The Long Game. It's not about the result, it's about the process when it comes to ESG

Headlines:

1. Advisers are not seeing significant client demand for ESG-focused investments
2. Huge structural growth opportunity exists in underfunded areas that passive investing will fail to reach
3. Misconceptions over performance trade-offs still exist
4. Lack of standardisation makes comparisons more difficult

Context:

Client demand

Clients are increasingly interested in outcomes and meeting their financial goals, rather than how they get there, where they are invested or the products that make up their underlying portfolios. Only in very specific cases will they lead with requests for particular types of investments.

Many advisers will outsource investment selection to DFMs, platforms or use MPSs, so many are ‘one step removed’ from investment conversations, providing the risk profile is suitable.

An element of trust is required when it comes to the providers being outsourced to (e.g the DFM) which can mean advisers sometime don’t feel permitted (or confident) to lead the clients towards sustainable investments.

Advisers are curious where decarbonisation would sit in the overall ESG solution. Demand is generally higher for thematic investing – where sustainable decarbonisation sits – as a diversifier from typical global equity funds, rather than a specific call for ESG and climate- or cause-related investments.

More education would be good – for advisers themselves and for clients – with advisers calling on providers to demonstrate how these themes are relevant.

Existing, long-standing clients are less open to change, with cost implications being one factor.

Helpful case studies like P&O Ferries as an example of poor governance can help bring relevant themes to life, rather than using industry jargon like ‘net zero’ or ‘ESG’.

There is a sense that many advisers are waiting for the FCA to mandate incorporating ESG into their processes. Parallels with the RDR and switching from commission to fees were drawn – i.e those who started the process early enjoyed a smooth transition.

There is a need for taking baby steps with smaller proportions of portfolios until clients become more comfortable taking a “leap of faith”.

Structural growth opportunities

Allocating beyond purely Scope 1 and Scope 2 into the less obvious Scope 3 (and 4) to climate solution providers introduces diversification away from standard global equity funds, active share opportunity, and a far broader investment universe than simply investing in big tech or clean energy, or disinvesting from oil majors.

We need to look at things from an inclusive perspective – by sector, by company size, by region. Emerging markets are currently the lowest scoring but hugely underfunded and therefore a bigger opportunity, for example.

Focusing just on the portfolio stance won’t address the carbon targets, funding gaps and allocation of capital that are needed to help the world reach net zero.

The data shortfalls around Scope 3, Scope 4 and more subjective aspects of positive impact investing and climate solutions provision make it difficult for passives to judge using rules-based strategies and algorithms. Active managers are far better equipped to question companies on their sustainability reporting.

Misconceptions over performance trade-offs

There are still assumptions that funds in this space won't perform as well. Risk-mapping tools perform an important role in helping to understand the risk/reward potential.

There is an expectation that as more institutional investors move further into these areas it will lift performance, which could pave the way in the retail space.

Companies further down the supply chain often offer mispricing opportunities that can be exploited by the right strategies, such as manufacturers of components in electric cars.

There is often an assumption that sustainability is all about growth yet straightforward p/e ratios can be misleading, offering value ideas to those managers who analyse against market consensus.

Sustainability research should be used to enhance the financial assessment but ESG ratings should be used with caution as they don’t fully capture the sustainability picture. Boohoo is an example of a company where poor sustainability practices instantly hit their share price but these were not initially reflected in ESG ratings.

Lack of standardisation

Because there isn't a standard across the industry, drawing comparisons is tricky, by company, at fund level, DFM or models and by ratings and research provider. Lack of consistency is therefore a huge issue. Increased regulation and efforts to create reporting standards are a welcome step – for example the EU Taxonomy, EU Sustainable Finance Disclosure Regulation and the FCA’s proposed Sustainability Disclosure Requirements (SDR) and investment labels.

The direction of travel suggests that we might get to a point where all funds are badged ‘sustainability’ or something like, but right now such an approach would reduce credibility for those that stand out from the crowd and may encourage greenwashing.

We have to think about ESG as a spectrum – from a strategy where ESG is considered right through to a focussed impact strategy. Offsetting cannot be the starting point but needs to be factored in when making company assessments.

While it is not expected that all clients will want to shift their entire portfolio towards sustainability or impact, considering allocating a proportion of the portfolio to these opportunities could be beneficial both from a risk/return outcome but also for wider society and the environment.

Key takeaways:

• Those typically most concerned about ESG aren’t significant investors yet, although this will rapidly change over time. Advice firms could ‘futureproof’ their practices by thinking about the next generations of investors, who are more interested in such strategies
• Standardised, clear, traffic light systems/labels on fund factsheets and model portfolios would be welcomed across the industry and regulation should achieve this in time.
• Funds with a sustainable or impact focus must report transparently so clients can see ‘where my money is doing good’, including, over time, contributions to performance
• The FCA is working on the next phase following its DP on ‘Sustainability Disclosure Requirements (SDR) and investment labels’ which will all help