Consumers increasingly want to align personal values with their investment portfolios. In response to the growing demand for values-aligned investments, the number of funds that incorporate environmental social and governance (ESG) factors has more than doubled since 2010, according to the U.S. Forum for Sustainable and Responsible Investment. Unfortunately, many advisors are discovering how challenging it can be to create the alignment their clients seek.
Complexity in ESG investing is found in multiple dimensions. The growth in the number of offerings creates one dimension of complexity, with another dimension created by wide variations in approach among seemingly similar ESG-oriented offerings.
In addition, clients don't have a uniform set of ESG priorities. In some cases, the priorities of one client may be diametrically opposed to the priorities for another client. Consequently, advisors accustomed to managing a standardized set of model portfolios may find that standardized models often will not satisfy values-motivated clients.
Answering the following six questions will help advisors address the inherent complexity associated with ESG investing:
1. What is the client's objective?
Defining the client's investment and ESG objective is an important first step in creating a manageable universe of potential investments. Some clients prioritize avoiding stocks or segments of the market that are inconsistent with their personal values. "Screening" to exclude certain securities is the way that many clients seek to achieve moral alignment between personal values and portfolio investments.
Alcohol, tobacco, gambling and weapons companies are among the most-requested exclusions to client portfolios. Clients focused on climate change often select fossil fuel free investments in which fossil fuel energy and utility companies are screened out of the portfolio. Low-carbon frameworks are also popular. Low carbon strategies reduce the carbon footprint of the portfolio relative to the broad market by excluding companies that have significant carbon reserves and greenhouse gas emissions. Low-carbon strategies may include some energy and utilities companies, an important distinction with fossil fuel free strategies.
Solutions-oriented strategies are also popular among climate-focused investors, investing in companies helping to address global warming and other climate-related issues. Diversity is another important theme for ESG-oriented clients. According to Calvert, only 25% of board members and an even lower percentage of executives at S&P 500 Index companies are women.
2. What types of ESG investments provide alignment with client objectives?
Screening-based investment strategies may be appropriate for clients focused on avoiding certain companies or industries and are comfortable with the risk that the excluded securities outperform unconstrained investment alternatives.
Investment strategies that integrate ESG ratings may be appropriate for clients interested in portfolios that seek to include companies with "positive" impact and exclude companies with "negative" impact. Investment strategies that incorporate ESG ratings may include some "good houses in bad neighborhoods," such as fossil fuel companies or utilities perceived to have a more climate-friendly business. Some investment strategies integrate ESG into the investment process but may override ESG considerations for a stock perceived as having strong upside potential.
Mutual funds and ETFs satisfy the needs of many clients, but customized separately managed account solutions are increasingly available and may help satisfy more complex client needs.
3. How does the investment manager integrate ESG considerations into their investment process?
There are a wide variety of approaches to integrating ESG considerations. There is considerably more ESG data available today than was the case a decade ago. Eighty percent of S&P 500 firms didn't report ESG data in 2011, according to the Governance and Accountability Institute. Today, more than 85% report on ESG data.
Daniel S. Kern is chief investment officer of TFC Financial Management, an independent, fee-only financial advisory firm based in Boston.
