process of values alignment. Doing some homework here is critical, agreed the panelists. Some funds are talking about ESG more than is “warranted by process and structure,” warned Maria Lernerman.
Advisers should ask “detailed questions about how they approach sustainable investing,” advised Mason Gregory. For example, are they a signatory to the PRI (Principles of Responsible Investing)? What ESG risks are they paying attention to? How are they engaging with companies on ESG issues?
“Dig deeper,” urged Maria Lernerman.
Interested in learning more about how advisers can help clients align their investments with their values? Listen to the complete recording of the webinar, which is available on the Investment Adviser Association’s YouTube channel.