By Jayson Forrest - Managing Editor  - IMAP Perspectives

Despite the burgeoning interest in ESG - which in this article is an umbrella term encompassing all responsible investing, including SRI, sustainable, impact and ethical - many advice businesses have yet to embrace this style of investing. And according to the Principal Consultant at Marcona Partners, Alan Logan: “If you don’t have a well thought out approach to ESG, then your clients aren’t going to think you can meet their investment needs.”

ESG  is an investment path that the Founder and Director of Evergreen Consultants, Angela Ashton, encourages financial advisers to take.

“Advisers need to understand that ESG investing is not that hard to do,” she says. “Most of the funds that advisers are currently using are most likely to already have good ESG integration and overlays in them. However, if advisers are uncertain about ESG, then they need to ask about it.”

The Head of Real Assets and Listed Strategies at Zenith Investment Partners, Dugald Higgins agrees, adding that the first step advisers need to consider when advising on ESG is to understand the funds they are using.

He says advisers need to be aware of the variety of ESG strategies in the market, adding that these strategies can be bucketed into about six groups, including: positive or negative screening; best in class; integration; impact; and stewardship.

“Any responsible investing or ESG strategies will fall into one or more of these groups,” says Dugald. “Once you start to understand the strategy landscape, then you can start to think about where the client fits in, which will probably be into one of three buckets. They’re either going to be: values-based - they want their money to reflect their own personal values; impact-based - they want to feel that their money is making a positive impact on the world; or they may be a little more sophisticated with their investing, and thinking about ESG overlays as a risk management tool.

“When you put these two pieces together, you start to see connections. If you have a client who is very interested in investing in a values-based approach, that will probably lead advisers down the path of products that use a lot of screening. If investors are looking at an impact-based approach, that will probably lead you more towards looking at funds that are more about ‘deep green’, integration or stewardship. So, you begin to look at the links between the type of investing and the style of investing.”

Australian Ethical has successfully worked with many advice businesses in developing and incorporating an ESG philosophy into their business models. According to Leah, those businesses that thrive in this space are using consultants to help them navigate the ESG path.

“Advice businesses wanting to tackle implementing ESG within their service offering need to work out what they are trying to solve and what they are trying to deliver. While a lot of the conversations around ESG and ethical investing tend to be bespoke, you can make ESG scaleable, as long as you avoid going to the ‘deepest green’ or trying to deliver on every client’s ESG objectives,” Leah says.

“Instead, take a more considered approach, and ask yourself: ‘Am I comfortable ticking a box with an ESG portfolio, knowing the portfolio will be mainstream soon?’ Some of the best boutique practices have already put an ESG policy and overlay in place with their mainstream models, which is working well for them.”

Angela agrees, adding that while there will be clients requiring a bespoke solution, in the main, advisers can build an ESG model that will suit about 60-80 per cent of their clients.

“You can build models that provide the standard exclusions, like fossil fuels, while providing some level of ‘deeper green’, and at the same time, meet all the other requirements that good portfolios should have, like diversification, style and duration. You can do all of this with an ESG portfolio.”

It’s unavoidable that the further an adviser drills down into ESG, the more bespoke a portfolio becomes. However, bespoke portfolios can also impact on the overall efficiency and profitability of an advice business.

“Don’t let perfect be the enemy of good,” says Dugald. “You don’t have to snap your fingers and shift your whole APL into ‘deep green’ overnight. We find that trying to get a very deep ESG overlay on some strategies that we like to use, like liquid alternatives, is difficult. So, you want to tilt your portfolio to those ESG players who have strong capabilities and have room to move on ‘deeper green’ options. You also want to tilt towards having less mass customisation, which is difficult, and more towards what will and won’t work for the bulk of clients.”

Dugald adds that a key component of doing this is educating clients about ESG and managing their expectations with this style of investing.

“If you were to provide clients with everything they wanted, like a vegan portfolio, then you’ll end up with a portfolio that’s not very useable and expensive to run.

“And even amongst portfolios that are using a lot of screens, you have to be very careful about where that takes you. For example, in Australian equities, a lot of screens probably lead the adviser down the path of taking a tilt towards small to mid cap tech stocks. Therefore, you need to be aware of the implications of that and how you communicate that back to clients.”

Perhaps the best ways advisers can engage with their clients on ESG is having the confidence and knowledge to accurately talk about ESG. Evergreen Consultants uses a questionnaire to tease out the appetite of clients for ESG, which Angela adds, can also help a business understand its own positioning and values on ESG.

“Most clients want ‘green’ but they don’t know how to get to that next level with their investments,” she says. “However, if advisers can articulate an offering that is well thought out, which displays knowledge and leadership, then clients are likely to accept that offering. Not only will these clients pay more to be ‘green’, often the return on performance isn’t their primary driver for investing. Instead, they are focused on doing good with their money, both ethically and responsibly.”

However, while Leah agrees, she is also adamant that investors do not believe they have to give up performance to invest in ESG. She points to the Australian Ethical/Investment Trends 2021 ESG Report, which reveals that ESG investors expect they will do as well, if not better, than mainstream investors with their portfolios.

Interestingly, for Dugald, he believes the conversation with clients shouldn’t be around whether ESG adds alpha to a portfolio, but it should be about risk management.

He explains: “You don’t want to start the conversation about ESG with clients by asking, ‘So, how do you feel about ESG?’. Instead, by breaking down the concept of ESG simply around the client’s thoughts on various issues or industries, you can then begin to lead them down the ESG path. This will enable you to ascertain whether they are values-based, impact-based or are a little more sophisticated with their investing, and thinking about ESG overlays as a risk management tool, and then go from there.”

With China’s increasing economic and political posturing, are investors’ attitudes to China - particularly in terms of social and governance - likely to affect the way they think about their portfolios?

Dugald concedes it’s an interesting question.

“All our managers involved with China are looking at getting reliable data that is accurate and transparent about the companies operating there. However, there are always issues when investing - both globally and domestically. And that’s where ESG risk overlays kick in. It’s about how you manage and respond to these risks. If you feel that an area or company is losing its social licence to operate but you’re not thinking about that, then you’re going to have problems.”

According to Angela, the social and governance side of China is an issue, pointing to the suppression of the ethnic minority Uighur people in north-western China. She believes issues like this affect multiple countries and multiple supply chains.

“The United Nations’ Sustainable Development Goals, as well as the Modern Slavery Act, were specifically set up to address these types of issues. So, when we’re talking about the Uighurs and wanting to take a stance as an investor, then that’s a specific issue you need to ask fund managers about in terms of their investment exposure in China.” 

In fact, issues around investments with China is something that Australian Ethical is constantly looking at, particularly in terms of supply chains, human rights abuses and animal welfare.

“For example, if a healthcare company we invest in shifts its animal testing to China, then that would ring alarm bells for us. We have certain frameworks and strict guidelines around things like animal testing, so a move like this would be beyond our threshold of acceptance,” Leah says.

However, Leah believes there is an interesting dynamic emerging between the rising middle class in developing countries and renewable energy. She says you’re not seeing the volume of power lines and utility companies being built in countries like China and India, as you are in some developed nations.

“These countries are going straight to renewable energy, like solar and wind. And while this will obviously still take some time to do, these ESG trends will potentially sustain and underpin some of the fundamentals in these newer sectors that Australian Ethical is investing in.”

The key to successful ESG investing, according to Leah, is to open up and extend the conversation with clients. She urges advisers not to be afraid to initiate ESG conversations with clients.

“You don’t have to have all the answers. There are consultants, research houses, the Responsible Investment Association Australasia (RIAA) and specialist fund managers that all have resources and tools available to help you on your ESG journey. So, if you can’t answer a client’s questions concerning ESG, go away, do your homework, and go back to the client with the right information,” she says.

“And if you are thinking about incorporating ESG into your current portfolio models, then that’s great - you don’t need to recreate the wheel. You have spent a lot of time around risk and return profiling, as well as putting in solid financial metics around what you do. So, don’t undo all of that. Instead, pick a couple of areas of ESG that you’re comfortable with and go from there.”  

Dugald concedes that the change in ESG over the last 2-3 years has been rapid, particularly in terms of the data available, the tools being used and the spectrum of issues now being covered.

“ESG is moving rapidly, which can be challenging for advisers to keep up with,” says Dugald. “It’s a journey that advisers need to stay at the forefront of, and that’s where reaching out to service providers, like research houses and consultants, can help.”

Leah Willis is the Head of Client Relationships at Australian Ethical; Angela Ashton is the Founder and Director of Evergreen Consultants; Dugald Higgins is the Head of Real Assets and Listed Strategies at Zenith Investment Partners.

They spoke in a session on ‘Communicating with clients on ESG’ at the IMAP Adviser Roadshow 2021.

The session was moderated by the Principal Consultant at Marcona Partners, Alan Logan.