Understanding ESG investing
How to help clients navigate the complexities of responsible investments
There is no question that the awareness of, and demand for, responsible investing – which aims to incorporate environmental, social and governance factors into investment decisions to manage risk and generate long-term sustainable returns – is on the rise across the UK.
And within the intermediary space, sustainable investment products and solutions are increasingly on the agenda for advisers' clients.
Advisers must keep up to date with the changing tides to mitigate risks, maximise returns and meet their client’s objectives.
But just how far has the industry come? Is ESG-focused investing still considered a "niche"?
What are the risks of ESG-focused investing? And how can advisers help their clients understand and navigate the role of ESG in their portfolios?
Finally, what can Brexit teach advisers about the demand for ESG strategies?
Read on to find out more about how to help clients prepare for the future of ESG-focused investing.
One third of advisers would never consider ESG funds
The financial advice industry is greatly divided in its approach about whether to consider ethical, sustainable and governance funds for its clients, according to the latest FTAdviser Talking Point poll.
The poll asked advisers the following question: “How likely are you to consider ESG funds for your clients?”
The results were mixed: 22 per cent of respondents said they are likely to recommend them and 44 per cent said it depends on the type of client they are dealing with.
But more than one third (34 per cent) of advisers said they are likely to never consider ESG funds for their clients.
Ricky Chan, chartered financial planner and director at IFS Wealth and Pensions was surprised that 34 per cent of respondents said they would never consider them.
He said: “In my humble experience, if you educate clients and have a genuine discussion about what ESG funds can do, then you often find that clients hadn’t realised that this was an investment option and so they become quite open to the idea.”
Julia Dreblow, founding director of SRI services and Fund EcoMarket, said: “I know opinions on environmental and social issues vary, but this implies that one in three advisers would overrule their clients' wishes - which is particularly terrifying at a time when the rest of the investment industry is heading the opposite direction.”
Mitch Reznick, head of sustainable fixed income at Hermes Investment Management, attributed the low proportion of advisers wanting to consider ESG funds due to a lack of acceptance of ESG integration.
He said: “The numbers are picking up that the market acceptance of ESG integration is not yet uniformly deep on a global basis, and also the existence of a small minority of sceptics who are reluctant to accept that ESG integration is inexorably linked to delivering superior risk-adjusted returns.”
Last month, the Baillie Gifford Positive Change fund warned that lack of standardised reporting methods from ESG funds means companies are able to appear in practice ESG compliant without running in line with any ESG principles.
This practice of trying to artificially appear ESG compliant is known as “greenwashing”.
Mr Chan said there should be a universally accepted minimum standard that applies to ESG funds as the criteria and investment processes vary widely.
He added: “By doing this, we can have more confidence that they are all genuinely trying to make a positive contribution to society, rather than some simply paying lip service.”
CPD: What you need to know about ESG investing
Words: Dave Baxter
When voters headed to polling stations for the European elections in May, many in the UK viewed the outcome as a verdict on one issue that has proved difficult to avoid in the nation’s recent history.
The twists and turns of the Brexit process have dominated UK politics and even had a major influence on how sterling-based investment portfolios have performed since the fateful vote that took place in June 2016.
In this context, it was no surprise that the UK’s results in the vote were seen as a reflection of people’s Brexit views.
Those backing the Brexit party were viewed as being firmly behind a departure from the EU, while supporters of candidates for the Liberal Democrats and Greens were perceived as opposing the departure, or at least backing a softer option than a no-deal Brexit.
This is an issue that is unlikely to go away soon, and should dominate current affairs in the short and medium term at the very least.
However, advisers mulling over the latest Brexit developments would also do well to consider other lasting effects the elections could have on client portfolios and their own businesses.
With clients focusing more on the causes that matter to them over recent years, advisers have increasingly had to adapt to this
While the UK’s contribution to the European elections was mainly viewed through the prism of Brexit, the result here and more broadly across the EU could provide a major boost for another part of the retail investment space.
Environmental, social and corporate governance portfolios, and other investment offerings shaped around client beliefs such as ethical funds, have long been the focus of growing demand.
With clients focusing more on the causes that matter to them over recent years, advisers have increasingly had to adapt to this.
There have been signs of this demand feeding through into provider behaviour. Asset managers increasingly offer the likes of ESG and ethical funds.
Meanwhile DFMs, who still run much of the client money placed with intermediaries, have expanded into this space.
Data from FTAdviser sister publication Asset Allocator, which covers the wealth management industry, found that even in the model portfolio space, which is less able to accommodate clients’ individual leanings than bespoke portfolios, a third of the wealth firms covered by the title now run portfolios with an ethical or sustainable slant.
Client preferences have even captured the attention of the regulator. FCA chief executive Andrew Bailey used a speech last year to highlight two areas of industry growth: passive funds and the likes of ethical portfolios.
However, ESG still faces plenty of barriers.
A good number of investment professionals still write it off as a gimmick rather than a dependable way of running a portfolio, while others question how ESG-oriented portfolios, which have only come about relatively recently, will fare the next time markets suffer a severe downturn.
Meanwhile there is little convincing evidence that portfolios oriented around client values have managed to amass much in assets.
As one example ethical products, which have been around for longer than ESG products, represented only 1.5 per cent of the overall assets in funds within the UK at the end of April.
Investment Association figures show that represents only a small rise in market share from the 1.2 per cent figure recorded in 2009.
All that said, the European elections offer fresh hope for ESG advocates on two fronts.
Firstly, the UK’s Green Party made convincing inroads, increasing their share of the vote to around 12 per cent.
For the intermediary space, this is a sign that there is real demand for ESG strategies and that they should adapt if they wish to attract and keep clients in future.
This may mean that ESG metrics come high up in the agenda of investment discussions, with advisers raising it rather than waiting for clients to do so.
The same message comes from the wider results: the Greens came in second place in Germany and Finland, and ranked third in France and Luxembourg.
A more important development came in the form of voting arithmetic.
The Greens’ voting bloc made gains, taking 75 of the 751 seats in the European Parliament.
While this still only gives them around a tenth of the overall votes, the fact that the parliament’s centre-right and centre-left groups lost a combined majority has given the Greens, combined with Liberal MEPs, much greater influence than they previously might have had.
This means that advocates of greener policies may well have greater leverage, further influencing EU policy.
There is a strong argument that advisers should at least consider a greater ESG focus when it comes to every client portfolio
This could include doubling down on the EU’s climate change targets. There are already signs this could happen, with a leaked draft of the EU’s strategic agenda for the next five-year period appearing to put a greater emphasis on countering climate change.
With Britain still likely to leave the EU in the coming years, such policy may not directly feed into UK law.
But fresh action on this front will both embolden those who care about ESG issues and threaten to have a greater impact on portfolios.
If future laws and regulations penalise companies which act in an environmentally harmful way, for example, those businesses could see a dent in their bottom line and their share price.
And with compliant businesses potentially due a lift in share price, ESG funds and portfolios could receive a boost.
As such, there is a strong argument that advisers should at least consider a greater ESG focus when it comes to every client portfolio.
It could come to have a greater effect not just on investment returns, but also on client attitudes as the people seeking advice change.
Incorporating values into investment strategies, whether on governance, the environment or broader ethical considerations, has so far proved more important for younger investors than the generations before them.
In Schroders’ 2018 Global Investor Survey, 76 per cent of respondents said sustainable investing had become more important to them in the last five years.
But the same research also found that those aged between 18 and 44 were significantly more likely than those aged 65 or older to frequently consider their carbon footprint, for example.
For now, younger investors tend to be regarded as the preserve of robo-advice firms and investment platforms, because it often proves commercially unviable for advisers or DFMs to deal with a client lacking in significant assets.
But as advisers’ current clients grow older and younger generations amass more wealth, firms will increasingly have to deal with demands for a more ESG-minded approach.
None of this is to say that ESG is not without its risks, even if there are benefits beyond keeping clients happy.
Intermediaries should closely scrutinise the funds or DFM portfolios they are using to avoid this pitfall
Hermes, a fund firm with a focus on ESG, has long argued that companies with good governance can bring about positive changes that boost business performance.
And with issues such as sustainability becoming increasingly mainstream, it has become essential for companies to pay them attention in order to survive in the longer term.
At the same time, fears that ethical and ESG approaches would force investors to avoid the best performing stocks and miss out on strong returns have long since been dismissed by many in the investment industry.
But there are still drawbacks. For one, terms like ESG are often confused with other, separate causes, such as ethical investing.
Intermediaries unfamiliar with these areas will need to carry out due diligence on what will or will not satisfy client needs.
There are also issues around so-called "greenwashing", where companies boast their environmental credentials without this translating into action.
Intermediaries should closely scrutinise the funds or DFM portfolios they are using to avoid this pitfall.
Finally, any intermediaries taking an ESG approach should make clients aware of more specific hazards.
As noted earlier, one risk comes in the form of how new ESG products are: nobody is certain how they will perform, come the next serious market downturn.
As with any investment, advisers need to carefully manage client expectations around risk and communicate with them regularly during difficult times.
The risks of quality
A more granular risk comes in a bias that can occur in ESG portfolios.
Because companies with strong credentials in areas such as governance are often those with the resources to invest in these areas, companies that make it into ESG portfolios often come with a "quality" factor.
So-called "quality" names, or dependable companies with strong balance sheets and reliable revenue sources, have performed extremely well since the financial crash, in part because of investor caution and low interest rates.
But this success means many such names now look expensively valued in stock markets.
Intermediaries should at least be aware of the ESG products and investment services on offer, given that client demand is only likely to lean further in this direction
And with the price gap between "quality" and beaten-up "value" names now at its greatest ever, some fear that a change in market conditions – such as an eventual rise in interest rates – could mean value names perform well while quality stocks could suffer major losses.
Hermes research published in 2016 found that while stocks with good ESG ratings tended to outperform their peers, they could struggle at times of a shift in market dynamics.
“The periods in which poorly governed companies have outperformed have tended to correspond to those periods in which cheap firms have also outperformed – the junk rallies of October 2015 and March 2016, for example,” Lewis Grant, a fund manager at the firm said at the time.
Advisers will therefore once more have to manage expectations, but also look for funds or investment managers who can attempt to mitigate this risk, possibly by introducing a “value” element into the mix.
But with ESG requirements likely excluding some value names, such as miners, this may be easier said than done.
As such, intermediaries should at least be aware of the ESG products and investment services on offer, given that client demand is only likely to lean further in this direction.
This might mean familiarising themselves with ESG-focused asset managers and DFMs, as well as working out what issues clients tend to focus on.
But as with any popular investment approach, advisers should also make sure they, and their clients, understand the risks as well as the advantages.
House View: Why ESG matters in value investing
As value investors, we have long taken environmental, social and governance considerations into account when investing in stocks.
After all, it is our job to weigh up risk and reward and we can only do this competently if we consider all of the potential risks around any investment we might make.
ESG is clearly a hot topic in finance at the moment but there are different ways of looking at it.
For example, lots of people tend to focus predominantly on the E, or environmental side, of ESG.
When thinking about that, people tend to be drawn to businesses like wind farms or start-ups offering new battery technology.
The problem with this focus on the environmental side is that it often leads you towards small, microcap, new technology businesses.
This can introduce some significant, and unwanted, style biases into your portfolios.
Instead, we believe it is worthwhile thinking about the whole of ESG in its
The E for environment is important, but so is the social (S) and the governance (G) side.
In the social aspect, we think of the stakeholders. These would be the suppliers to the business, the customers, all the staff, and the regulators it deals with.
It is every relationship that a company will have with the entire value chain and these relationships are of crucial importance when thinking about the sustainability of a company’s profit margins, for example.
If a business is paying too low a tax rate, underpaying its staff, or
squeezing its suppliers, then fundamental economics suggests that the associated risks increase.
So to us, the stakeholders/social part of ESG is an extraordinarily important and all-encompassing risk to consider when thinking about companies to invest in.
The governance side is equally important because it examines how a company is managed.
Questions we ask here would be: are there appropriate staff on the board? Are there appropriate checks and balances? Is there an appropriate incentive structure?
Ultimately, we need to consider whether the management team is capable of running the business in the best interest of shareholders.
Of course, as active shareholders, these governance questions are an extraordinarily important part of an investment case for us.
If we do not believe a company is acting in the interests of long-term
shareholders, we will do all we can to actively engage company management to protect and grow our investment.
Thinking about ESG is fundamentally important to all of our investment decisions and it is a theme that fits in with the value style of investing.
Ethical investing is often about trying to achieve long-term change.
This chimes with our approach, as investors need to take a long-term view in order to access the best possible returns from a value investment style.
Ultimately, value investing is about buying cheap stocks where we think the potential reward is greater than the risks.
In analysing the risk part of that trade-off, we will take into account anything that helps us reach the most considered conclusions, and ESG is a crucial part of that.
Kevin Murphy is a fund manager at Schroders