How to embed ESG as best practice

By Victoria Reuvers

“Purpose is not the sole pursuit of profits but the animating force for achieving them … In fact, profits and purpose are inextricably linked.” – Larry Fink

Sustainable investing is growing, both in supply and demand, but several advisers are still confused on how best to execute. At a high level, many advisers acknowledge the need to future-proof their practice and/or attract new types of clients. However, implementing an environmental, social and governance (ESG) solution for a client is still problematic for some. Questions like “how do I raise it with my clients?” remain commonplace, so we explore the road ahead and seek a reasoned approach to execution.

Under the “value proposition” lens, it is hard to argue that sustainable-investing solutions—including ESG portfolios—are a fad and should thus be excluded from your toolkit.

In contrast, not offering ESG may actually isolate your business from a significant and growing portion of the market (as evidenced in the following table), where 72% of investors are at least moderately interested in ESG investing.

In a Morningstar study of 948 people, 72% of investors are likely to consider sustainably-minded solutions; with broad-based interest across millennials, generation-X and baby boomers:

The far more difficult question—and one we seek to advance in this article —is how to execute using ESG solutions. For example, you may like the idea of offering ESG in your practice, but there is little evidence available to tell you the best way to structure the financial planning process. With this in mind, we break down three of the building blocks that are likely to be foundational in a great execution plan.

At the heart of the financial planning profession is the concept of knowing your client. To date, most practices have adopted risk profiling and fact-finding tools to build a repeatable and robust framework that not only matches gaps to solutions but also meets the requirements of the regulators. But rarely has the fact finding process included ESG or values based preferences.

Whilst the debate about the best way to incorporate ESG into advisory practices continues, one observation from behavioural science appears clear—just asking the question is unlikely to be enough. The rationale demanding a more thorough approach is that asking clients value-based questions will tempt them to answer in a way that reflects what they think others want to hear, not what they really want. That is, no one wants to say I’m not interested, because that seems cold-hearted. But no one wants to invest in something that doesn’t align to what they really want either.

To overcome the challenge this poses, the industry has some work to do. We expect some great ESG preference tools to become available as the product supply increases (for example, Morningstar’s Behavioural Science team are developing one such version to support the Morningstar ESG Portfolio Range at present), which should go a long way in bridging the divide.

However, even with the addition of great ESG preference tools, it seems clear that many of the ESG preference tools will be better suited to prospects rather than existing clients. For prospects, you can easily establish a clients’ ESG preferences via the fact-finding process, perhaps by adding it to the questionnaire or risk tolerance assessment. Finding effective ways to raise it with existing clients will likely require more thought.

In this sense, it’s hard to see an approach that is one-size-fits-all. Not only are each clients’ financial goals different, but the adviser process must be capable of handling the change necessary to adapt to ESG-related goals. That does not mean it isn’t worth exploring—quite the opposite— as it may create an opportunity to deepen the client-adviser relationship and possibly drive new business. But we need to be realistic as to the challenges it presents.

While this is an area ripe for development, to help make it practical, we offer three examples of ways advisers are currently raising ESG capabilities with existing clients. This is not conclusive, nor suggestive as such, but intended to be thought provoking. Examples include:

• An upfront announcement to the client base regarding a new capability or function, with the option to enquire if they are interested.

• A structured approach to client annual reviews, perhaps using a premeeting checklist that asks the client to review their risk tolerance, goal setting and whether their financial plan is aligned to their life values (including ESG preferences).

• An offer to the children of existing clients, perhaps as a marketing or value-adding exercise. This may express that ESG often appeals to older generations too, with an option to enquire if they are interested.

The key is to deepen the understanding of where clients’ see themselves on the returns-driven to sustainably-driven spectrum, then making sure there is the capability to tailor the financial plan accordingly.

Take two investors with the same age, the same savings patterns and the same retirement goal—yet one is sustainably minded while the other is returns driven. They share a lot in common, but the messaging will not resonate equally.

If you can bring the ESG impact to life, you are well on your way to changing the past performance conversation into a well-rounded assessment of value. Tying into the United Nations Sustainable Development Goals is one such effective way this may be done.

Do you really understand how sustainable a given company is? Or tougher, how sustainable a portfolio of companies might be? This is extremely difficult, even for the experts, as corporate and governmental policies change over time. For instance, it might be easy to say that a tobacco company ranks poorly on the ESG front, but what about an oil driven emerging market that offers government bonds? Having an ESG portfolio capability function will likely require outsourcing of some kind—at a minimum, having a research provider on your side. More advanced solutions include a managed portfolio offering, taking the burden of misallocation risks out of your hands.

Only you can decide what products are most suitable for a given client, but whichever way you go, it is likely you’ll need to develop a relationship with trusted ESG specialists that can help provide the solutions your clients need. This has the added advantage as a means to stay on top of a quickly growing field.

Offering ESG portfolios is theoretically easy—using the client, impact and product foundations—however it is worth elaborating on potential downsides. For example, a common mistake we are already seeing in the industry is something we can simplistically label the “plug and play” approach to ESG. That is, a client shows a preference for ESG, so the adviser picks a handful of ESG funds and replaces the conventional holdings like-for-like. Such an approach is sub-optimal for many reasons, leading to a portfolio profile that can deviate considerably (both in risk and return) from the desired outcomes. For example, the ESG indexes tend to carry meaningfully different sector and size biases than traditional indexes, which can impact everything from credit quality to liquidity.

This leads to another important point. While we believe offering an ESG portfolio range has the ability to strengthen your practice, you do need to be ready for different conversations. Some of these conversations will be meaningfully positive (such as developing a deeper understanding of your clients’ opinions and values), but others will be more challenging. One such example is that ESG portfolios can be expected to behave differently from conventional portfolios (tracking error from conventional benchmarks may be higher), so it does raise the prospect of how you’ll handle relative performance-based queries.

As with most things, setting expectations upfront will be paramount, but so will the ongoing communication. For those that already use an individually-documented investment strategy with each client (usually involving a statement of principle, purpose and expected behaviour), you may need to evolve this thinking to consider ESG factors. For those that don’t, you’ll need to be clear with your client on why an ESG solution is fit for purpose and think carefully about how to reinforce this message across the journey.

Ask your everyday person on the street and they are increasingly preferring companies with a strong environmental record or those that embrace other developments such as gender equality.

This movement is certainly not a fad, it is very real, and raises the interesting prospect to differentiate your value proposition.

The development of ESG products is likely to grow further and you have a great opportunity to strengthen your practice by using them. While the industry continues to grapple with the best way to incorporate ESG preferences into previously standardised practices, a foundational approach could see you step ahead.

The benefits of offering ESG solutions are likely to far outweigh the drawbacks, but there will be challenges. To support adviser’s in their journey, Morningstar have decided to offer ESG Managed Portfolios, which comprise five portfolios aligned to Morningstar’s established risk profiles and compatible with other leading risk tools. The portfolios are managed using Morningstar’s distinctive long-term valuation-driven approach and use both active and passive funds with the aim to maximise the potential reward for risk while reducing the cost as far as possible. The portfolio management team draws on expertise from over 100 investment professionals around the world and are supported by Morningstar’s industry-leading research, data, and thinking around ESG considerations.

Future proofing your business—by evolving your “value proposition”—can be improved by including a focus on environmental, social and governance (ESG) investments. This is a great opportunity to change the way your clients perceive success, moving from performance-driven expectations to rounded goals. To successfully embed ESG into your practice, one must start by getting the foundations right. While there is no one-size-fits-all approach, it is likely to revolve around at least three key variables:

1) finding a way to raise it with your clients in an effective manner

2) finding ways to visualise the ongoing impact, and Like anything, there are likely to be some challenges to offering ESG portfolios. You can expect client conversations to change—mostly for the better, but possibly for the worse at times. For example, ESG funds carry higher tracking error against conventional portfolios (even if there is no change in overall risk), which may create perceived disappointment if ESG funds experience a weak period.

3) knowing your products of choice.

Like anything, there are likely to be some challenges to offering ESG portfolios. You can expect client conversations to change—mostly for the better, but possibly for the worse at times. For example, ESG funds carry higher tracking error against conventional portfolios (even if there is no change in overall risk), which may create perceived disappointment if ESG funds experience a weak period.