This is the third post in our September Investment Forum Highlights series. Our expert speakers Elizabeth Stuart and Anastasia Georgiou from Morningstar, and Mikkel Bates from FE Fund Info shared essential information for advisers about discussing ESG with clients, meeting changing regulations, and following your clients’ values regarding sustainable investments.

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What’s the minimum advisers need to do for ESG without setting too much that we’ll need to change later?

Adam Smith:

Given the uncertainty on the rates and the uncertainty of the data, I’ll ask this carefully: what’s the minimum we need to do to in your view “get by”, because obviously it’s an evolving landscape. I don’t think anyone will go to far one route unless we have to back out to another, but what’s the minimum we can do to be sensible and move in the right direction without spending too much or changing too much in terms of process first?

The regulations will be coming in December, so arm yourself with the information you need or maybe hire a specialist.

Elizabeth Stuart:

In terms of your process, like you said, the regulations, and you won’t have long to wait, even if you started changing your process now, December is around the corner. You won’t have a terribly long time to wait before that comes through and everybody will be scrambling. But even just in terms of internal education or maybe writing a policy to guide people, giving out packs of information, where they can go for information, but just arming up. Hiring a specialist or someone to be on hand. But nothing super drastic until you know exactly where you have to go. But yeah it’s just about arming yourself with the knowledge more than drastically changing process before you know where you’re going.

Most clients are still more interested in their investments, and it can’t be an adviser’s job to force values onto a client—where is the line of what we’re obliged to do?

Jane Hodges:

We’re getting a lot more interested clients on sustainable issues. But the fact is, is that still the largest portion are particularly interested in their investment portfolios at the moment, or if they are interested their interest very generically. And there are a few that are passionate and want to talk about all of their values but this is still a very small minority of the customers I’m seeing. So I guess that question from Adam really is, it can’t be an adviser’s job to force a set of values on a client and to try and lead them through a story that’s going to cost them a lot of money and us a lot of time when it’s not actually something that they feel very passionately about. So where is the line between what we’re obliged to do, what we want to do for clients that are passionate, or we’re actually at the moment the larger proportion of my clients are, which is saying, “if you can do it sustainably and it doesn’t cost me any money, then I’d like to go that route”.

Many clients don’t understand what ESG really includes, in fact only one in five investors can pick out what it means. It’s often up to advisers to understand what’s meaningful to clients, whether that’s exclusions or having an impact.

Anastasia Georgiou:

As we’ve already talked about ESG is a really confusing space for clients right now, when they talk about it, they could be thinking about ethical funds. They might be thinking about green labels, socially responsible, or really just avoiding nasties. So there’s not really even consensus with the investors because they don’t really understand enough, but that’s also not surprising because the space has, as you know, so many acronyms and asset managers are incorporating ESG in very different ways. So it’s a very difficult topic for investors to navigate as well as advisors. And obviously, the regulatory push which Mik and Elizabeth have been talking about is hopefully going to create or is aiming to create some consensus and comparability.

And that’s something that at Morningstar we’re really focused on it, to try to create a sort of level playing field and trying to cut out some of the noise within this space. And when Adam was talking about whether clients even understand what ESG means. I don’t know if any of you caught the survey that Boring Money ran last year, but they actually presented investors with different meanings of ESG. And actually only one in five investors was able to pick out what it meant. So it’s difficult. And even on Morningstar’s website, which is predominantly hobbyist investors coming in, we’ve been running a poll for the past month and again, only 50% of investors felt they understood what it meant to invest sustainably.

So it’s tricky. And I think for advisers, it’s really about starting to talk to their clients about those different avenues of ESG and trying to get to what does it mean to them, because I think, it means different things to different people. It’s almost like a decision tree in terms of a conversation to figure out “okay, for this particular client, what is meaningful for them?”  For some, it will be, exclusions, for others, it will be about having an impact.

The ethical fund industry has grown the last 30+ years with no industry-wide guidelines. Oftentimes excluding an industry for being unethical doesn’t relate to whether it’s sustainable. Last year the IA published its Responsible Investment framework, standardizing terms. From March next year, advisers will have to ask every client is they want to incorporate ESG into their decision—but what isn’t regulated is the client’s answer, which might be complicated to make happen. The regulators want certain things but fund groups have their own policies, and some funds won’t incorporate ESG at all which may make them look bad but lots of clients won’t care. Advisers will also need to post publicly how they incorporate sustainability risks into the investment process. You need to have an idea of how you engage with fund groups and what you look for in impact and sustainability.

Mikkel Bates:

Obviously I’ve already said, you’re talking about subjective values, so you’re going to get as many subjective values as you have clients basically. But part of the problem is that whatever you want to call it– traditionally it’s been the ethical industry, ethical fund industry– has grown up over the last 30 plus years with no industry-wide guidelines, no guidelines on the language used. And so every company that’s launched an ethical fund or an ethical fund range has used its own terminology. I’ve done some work for some of the ranges and, you know, the industry, they talk about shades of green, whether it’s light green, dark green.

But nowadays, the issue of an ethical policy of exclusion is being sidelined, certainly in terms of the context of the requirements for environmental and climate change related issues is being sidelined because excluding a whole industry because it may be unethical for whatever reason, whether it’s tobacco or gambling or alcohol or weapons, that doesn’t generally have much relation to whether it’s a sustainable business or even a sustainable industry.

But this all led, late last year, to the IA publishing its framework on what they call responsible investment, and that’s chapter one of their framework really. And what they’ve done is come up with a half a dozen terms like stewardship, ESG integration, exclusion, impact investing, and so on, and put definitions to them to try and generate some consistency. And this is the first time, 30 years after the industry started on ethical or sustainable or responsible investment, that this has been done really. And if there’s any way that that can lead to not a narrowing down necessarily of a client’s values because clients’ values are clients’ values but a standardizing of them.

I’ve been talking quite a lot to people in the past about what I see as the disconnect at all stages of the chain. You’ve got the regulators, we know what the regulators want, they told you what they want, they want fund managers to record their funds and look at the sustainable impact and sustainability risks and incorporate them in their investment process.

They’re telling fund groups and advisers to post on their website how they incorporate sustainability risks into either their investment process or their advice process. Advisers will have to, from March next year, ask every client whether they want to incorporate ESG into their investment decision. And then that’s when you get to the bit that the regulators don’t regulate, which is: what’s the client going to answer?

If it’s, “Yeah, I want to incorporate ESG. I don’t want invest in animal testing”, they really are going to cause you a problem because some funds may avoid unnecessary animal testing, but it’s unlikely to be the main focus of it, and it’s certainly not an ESG criterion. So that’s why I said earlier, one of the important things that you need to start with now is to try to understand what your clients’ values are and how they can be incorporated, and if necessary guide them into, you know, “actually, yeah, I appreciate that, and we’ll look for a fund that avoids animal testing unnecessarily”.

Animal testing is a questionable one, because if you’re a drug company, you cannot get a drug approved for human use unless it has been tested on animals in the UK, US, Europe. So you have to be speaking about what is unnecessary animal testing. But in terms of ESG, there’ll be as much of an education process for you or for your clients as your clients to explain to you what their values are. And there is this disconnect because at the one end, you’ve got the Paris climate agreement and the UN SDGs, that are driving the regulators, you’ve got the fund groups which have their own policies. And the one thing that they all talk about is their engagement and governance. And so on some funds we’ll talk about ethical exclusions or sustainable investment or positive impact.

But no one’s actually told the client what they really want or what they should have. And so it is a question of both asking them and telling them and when you ask your client, as you have to ask your client, do they want to incorporate ESG into the investment process? They might say, no, I’m happy, you know, I want this to maximize my returns. You don’t have to consider it and not all funds will necessarily consider it.

So we talked earlier about Article 8 funds, being those that talk about and promote sustainability and Article 9 funds being probably positive impact funds, green energy and so on. Initially at least, there’ll be a great swathe that other funds that don’t incorporate it now, they’re being not sidelined, but they’re being tarred with a not very positive image by the regulation on day one, which says they need to put on their website and on their pre-contractual information, that they do not incorporate sustainability risks in the decision process. And that will sound like a very negative issue, but for some clients, they may be absolutely fine with that.

One more thing on that as well. Advisers will need to post on their website and probably include in the client agreement letters and so on, how they incorporate sustainability risks into the investment process and what they look for in funds and what criteria they apply when looking at sustainable funds. So you can guide your clients that way a bit as well. So you’re pushing the client down to say, “these are the things we consider when we’re looking at sustainable investment funds. If you, if you have other issues like avoiding animal testing, you know, we can look at that separately, but that’s not our main criterion”.

The statement wouldn’t be individual to the client but more a general explanation of how your firm incorporates ESG and what criteria you look at. 

Mikkel Bates on what kind of statement– and how specific a statement– is needed for advsiers to post regarding how they approach ESG:

I think the expectation is it’ll be pretty generic because it’s a standard statement you need to put on your website and so on and in generic pre-sale, pre-contract documents, on how you incorporate sustainability in your advice process. And so you’re not saying, “for you, Mr. Client, this is how I would incorporate it”, but, “this is how we as a firm, as an adviser, incorporate sustainability risks into our advice process”.

And if anything, that’s probably intended to be something that clients, when looking for a new adviser, I could see that they’ll scroll through a number of websites and they’ll see the statement and they’ll see that’s a whatever you want to call it, a green, an ethical IFA, a sustainable IFA. And here’s one that, yes, they’re a generalist IFA, but they incorporate sustainability risks in this fashion.

I couldn’t give you a statement for this off the top of my head for what you should say in it, but I think you need to have some idea of how you engage with fund groups, what you look for in their funds generally. Whether you look for exclusions as a policy, so an ethical fund range, whether you focus on environmental funds, positive impact funds, it might even be that your focus is on positive impact funds, which therefore will score pretty poorly on most ESG ratings and against the regulators’ requirements, because you’re investing in companies that don’t meet a lot of criteria because you want to engage with them and help drive improvements in them.

I believe advisers will start to incorporate ESG into their technology, and though other things will be more important the goal would be to move towards the ESG requirements over time.

Anastasia Georgiou:

Maybe go back to your point around: “do we think advisers are going to incorporate the ESG preferences into their technology? “and I certainly think that they will. I think that it is obviously a part of the suitability process. The time horizon, capacity for loss and risk profile, will trump the ESG preferences, but I think using a series of questions gets advisers to the direction of what the client’s values are. That way advisers can document it and can use this as an education piece as well, so investors understand what it means.

As an adviser, you know what they’re thinking about and what you’re looking at. It will be more of a direction of travel in terms of getting a portfolio that moves towards the ESG requirements. So maybe you’re not going to have a hundred percent of your portfolio having an impact and excluding, you know, X, Y, Z, but you can see within the portfolio that perhaps 20% of that portfolio has a positive sustainable impact and maybe the requirement is to exclude all the tobacco exposure, but it’s currently 20%  and over time, maybe you look to get that down to 10%. 

I don’t think it’s a scenario where you will have a perfect fit necessarily day one, but I think it starts a dialogue and helps your investors to understand what’s feasible and helps them to see how their portfolio reflects that.

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