Implementing ESG into your advice process
With increasing investor demand for ESG solutions, the importance and impact ESG considerations are having on portfolio construction is also increasing. As advice practices work through the many considerations to offering this solution to their clients, one of the most pertinent to ongoing success, is how to implement a tailored approach to a client’s individual ethical considerations in a scalable and efficient manner.
It wasn’t that long ago that ethical investing was a niche advice segment, serviced by a group of specialist financial planners. Now, and for the foreseeable future, there isn’t a conference or PD Day that doesn’t contain some focus on ESG. There is significant content dedicated to the specialist investment options available and how mainstream managers already include ESG strategies in their current investment philosophy and portfolio management. There is also increased demand from investors seeking more advice, transparency, and investment options to cater to, and achieve, their unique ESG preferences. Investors have moved way beyond deciding to invest all or part of a portfolio in an ethically-focused investment vehicle, with increased awareness and access to digital information, they are making far more detailed and specific demands to ensure their personal ESG beliefs are catered for.
It’s a trend we are seeing worldwide, driven by the societal demands for increased social governance. Bloomberg Intelligence quote that ESG assets are on track to reach $53 trillion by the end of 2021 and will attract 13% of all ETF asset growth, estimated at $190bn invested via ESG ETF’s. Significant growth but not surprising when you consider the corporate sector is actively promoting strong ESG governance, in part because its good business sense and they are being propelled by legislators in their local jurisdictions to comply with more stringent governance requirements. As we look to a more sustainable future, we are also seeing the birth of new businesses and industries to meet the demands, driving new and increased investment opportunities.
While planners have always had a duty of care to their clients, the extent to how deeply they explored ESG at a client or investment level has been at their discretion. This is possibly why the sector was historically relatively small, there is still a large divide between those that actively focus on ESG and those that don’t, which is not surprising when you consider the complexity of the topic, lack of clarity around consistent principles and even terminology used in the sector. A number of industry whitepapers state that one of the barriers to this sector’s growth has in fact been this lack of education and inconsistent methodology. This is a complex area, requiring a significant amount of specialisation that would enable a business to strategically target this advice segment as a business model. Therefore, an advice business needs to make a determined choice about its investment philosophy, business strategy and subsequently how deeply ESG considerations will drive resources and focus during the advice process.
The financial planning sector, and in fact investors, have also been a little cynical about investment returns from ESG options, often viewing the reduced investable universe as having the potential to detrimentally impact performance. Many ethical investment managers have had to consistently overcome this initial objection before they were allowed the airtime to talk about their fund in detail. The performance impact argument now holds little validity as investment opportunities increase, and specialist managers have been able to build consistent long-term performance figures often outperforming mainstream managers.
Increased investment choice, availability and investor awareness of how their wealth decisions can positively affect change will continue to place ESG investing higher on the agenda for advisers. However, importantly we are also seeing legislators playing a part in forcing the advice sector to consider ESG strategies more actively when giving advice. The EU for example is implementing legislation that will require European advisers to actively consider ESG preferences during the advice process and then disclose how these preferences are utilised to choose a suitable investment strategy or investment option/s. Suitability and Best Interest has always played a key role in the advice process in Australia, regardless of legislative requirements, but the depth in which advisers will need to explore ESG preferences and adapt fact finding processes to understand and record them at a client level, is going to increase dramatically. Just how deeply legislation will play a part in driving ESG awareness at an advice level remains to be seen, but even without legislative drivers, financial planners will need to consider how they implement this advice component sooner rather than later. If for no other reason than to meet client demand and remain relevant to their clients and prospects.
Therefore, practice owners and financial planners will need to consider three core considerations:
1. Business and Advice Strategy
2. Investment Philosophy
3. Implementation Strategy
Business and Advice Strategy
As with every business the fundamental question, which anchors a business strategy is “who is our target customer and how do we serve them?”.
How specialist the advice service needs to be, will be predicated by the profile of the client base. If an advice firm is wanting to target ESG investors specifically, practice principals will be required to build and develop marketing, advice and business processes around this specialist segment. There is already a strong and experienced contingent of advice practices that are successfully catering to this sector, supported by industry associations such as Responsible Investment Association Australia. Any new entrants to this advice segment will need to build appropriate business and advice models to do the same and be competitive. However, as this article has discussed the future of ESG advice is no longer purely a specialisation business decision, allowing a do we or don’t we approach. Client demand and legislation is forcing each advice practice to consider how they will consider ESG filters, whether or not they specialise.
Successful businesses develop business strategies around solving client problems and this is just as important from an advice perspective. Therefore, as well as making a strategic business decision, practices will need to enhance their detailed awareness of their client base and specifically how important ESG considerations are to the client book in general and to each individual. By addressing this, the planning practice will be able to ensure they are offering the correct advice model, investment philosophy and ensure the investment solutions utilised match the needs of the client beyond growth and risk management.
This sounds simple but will require deeper thought into what type of questions to ask clients and whether that is through one-on-one engagement, the use of a client survey and/or education processes such as webinars and marketing materials. There is however a real opportunity to engage with clients, ensure they understand the questions they are being asked, what ESG investment considerations are prioritised and how you are considering addressing this advice need. To do nothing could lead to confusion, but importantly lead to a service gap that encourage competitor activity.
Investment Philosophy
Understanding, developing, and communicating a core investment philosophy offers several benefits. Robert Talevski, of Activus Investment Advisers points out that these include enhanced client engagement and clarity of proposition, which will allow a practice to create a strong foundation for strategy development. Importantly, a quality investment philosophy also allows a practice to outline clear criteria for asset manager selection.
In recent years we have seen an increase in advice practices developing an investment philosophy, to assist not only with asset manager selection but to reduce overall risk and help articulate how Best Interest Duty influences portfolio creation methodologies. Therefore, it is intuitive to consider that having an established investment philosophy will allow a practice to define and document a set of core beliefs and how these will be implemented to the benefit of clients. This is particularly important when an advice practice does not offer a specialist ESG advice model and when addressing ESG for the first time or in a more comprehensive manner. Implementing an investment philosophy will allow a business to integrate ESG investment considerations at a global model level much more easily, both from a model construction and an asset selection perspective. As these considerations increase, in line with ESG influences there will also be a framework to quickly and efficiently react and adapt as necessary.
Having ESG principles formally integrated and documented within a defined investment philosophy also allows an advice practice to easily articulate to their clients the process for incorporating ESG considerations within an individual’s portfolio and create a series of questions for the fact find process to help explore and understand the client’s individual ESG preferences. During discovery or review meetings the client can then decide, whether the principles in place align to their own set of beliefs
Implementation Strategy
Once an advice business has defined its business and advice model and developed a core investment philosophy, there will be greater clarity on how to implement ESG and the level of specialisation to offer clients. The industry has never been in a better position to provide options, at both an investment or technology level.
The amount of information available to assist practices in building investment models, that incorporate ESG principles and how to tailor them at an individual level is rapidly increasing. For example, we have seen Evergreen Consultants recently launch their Evergreen Responsible Investment Grading Index (ERIG), which is currently rating over 2000 managed funds and benchmarking them against a series of ESG filters. The industry has moved far beyond specialist managers offering access to ESG investment, with mainstream managers now being required to articulate how they include ESG in their own investment philosophy and processes.
Building investment models that consider either ESG rated funds or specialist managers provides a clear connection to an advice firm’s investment philosophy and comfort to clients that the practice is a socially responsible one. With specialist managers now competing alongside mainstream managers in terms of performance ratings the playing field has levelled somewhat and in fact can make ESG ratings and the implementation approach the true comparator. In fact it could be argued that it puts specialist managers in a much stronger position.
However, managed funds continue to limit transparency in underlying holdings and often provide a more generalised approach to ESG. This may be valid but does mean an investor has to select a managers view of, and approach to, ESG rather than building a portfolio of stocks that mirrors their own belief system. The only way to do this would be to select a model of direct equities, invested in businesses that match an individual’s own set of beliefs and willingness to invest in particular companies. Whilst some advice firms do offer direct equity advice, it is often a very expensive advice model open only to HNW clients but is extremely complex when trying to include ESG filters at an individual portfolio level.
To meet increasing demand and assist advisers in meeting their ESG requirements we have seen a growing number of ESG focused Managed Account models being established. At Praemium specifically, 23% of new Australian Equity or Multi-Manager model establishments are on an ESG basis. Managed Accounts continue to offer the efficiency of outsourcing to a professional asset manager and this is still relevant and consistent when selecting an ESG model but they allow an even deeper level of personal customisation, whilst retaining a scalable advice model.
The more equity focused a Managed Account model is, the greater level of transparency for an investor. Managed Accounts and modern platforms are designed in such a way as to utilise this transparency and allow customisations at an individual portfolio level. Investors can make very specific and self-directed selection choices on specific assets by requesting a particular stock be excluded or substituted for an alternative. They can therefore, direct their financial planner to enact specific ESG requirements but allow the technology to deliver these rules at a portfolio level automatically. For those that have specific and often strong aversions to particular companies, this is a great solution and does not dilute or contradict the underlying investment philosophy of a practice.
Often though investors don’t have the knowledge of a specific businesses they want to avoid but are far more likely to have beliefs that will direct their ESG screening needs. A Managed Account solution, with a direct equity focus, coupled with advanced technology is the key to ESG filtering at a client level. The right technology partnership will allow an advice business to implement their investment philosophy, and its own initial ESG screening approach, whilst offering the ability to consider an investor’s own specific screening needs. Investment platforms are continuing to develop and assist in the implementation of ESG screening. For example, Praemium has developed 9 automatic screening exclusion options, which can be embedded automatically at a portfolio level, such as Thermal Coal, Controversial Weapons and Animal Testing. This ensures that as the model is reweighted by the model manager, individual ESG screening requirements can be seamlessly and scalably managed at an investor level. By utilising technology to include these investment rules practices can easily manage their own ESG approach and ensure any strong personal beliefs of their clients can be accommodated.
The popularity and growth of ESG investing will indisputably continue in the coming years, presenting well-prepared advisers with an opportunity to enhance their service and attract a new and growing segment of investors. In preparing for this, advisers with a robust advice model, linked to a defined investment philosophy will ensure that the implementation method required is clear. As technology develops we will also see a greater level of flexibility and personalisation evolve to assist an adviser in delivering not only on their Best Interest Duties and any potential new legal obligations but easily and efficiently deliver to their clients’ investment objectives in a manner consistent with their personal ethical considerations.