Our “ESG 101” series is intended to facilitate discussions between financial professionals and their clients on all aspects of environmental, social and governance (ESG) investing. In this article, Kelly Hagg, Global Head of Product Strategy and ESG, and ESG Research and Development Analyst Quinn Massaroni discuss why financial professionals should care, using examples from the fast-evolving U.S. market, and outline how various ESG styles of investing can be used to suit different client needs.
- While financial professionals are feeling increasingly obligated to discuss ESG with their clients, there is no one prescribed method of integrating ESG into the investment process.
- At the same time, there are a vast range of investor values and preferences to consider.
- Understanding the various ESG investment categories can provide a framework for talking about ESG values with clients and evaluating suitable fund options available in the market.
ESG. For many financial professionals, this acronym has become part of their everyday vernacular. For others, ESG investing is still a niche investment style. Given the rapid growth of ESG in recent years, however, even those who are somewhat skeptical have surely taken notice and are asking (and being asked by clients), “What is ESG and why should I care about it?”
ESG is the practice of using environmental, social and governance criteria as an additional tool to help enhance investment professionals’ evaluation of companies and identify financially material issues that could impact an investment. Simply put, ESG provides additional factors to consider within the investment process. While ESG data adds to the resources that can be used to assess risk and opportunity, there is no single, prescribed way to integrate this data into the investment process.
Later in this piece, we will discuss different ESG applications and how they can be used to help clients align their individual values with their investment objectives. But first, let’s take a look at how the ESG market has evolved over the past two decades and what that means for financial professionals and their clients.
Why ESG? Why Now?
When it comes to explaining the recent rise of ESG investing, there are two key drivers to consider: market trends and client demand.
Market Trends. We’ll start with fund flows because they send a clear message about ESG’s staying power in mainstream investing. By the end of Q2 2021, sustainable fund flows had grown to $2.2 trillion globally. The U.S. alone saw 25 new sustainable funds launched in a single quarter.1 These fund launches and asset flows are indicative of growing investor interest and confidence in ESG strategies. But what could be most compelling for financial professionals is the range of ESG strategies that are now available, as well as improved cost options.
ESG investing has evolved over the past decade and we are now seeing more sophisticated ESG integration, application across asset classes such as fixed income and multi-asset, and more varied strategies. There are now several ESG options to choose from, which allows for more individualization based on client values and preferences. The availability of varied ESG options has been a noteworthy driver of adoption and will likely help continue to build investor confidence in ESG as an integrated component of a diversified portfolio.
Once considered niche and difficult for investors to access without an expensive discretionary mandate, ESG-focused products are now becoming mainstream, in part because they are more affordable and flexible than ever. The boom in new products has included ESG funds – spanning asset classes and strategies – that are available in low-cost wrappers such as ETFs that, when delivered at scale, can offer lower management fees. This change has driven ESG investment products to become an increasingly common tool for financial professionals seeking to offer an attractive and uniquely tailored component within a client’s portfolio. At the same time, the prevalence of options available to investors at all entry points essentially means that ESG investing has been democratized over the past few years.
Client Demand. There’s a disconnect on the client demand front in the U.S. that is best illustrated by two conflicting results in Cerulli’s 2020 advisor survey.2 The first finding indicated that over half of surveyed U.S. advisors considered lack of client interest as a primary factor preventing them from adopting ESG strategies. However, another result found that nearly half of U.S. retail investor households are interested in investing with environmental or social responsibility in mind. These results suggest that, in some cases, financial professionals may be underestimating clients’ levels of interest in ESG.
So what is behind the numbers and the disparities uncovered by these survey results? In recent years, there have been considerable shifts in both demographics and consumer preferences that have impacted the demand for sustainable investment options. To start, we are in the midst of the greatest American wealth transfer in history: Some estimates indicate that baby boomers will pass along nearly $70 trillion in assets to philanthropic causes and/or to their children between now and 2024. This is a noteworthy event, given that millennial clients, driven by their higher levels of concern about climate change and equality, are significantly more interested in ESG investing.3
In addition to the age-based wealth transfer, the share of global wealth is also shifting along gender lines. Women now account for 32% (and counting) of global wealth4 and are on average more focused on using their assets to positively impact society than their male counterparts.5 The impacts of these burgeoning client segments are already being felt in advisors’ conversations – ISS Market Intelligence found that 31% of U.S. advisors saw an increase in clients proactively asking about ESG investing between 2020 and 2021.6
While it is known that millennials and women are concerned about incorporating societal and environmental impacts as they build wealth, financial professionals may want to create a dialogue in which these values can be expressed and applied to individual portfolios. These conversations potentially allow financial professionals to build greater trust with their clients and discuss a broader set of risks and opportunities as they seek to add greater long-term value.
ESG Categories to Suit Different Investor Needs
While financial professionals are feeling increasingly obligated to discuss ESG with clients, there is no one prescribed method of integrating ESG into the investment process. At the same time, there are a vast range of investor values and preferences to consider. Taking this into account, ESG investment approaches can be grouped into four general categories: Values-based, Best-in-Class, Thematic and Impact. These ESG approaches are not mutually exclusive and may overlap within single investment strategies. But they provide a basic framework for talking about ESG values with clients and evaluating the fund options available.
Values-Based. Values-based investing seeks to generate “ethical” or “moral” returns by excluding sectors and issuers associated with potentially harmful products, services or practices that conflict with an investor’s values or beliefs. This approach to ESG investing may have the longest history and rose in global prominence during the late 1980s when students pushed for divestment from companies doing business in South Africa during apartheid.
Since then, values-based investing has been both a staple of ESG investing and a point of criticism. Some investors avoid the values-based approach because it limits diversification and the investable universe, whereas others feel that exclusions are the best way to ensure their portfolios fully represent their values. Many nuanced ESG strategies still employ exclusions to ensure that the fund authentically supports the environmental or social objective of the fund. For example, funds focused on limiting overall ESG risk may exclude companies that derive revenues from thermal coal, given its role in increasing greenhouse gas emissions and contributing to air pollution. Regardless of whether clients are looking to exclude sectors or companies from their portfolio, such discussions are often the first step in identifying clients’ ESG values and investment objectives.
Best-in-Class. This approach invests in companies that are leaders in their sector in ESG implementation and performance, while also excluding companies with undesirable profiles. Often, a best-in-class (BIC) approach is used to ensure that a fund is sector agnostic, while still capturing long-term ESG risks by identifying ESG outperformers even within “dirty” sectors. When considering BIC investments, investors will want to dig into the strategy to determine what criteria are being used to assess ESG performance within a fund. For example, some funds will assess companies based on their ESG risk profile using internal or third-party scoring. Others will use a combination of factors including risk assessments, history of controversies, revenue thresholds and engagement feedback. Overall, the BIC approach offers a dynamic ESG solution for investors who care about environmental and social factors but do not want to sacrifice broad exposure in their portfolios.
Thematic. Fund managers may focus on ESG themes or assets directly tied to sustainability by investing in companies that are actively addressing social or environmental issues (or “themes”) through their products or services. Thematic investing strategies offer a particularly interesting opportunity to financial professionals and clients alike to address specific ESG factors in a thorough and complete way. Where best-in-class tactics offer broad access, thematic investments allow for specialization. When individual investors are specifically dedicated to a topic – such as gender or racial equity, climate change, or biodiversity – it is valuable to have an investment option that targets those specific causes.
Thematic investing is often accompanied by sustainability reporting to illustrate the progress that has been made on a given theme. Such reports are a valuable tool for financial professionals to communicate the extent to which investments are achieving both the desired financial and thematic outcomes their clients have targeted.
Impact. Impact investments target competitive financial returns and positive, measurable environmental and social outcomes by primarily investing in companies that serve to benefit society and/or the environment. As the name suggests, the impact approach is more focused on environmental and social outcomes than other standard ESG approaches. As such, these strategies are often accompanied by impact reports that provide investors with a clear measure of how the strategy or fund contributes to specific outcomes, such as the UN’s Sustainable Development Goals.
When communicating with clients, financial professionals will need to discuss what an investors’ priorities are and to what extent they are looking for impact within their portfolios versus a direct risk mitigation approach. When considering impact strategies, it’s important to assess the objective of a given fund for alignment with client objectives and values. In lieu of standardized reporting, financial professionals may need to explore a fund’s impact reports to help ensure clients understand how impact is being measured.
Understanding different ESG investment options and building a knowledge base of how certain strategies cater to specific sustainability commitments is a good starting point for financial professionals who want to form stronger relationships with existing and prospective clients. Traditionally, client discussions are centered on risk and time horizon objectives but introducing values and worldview concepts into the conversation allows retail investors to think about their financial legacy.
Financial professionals who can support the client in pursuing both their financial and ESG goals will better understand their clients’ views and objectives before recommending an appropriate, individualized financial solution, thus allowing trust to be built with their clients. ESG investment strategies have evolved to support the preferences and values of many investors. This evolution offers financial professionals the necessary flexibility to access a spectrum of ESG solutions and match them to clients’ goals and objectives.
Environmental, Social and Governance (ESG) or sustainable investing considers factors beyond traditional financial analysis. This may limit available investments and cause performance and exposures to differ from, and potentially be more concentrated in certain areas than, the broader market.
Diversification neither assures a profit nor eliminates the risk of experiencing investment losses.
1 "Global Sustainable Fund Flows: Q2 2021 in Review." Morningstar. June 2021.
2 "Asset Managers and Advisors May Be Overlooking Retail Investors’ Appetite for ESG Investing." Cerulli Associates. April 2021.
3 "Older Americans Stockpiled a Record $35 Trillion. The Time Has Come to Give It Away." The Washington Post. July 2021.
4 "Women’s wealth 2030: Addressing the gender gap." UBS Wealth Management. March 2021.
5 "Women twice as likely as men to favor ESG." Investment News. April 2021.
6 "Nearly One-Third of Financial Advisors See Uptick in Clients Seeking to Discuss ESG Investing Options, ISS Market Intelligence Survey Finds." ISS Market Intelligence. September 2021.