Clearly Signposted, how to integrate ESG into the advice journey

Headlines:

1. The FCA expects advisers to take sustainability into account in their investment advice but hasn’t yet been totally clear how it expects advisers to do this
2. In explaining the concept of sustainability to clients, it’s important they understand it’s a balance between how they feel about investing in certain areas, and a more restricted investment approach
3. Advisers need to look beyond the names of funds to understand what the objective and strategy of the fund are and assess whether the fund is actually being managed to these
4. Ongoing reporting should allow the adviser to monitor that the fund is being managed in line with its sustainability objective and to provide the client with information on its performance against this objective 

Context:

Regulatory expectations on sustainability

The FCA expects advisers to take sustainability into account in their investment advice but hasn’t been totally clear how it expects advisers to do this.

Clients are becoming more aware of the importance of sustainability in investment, but this is far from universal. However, regulators are putting more attention to this. In a recent discussion paper aimed at investment managers (DP21/4) the FCA noted that they will be confirming that:

Financial advisers should take sustainability matters into account in their investment advice and understand investors’ preferences on sustainability to ensure their advice is suitable

EU regulations, with which FCA are expected to maintain equivalence, are being updated to require advisers to ask clients about their attitude to sustainability in sufficient detail that they can match them with an appropriate investment. It is therefore important that advisers integrate views on sustainability into their advice process for all clients rather than just react to client requests or ask cursory questions on a client’s interest in this area.

Many of our participants had already incorporated sustainability into their advice process though some were still working through the detail, and there was a concern from some about having the capacity and expertise to do this.

Client assessment

In explaining the concept of sustainability to clients, it’s important they understand it’s a balance between how they feel about investing in certain areas, and a more restricted investment approach.

Advisers can seek to understand a client’s attitude to sustainability through a structured set of questions, in a similar way to how they assess attitude to risk. In doing this, three principles should be borne in mind:

• Explain the concept: While clients may be familiar with the concept of sustainability it will usually need explaining in an investment context. That is, that sustainability considerations may limit the negative effects of a client’s investment, or create positive outcomes, but may restrict the areas they are able to invest in and/or their investment returns.
• Ask the right questions: Ideally questions will be clear and easily understood, avoid a binary “yes/no” response and not be biased or leading.
• Use meaningful client descriptions: The responses to questions will help classify clients by their attitude to sustainability. Classifications should not be binary and should be in words that the client understands.

Some practical issues came up here. The first was that the results of the assessment need to be able to be acted upon. Some assessment tools in the market go into significant levels of detail which can then mean there are no investment strategies available that meet all the chosen criteria.

Another consideration is how many portfolios this can generate. The Quilter approach uses three client types when assessing attitude to sustainability – ESG aware, ESG focused and ESG dedicated. Combining this with five risk levels results in 15 different portfolios. If we then consider investment approach (ie active, passive, blended) we can end up with 35 or more different portfolios (Quilter only offers active models for ESG dedicated clients).

Investment selection

Advisers need to look beyond the names of funds to understand what the objective and strategy of the fund are and assess whether the fund is actually being managed to these.

Advisers are responsible for ensuring the funds they recommend are suitable for clients in terms of their sustainability characteristics. The inconsistent use of language and the potential for “greenwashing” make it incredibly challenging for advisers to assess funds consistently.

In a letter to AFM chairs last July the FCA highlighted its expectations around how funds market themselves in respect to ESG. This is being followed up by a consultation on fund labelling that is expected shortly, and this will hopefully introduce some level of consistency to naming.

Ratings can be used to assess a fund’s sustainability characteristics although care needs to be taken here. For example, MSCI rates funds for sustainability from C to AAA though the ratings are within rather than across sectors. This can cause anomalies such as some mining funds having AAA status but still raising significant ESG concerns overall. Several participants were already using the Worthstone system, both to build portfolios themselves and to monitor what DFMs were doing for their clients.

Monitoring and reporting

Ongoing reporting should allow the adviser to monitor that the fund is being managed in line with its sustainability objective and to provide the client with information on its performance against this objective.

Of course, having established that a client wants to invest sustainably, advisers will need to think about how they monitor and report on this to clients on an ongoing basis. The more focused a client is on ESG, the more challenging it is likely to be to deliver meaningful reporting that measures the sustainability of their portfolio.

Reporting on exclusions and product involvement should be reasonably objective and is generally well understood by clients and investment managers. The carbon footprint of a client’s portfolio is also a useful measure and is likely to go to the heart of many client’s sustainability objectives. However, data isn’t always available and different firms may measure their carbon footprint differently. Finally, the UN’s Sustainable Development Goals span a wide range of positive outcomes but delivery against them can be difficult to measure objectively and some goals may be difficult to invest against.

Key takeaways:

• While many advisers understandably feel the subject of ESG has been 'overhyped', there seems no escaping from the fact that client attitudes to sustainability must be factored into the advice process. The FCA clearly has an expectation that advisers should be doing this, and we are likely to see more explicit direction in this regard over the coming months
• The regulator is also focused on making fund labelling more consistent to help advisers identify products that meet client needs but this is only part of the challenge. Structuring an approach to client assessment that is consistent, complete, and actionable is no mean feat. Moreover, factoring sustainability into investment selection that already has to consider risk, investment approach and potentially other preferences, will quickly expand the universe of investment options that need to be researched, monitored and reported on
• As always, a structured approach to assessing and classifying clients will be needed and will help advisers demonstrate suitability. Using a client profiler tool that can combine attitude to sustainability alongside attitude to risk will help achieve this. These profiles can then map to corresponding fund choices that will help advisers ensure that their investment selections stay consistent with client requirements and provide reporting that illustrates sustainability performance on an ongoing basis