The rise of ESG Investing

I met a financial advisor for a coffee a few weeks ago. He wanted to pick my brains about ethical investing. He said he wanted to be 'more green' and wanted my advice on building ethical portfolios for clients. He seemed to think ethical investing was merely about avoiding tobacco and arms; it's moved on a lot, I said, as I rolled my eyes, questioning whether he was willing to be truly committed and informed about the world of ethical investing. I came across this great piece of investment research by Calvert Research and Management called 'The Rise of ESG Investing' which talks about the latest trends and client drivers. It also talks about financial advisors and their attitudes towards ESG. The study is US based. However, I think it translates well to the UK market too. I marked out some interesting bits and listed them below with my comments.

On Millenials

Born between 1980 and 2000, Millenials command wealth, a social conscience and power. By 2020, it is estimated they will make up 46% of the workforce. This is a generation with sway and swag, who hold social responsibility, social justice, equality and environment causes as top priorities.

Research quoted in the report states that 53% of millennials make investment decisions based on social responsibility factors, compared to 42% of Gen Xers, 41% of baby boomers and 39% of seniors. I don't see too many millennials in my advisory practise and I really enjoy seeing them when I do; but it is encouraging to see the younger generations voicing themselves so clearly.

ESG Takeaways

Advisers should incorporate basic ESG questions and filters into their initial discussions of goals and objectives with current and prospective clients and take a proactive approach to identifying needs and interests. 

I strongly agree. I don't push ESG investments as a 'right' or 'preferred' way of investing; it is not for everyone, and yet, the client has a right to make an informed decision - ESG or not. I imagine advisors enjoy offering a broader menu of options to clients and those who have worked hard to acquire expertise & conviction in ESG investing reap the benefits in attracting investors interested in responsible investing.

For many advisers, portfolio performance is a non-issue when it comes to ESG considerations. It ranks near the bottom of the reasons advisers utilize it; for non-users, ESG's limiting of investment options ranks near the top of considerations. Just 29% of advisers believe there is a positive correlation between corporate financial performance and ESG factors. While manager selection for ESG strategies may be limited compared to the broader universe of funds and managers, the menu is increasing in size. Overall, investment research broadly suggests that the performance of socially conscious funds has a "positive tilt relative to the overall universe of funds". While returns may not be a real hurdle, there is an increasing breadth of options - and potential strategies - that advisers can utilize.

Returns aren't a hurdle. True.

There are around 113 funds that meet the ESG/Ethical criteria as regulated funds for clients in the UK so yes, the universe is smaller. Also, the menu of available investment options excludes passive funds (there are a few, but they don't meet enough criteria to be included in any meaningful way) which means clients may pay a bit more for an ethical portfolio which necessarily includes actively managed funds and consequently higher fees than passive funds. However, more and more, I see a greater abundance of options including with company pensions, such as the L&G Future World fund focused on climate change, which is encouraging.

Adviser usage of ESG factors

The strongest indicator of adviser utilization of ESG factors was the level of client interest in social and environmental issues and, secondarily, the adviser's own knowledge of responsible investing as well as their performance of the importance of evaluating ESG factors for client portfolios.

I have met clients who are keen to invest ethically but then are put off by an adviser's own biases; I believe this is more to do with the advisers own level of felt competence in the area than the facts of whether ESG is an inferior strategy as an investment option or not. 56% of advisors cite client demand as the main reason to utilize ESG. Among advisors who don't use ESG investments, 58% said their clients are not interested in ESG factors, 29% said it leads to limited investment opportunities and 22% said it leads to poor or limited returns; I hear that last one most often too when I talk about it informally with advisor colleagues.

ESG factors brought up most often in client meetings

Among all ESG factors, the "E" - environmental - draws the most client interest. In our survey, 39% of advisers said that clean technology was one of the most commonly prioritised ESG criteria in client meetings, followed by climate change (35%) and emissions and waste (26%). 

An ethical investment questionnaire now has so many factors to it including pornography, human rights violations, genetic modifications, product stewardship and animal welfare.  It has definitely moved on from a simplistic negative screen of avoiding tobacco and arms companies. The survey also lists under social and governance issues the factors most frequently mentioned were human rights (22%) and corporate transparency (16%).

Knowledge stands in the way

Just 38% of responding advisers in our survey answered "Yes" to our question, "Do you feel knowledgeable when it comes to ESG investing?" Aside from client demand, advisers cite moral/ethical reasons as the secondary driver for their use of ESG.

38% is quite a large number. So, for clients who are looking to invest ethically or with ESG in mind, going to a knowledgeable advisor on ESG makes sense.

Further resources:

Ethical investing: Positive and negative screening criteria

Three myths about Ethical Investing

Sustainable tourism: A week in Morocco

Growing a Culture of Social Impact Investing in the UK

Book Review: Simple Wealth, Inevitable Wealth

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“The mortal enemy of investment success is fear.” - Nick Murray I was fortunate enough to buy Nick Murray’s book The Excellent Investment Advisor early on in my advisory career. It made complete sense to me, stressing the role of an investment adviser as behavioural coach. I recently heard about Simple Wealth, Inevitable Wealth on a podcast with a US-based financial adviser, I bought it - a 1999 copy set me back about £25 and it is worth it!

Some of my favourite lines from the book are below with my thoughts:

“”Wealth isn’t primarily determined by investment performance, but by investor behavior.””

Numerous conversations with clients have convinced me that we have our unique perspectives and biases around investing which influence our decisions. A great investment portfolio needs to have global diversification, asset allocation, low costs, etc. Given a well-constructed portfolio, clients who have the ability to stay detached and take the long-term perspective with patience and discipline can usually achieve greater financial success.

On picking a financial adviser:

“Do not care what they know until you know that they care.”

Since you are trusting your financial adviser with your wealth and your family’s wealth, technical capabilities and competence can only take you so far. Trusting in your adviser’s judgment is important and so take your time looking for someone you can really trust.

On Risk:

  • “People greatly overestimate the long-term risk of owning stocks. People seriously underestimate the long-term risk of not owning stocks.”
  • “The great long-term financial risk isn’t loss of principal but erosion of purchasing power.”
  • “The real long-term risk of equities is not owning them.”

Here, he means stocks as an asset class. Important to remember you only invest in stocks if you can stay invested for 5 years or more. If you haven’t ever invested in equity, that would be quite risky behaviour, according to him.

On Investor behaviour:

“The single most important variable in the quest for investment success is also the only variable you ultimately control: your own behavior.”

I have to agree and love that this is within our control. You can’t control the markets, economic forces of nature or will things to go your way. You can choose how you react to all of it.

On the active/passive debate:

“At the end of the day, it isn’t indexing v/s active management. It’s cost.”

The cost of your portfolio has a direct effect on the growth of your portfolio - an important factor in portfolio construction.

Really enjoyed reading this book & highly recommend!

Why you should care about losses

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Humans care more about losses than we do about gains; we also have many investment biases studied by behavioural scientists which I find fascinating. I will always remember with amusement a client who told me her investment return dream scenario, “100% upside and 0% downside, in 5 years, “she said. We both laughed, of course.

Pre 2008, I don’t remember having to discuss drawdown (decline in investment or fund) risks with clients; it became necessary to illustrate after the ’08 crash – bonds are held in portfolios as insurance, to help manage this risk.

Yes, we all love the higher returns from equities, and yet, you also have to consider the downside losses too, when evaluating the appropriate risk for your portfolio.

Compounding works in both directions. The bigger the loss, the harder it is to make a recovery. A 10% loss requires only an 11% subsequent gain to get back, while a 25% loss requires a 33% recovery and a 50% loss requires you to double your money to get back to your original position. The picture above illustrates this well.