A 2018 report from the U.S. Forum for Sustainable and Responsible Investment found that, in the U.S. today, $12 trillion in client assets are held in socially responsible investing (SRI) offerings—a 38-percent increase over the $8.7 trillion in 2016. The study also says that $46.6 trillion in total assets are under professional management nationally. What does this mean? One in four managed dollars in the U.S. has a sustainable, responsible, or impact focus.
My colleague Peter Essele and I view the growing number of impact investing strategies available today as an opportunity for advisors to add significant value to the services they offer. To help you make the most of this opportunity—for your clients and your business—we’ll break down some essential SRI terminology, as well as discuss how to evaluate offerings and manage clients’ expectations.
Getting to Know the Lingo
There are several terms used industry-wide to reference sustainable investment methods and concepts:
- Impact investing is a targeted approach to investing designed to have a measurable impact. Typical areas of concern are social and environmental.
- Environmental, social, and corporate governance (ESG) integration describes the incorporation of ESG data alongside traditional security analysis. Asset managers use this data to gain greater insight into how a company operates with respect to the environment, as well as how it deals with employees, suppliers, and customers.
- Sustainable investing is used to describe a spectrum of strategies, though the most common usage refers to an ESG approach to investing.
- Exclusionary screening, a pioneering approach to SRI, allows investors to exclude from the investment universe companies that conflict with moral or ethical views. Common exclusions include tobacco, weaponry, and fossil fuels.
- Positive screening actively seeks out companies with attractive ESG scores relative to industry or sector peers. The two most common approaches are best in class and ESG momentum. Typically, best in class includes broad exposure to all sectors and invests in (or overweights) names that score highly from the ESG perspective. ESG momentum overweights companies that exhibit improved ESG measures relative to their peers.
- The active ownership investing style involves buying shares in companies with the intent of changing behavior. This includes changing company policies and practices through proxy battles or communication with firm management.
Evaluating ESG Investment Options
As sustainable investing continues to gain steam, advisors must be increasingly vigilant when evaluating investment managers that label themselves as SRI, ESG, or impact. Plenty of managers have been incorporating ESG analysis into their research for years, but others have been and are embracing ESG nomenclature simply to capture assets. According to Morningstar Direct, 40 new sustainable mutual funds were launched in 2017 to go along with dozens of asset managers who added sustainable terms to their products. With this trend set to continue, advisors who look beyond product nomenclature will find interesting details beneath the surface.
For instance, a well-known exchange-traded fund (ETF) and index fund provider recently released a suite of ESG ETFs that will undoubtedly get lots of attention from loyal retail consumers. Upon further review, however, the products’ mandate revolves around negative screening rather than the incorporation of ESG risk analysis. Because of the lack of regulation around product nomenclature, advisors will need to serve as gatekeepers for their clients, helping to separate the genuine players from the bad actors in the ESG space.
An advisor can use the following guidelines as a starting point to determine a fund’s ESG legitimacy:
- The basics: How long has the manager been implementing ESG within its investment process? Is there a well-established investment team, repeatable investment process, and proven research capabilities?
- ESG framework: Can the manager articulate how it applies its ESG framework to the targeted asset category? For mutual funds, is this framework stated in the prospectus?
- Factor reporting: Does the manager have the ability and willingness to provide updates on how it scores on ESG factors, such as the United Nations’ 17 Sustainable Development Goals, which include factors like gender equality, clean energy, and climate action.
What about sustainability ratings? To help with the process of evaluating the SRI universe, Morningstar introduced its sustainability ratings methodology, which assesses how well the companies in a fund’s portfolio manage ESG factors relative to their industries. The Morningstar ratings can be used in initial screens across investment categories. Strategies are ranked using one to five globes—one globe is the lowest sustainability rating and five globes represent the highest rating.
In some cases, a fund can score well on the globe scale simply because it happens to be exposed to highly ranked ESG companies. Therefore, it’s important to determine whether the fund has a sustainability mandate in place. For example, if you were to use globe ratings alone, you could identify an attractively positioned fund today, only to find that its sustainability rating drops next quarter because it has changed the portfolio’s investment mix and has no ESG mandate in place. To better account for the intentionality of pursuing sustainability, Morningstar continues to refine its ratings. Its analysts now look at a fund’s historical ratings to better assess whether a current high score is the result of intention or coincidence.
Introducing ESG to Clients
So, how can you begin to incorporate SRI into your practice? Often, advisors looking to integrate impact investing strategies into existing client relationships are unsure of how to broach the subject. Clients, likewise, may have heard media reports about the rising popularity of SRI and may want to know more but aren’t comfortable bringing the topic up during meetings with you. Here are a few clients you might want to start with.
Opportunities with the charitably inclined. “A great starting point could be identifying clients who are involved in their communities,” says Doug Classen, senior vice president at Dana Investment Advisors, a manager on Commonwealth’s Preferred Portfolio Services® (PPS) Direct SMA/UMA platform. “Clients that are involved in social, foundational, and charitable causes are strong candidates [for sustainable investing]. But if you don’t ask, you will never know.”
Some clients may liken sustainable investing to philanthropy and want to keep their investments and philanthropic efforts separated—unaware that SRI involves the all-important element of generating financial returns, unlike their charitable giving.
Sustainable investing and charitable giving don’t need to be mutually exclusive. For instance, advisors can help clients engage in both—through philanthropic efforts with sustainable investments via donor-advised funds. Clients can donate assets to support a certain cause while maintaining the investment discretion to choose impact or ESG portfolios.
Opportunities with women and millennials. The growing individual client segments of the future—women and millennials—are a popular focus within business planning, as the increasing amount of personal wealth controlled by these investor categories has been well-documented. And these groups have expressed a considerable interest in SRI.
A recent U.S. Trust study found that 77 percent of wealthy millennials have placed assets in ESG investments or are interested in doing so. Further, nearly 70 percent of women executives are invested or interested in ESG investments. With these client segments set to inherit trillions of dollars of wealth over the next 20 years, advisors prepared to cater to their sustainable investing preferences will be well positioned for the generational shift.
Setting Client Expectations
The successful integration of SRI into a client’s financial plan hinges upon realistic expectations. With the glut of buzzwords and differing approaches around, it’s easy for preconceived notions to blur a client’s understanding of what you can offer from a socially responsible perspective. The table below shows some examples of common client misunderstandings that could represent teaching opportunities for advisors.
Common Client Misconception
How to Set a Realistic Expectation
“I like your plan to buy these ESG funds because it will ensure that all the companies I’m invested in have positive impacts on the environment and society.”
Although approaches to ESG vary from one asset manager to the next, it’s important to address broad client statements. Reiterate that ESG is a sort of filter through which managers evaluate risk factors and opportunities. These factors will be weighed differently across different sectors/industries. Consequently, an ESG portfolio could hold an energy company because of high marks on its societal and corporate governance measures despite a neutral or even negative mark on the environmental side.
“I look forward to investing with an SRI approach according to my beliefs. I don’t want to own energy, health care, or financials. What do you recommend?”
Although exclusionary screening will always be a component to SRI, advisors can add value by reminding clients of the negative correlation between restrictions and portfolio diversification. Advisors can add significant value by narrowing down the client’s broad, restrictive ideals to his or her more specific concerns. As a result, you would have more investment options to suggest and avoid fewer consequences to overall portfolio diversification.
“I’d prefer to incorporate these ESG funds across my account, but I’m uncomfortable making such a broad sacrifice to performance in the name of sustainability.”
Studies indicate that the incorporation of ESG factors into an investment process can be accretive to performance. Certainly, some funds and strategies will do better than others over a full market cycle, but the presence of ESG does not necessarily indicate less competitive performance potential.
As SRI Trends Grow, So Can Your Business
Regardless of how one feels about an ESG approach to investing, being aware of the broader SRI growth trend will serve as a key input into advisors’ future business planning. Those who choose to develop familiarity with the complex terminology and varying impact investing strategies will have opportunities to add value to growing client groups who will demand it.
Are you seeing increased interest in impact investing strategies among your clients? Do you see any trends based on age, location, or gender? Please share your thoughts with us below.