The first step in providing ESG-compliant portfolios – as, of course, with any other kind of portfolio – is to assess the client’s goals and preferences. That said, a survey conducted in 2021 by consultant NextWealth found no more than a quarter of advisers ask about ESG in their fact-finding process while, according to adviser software provider Dynamic Planner, these tend to comprise general yes/no-style questions that rely on clients already having some knowledge of what ‘ESG’ actually means.
In this situation, experienced financial advisers will use a variety approaches – simultaneously ascertaining the client’s risk appetite, financial aims and ESG concerns to make the most informed recommendations. Since many clients might not think to frame any ESG-related questions themselves at the fact-find stage, there is an onus on advisers to raise the subject in a manner to benefit them.
As the next step, advisers then need to consider how to integrate ESG considerations into their client’s portfolio. The UN-led Principles for Responsible Investment (PRI) network defines ESG integration as “the explicit and systematic inclusion of ESG in investment analysis and investment decisions”. This includes integrating ESG into risk assessments, an approach favoured by investment houses such as Royal London Asset Management, whose in-house team embeds ESG factors into their analysis and research.
Financial advisers can start to select the most appropriate ESG investments depending on the client’s preferences. There are many ways to do this – for example some clients prefer an exclusionary approach, which filters out so-called ‘sin sectors’ such as tobacco.
Other clients might prefer ‘engagement’ – where investors buy into companies that may have been criticised for their environmental, social or governance practices in order to try and influence their behaviour. Sometimes advisers select portfolios because of their relevance to a particular concern of the client, such as deforestation. Clients can also opt for impact investing, which looks for companies to deliver a positive social or environmental impact in addition to returns.
These types of approaches will be very personal to individual clients but also potentially onerous for the adviser to oversee. Alternative approaches rely on the investment being ‘ESG-compliant’ – whether that means it is self-assessed or scores well on a respected ratings service such as that provided by data company MSCI.
A portfolio can then be constructed by selecting ‘best-in-class investments’ that combine ESG credentials with other metrics such as performance and risk. Given the personal nature of ESG preferences, there has been much criticism of scoring systems, including inconsistency and ‘greenwashing’ – where ESG a business exaggerates its ESG credentials – but this sector must surely have some merit when used appropriately.
Advisers are of course expected by the regulator to conduct suitable due-diligence into their investors’ funds. In the context of ESG investments, this could mean meeting with representatives of the companies in the portfolio, analysing disclosures, evaluating ESG ratings and taking account of third-party research.
A variation on the approach that employs ESG ratings is to use investment vehicles tied to ESG indices, such as the indices created by MSCI, FTSE-Russell, S&P, Qontigo and others. One advantage here is these institutions have a strong research and data-backed approach and the resulting indices carry their brand values – providing comfort to the investor as well as a compliance audit trail. Often ESG versions of mainstream indices are created, such as the FTSE4Good or the S&P ESG series, which provide a tilt to an existing proven proposition.
More tailored solutions include the MSCI Climate Change and MSCI Global ex Tobacco Involvement indices. Advisers will have to explain the methodology of the index, whether it is efficient in achieving its goal and technical factors such as liquidity, rebalancing and dividend treatment. There is already a wide range of such solutions, which requires further study by the adviser.
Financial advisers can also directly select ESG-oriented funds for their clients. According to the FCA’s 2022 consultation paper, a fund claiming to pursue ESG or sustainable aims must have appropriate objectives and fund policies. Moreover, the fund should disclose data regarding its performance in ESG objectives in a clear format.
ESG themed funds provide more flexibility and variation since a fund manager can show more discretion than a rules-based ESG index. Funds might be selected for high ESG ratings or their perceived positive environmental, social or governance impact.
ESG investment portfolios can also include green bonds, which are used to finance climate-friendly projects. Green bonds diversify an ESG investment portfolio, raise awareness for the bond issuer’s green activities and provide finance to climate-friendly activities. Of related appeal to some investors are social bonds which create debt instruments used to support projects that deliver a social good.
There are many different ways for advisers to build ESG-compliant portfolios for their clients and the same principles of understanding client needs and performing suitable levels of due-diligence and research apply. As more clients become more aware of ESG-related considerations, the range of solutions will only grow and advisers will need to rise to the challenge of navigating this long-term investment theme.
This article was written for International Adviser by Alexandra Mortimer an analyst at FVC.