Although not an entirely new phenomenon, values-based investing has undoubtedly seen a surge in popularity in recent years with a 38% increase in AUM since 2016. These questions give you a chance to build deeper relationships with clients — if you know how to answer them.
Although not an entirely new phenomenon, values-based investing has undoubtedly seen a surge in popularity in recent years. Twenty-six percent of U.S. assets under management now employ socially responsible investing strategies, a 38% increase since 2016, and that number is only poised to rise as investor interest grows.
Propelling this market growth, in large part, is the millennial generation, who are twice as likely as their older counterparts to seek out sustainable investing opportunities. This is, after all, a cohort that came of age during the Great Recession and witnessed the global effects of poor governance. They’ve seen the #MeToo movement precipitate shake-ups at the highest levels of corporate and political life, been privy to dire warnings regarding the health of our planet, and lived through the longest war in U.S. history. When placed in that context, it likely comes as little surprise that they rank values-based investing among the top three priorities when selecting a financial advisor.
Female investors, too, are a significant driving force behind the growing interest in values-based investing and, as they ascend the corporate ladder and inherit wealth, this demographic’s influence is ever-growing. As of 2015, women controlled 51% (approximately $14 trillion) of personal wealth in the U.S.; they are on track to oversee $22 trillion by 2020.
For the purposes of this column, sustainable investing involves the integration of environmental, social and governance (ESG) criteria to subsequently allocate capital toward companies that consciously treat their resources — whether it’s human capital, their surrounding communities or the planet — with respect. This philosophy certainly represents a tremendous opportunity for investment advisors to establish a competitive advantage and grow their practice, yet many struggle to reconcile that burgeoning client interest with commensurate adoption of sustainable investing strategies. From concerns about companies’ true alignment with personal values, to ambiguity regarding nomenclature, there is a largely untapped chance for financial advisors to educate themselves — and their clients — about the benefits of investing in sustainable companies. That’s why, as client demand for sustainable investing expands, we believe there are some key questions investment advisors should expect, welcome and be prepared to answer:
1. Performance: “Does sustainable investing mean I have to compromise returns?”
One thing holding advisors back from embracing sustainable investing is confusion around financial performance. According to Cerruli Associates, more than a third (35%) of advisors who do not currently employ ESG strategies cite concerns about its potential impact on performance as a deterrent, with 75% noting that it is at least a moderately important factor in their decision-making process.
We believe that companies that prioritize responsible and equitable business practices — including environmental safety, workplace diversity and strong corporate governance — will, in the long run, outperform those that do not. And we’re not alone in our thinking: Data from financial institutions such as JPMorgan, BlackRock and Goldman Sachs also suggests that the consideration of ESG factors can provide investment advisors with full context on the risks of investing in a company without compromising returns — and, in some cases, even exceed the benchmark.
We suggest that, where possible, advisors reference empirical data and leverage any available strategy backtesting tools to enhance investors’ confidence in sustainable investing. There is a growing body of research that uses backtesting simulation to illustrate the impact of ESG integration on various investment strategies. One such report from MSCI found that integration of ESG criteria into passive strategies generally enhanced risk-adjusted performance over a decade-long period, tilting the portfolio toward higher-quality and lower-volatility securities.
2. Product: “How can I align my investment portfolio with my values?”
Developing a robust understanding of your clients’ values can be a complex process that involves multiple considerations and trade-offs, often not so simply distilled to “reducing carbon emissions” or “investing in clean energy.” For example, many clients will approach an investment advisor with the goal of divesting from oil and gas while simultaneously investing in companies that are the largest supporters of clean energy. However, the inconvenient reality around clean energy is that some of the largest oil companies have invested heavily into renewables. That’s why, before embarking on a sustainability journey with your client, it’s important to first engage them in a candid conversation to clarify their expectations and explain the trade-offs inherent to investing for environmental and societal impact, while concurrently discussing traditional metrics such as returns, index tracking error and risk tolerance.
Once you’ve thoroughly explored clients’ needs, there is no shortage of sustainable investment products in the marketplace — per EY, the number of available sustainable investing funds has nearly tripled since 2008. However, not all products are created equal, and clients have little visibility into whether these “off-the-shelf” mutual funds or exchange-traded funds (ETFs) don’t match a client’s specific priorities or offer enough flexibility to accommodate them.
These shortcomings may explain the recent uptick in separately managed accounts (SMAs) — portfolios of single name equity securities that allow for much greater portfolio customization than ETFs. SMAs represent a natural fit for sustainable investing, as they may be adjusted to include or exclude specific stocks based on an individual’s preferences — whether it’s screening out private prison operators, penalizing wasteful manufacturers, or favoring companies that promote equitable labor practices.
SMAs can offer the same diversified index-like exposure as ETFs, but with fewer restrictions around the equities that can be held and their allocation levels. They therefore enjoy greater tax benefits, such as gain deferral and security-level tax-loss harvesting, that may be attractive to clients.
Advisors should be prepared to engage in conversations that places the client’s needs at the forefront. They should assess the strategy’s historical performance, underlying data sources, exposure to various factors, ability to withstand various market conditions, alignment with their overall allocation model, reporting capabilities and more. Moreover, they must ask themselves whether a product reflects the client’s ethical convictions and priorities.
3. Reporting: “Can you show me the impact my investments are having?”
According to a survey by the Chartered Alternative Investment Analyst (CAIA) Association and Adveq, the most significant hurdle to ESG adoption is a dearth of standardized, comparable data on material sustainability issues — which is essential to understanding impact performance. Although there have been efforts in recent years to bring more uniformity and cohesion to sustainability terminology and reporting, there is still work to be done.
That said, the entry of major players into the sustainable investing space makes one thing clear: this is no longer a fringe interest, and is steadily moving from the margins to the mainstream. Now, there are numerous reputable third-party vendors offering quality data that communicates companies’ performance against key metrics such as governance, environmental impact, human rights issues, fraud, tax evasion and more. Equally, there are a number of NGOs that are further empowering investors by actively collecting metrics on a broad swath of sustainability issues. And, thanks in part to efforts by organizations such as the GRI (Global Reporting Initiative), the IIRC (International Integrated Reporting Council) and UN PRI (United Nations Principles for Responsible Investment), and their efforts to develop clear reporting frameworks and standards, approaches to sustainability data collection and use are improving by the day.
However, investors can’t trust what they don’t understand, and advisors have an opportunity to help them cut through the noise. One way they can add value and forge deeper client connections is by reframing the way they approach portfolio reviews — by augmenting discussions about quarterly returns with insights on how a client’s holdings are contributing to pressing global issues, advisors have the potential to ignite clients’ passions. While this may be as simple as communicating the ways in which the client’s investments have bolstered companies that are exploring green technologies, or reduced exposure to executive misconduct scandals, diligent advisors can go the extra mile by using data to quantify impact (e.g. a portfolio’s carbon emissions or executive gender parity).
Education is paramount when it comes to engaging clients around the issues that matter to them, and there exists a plethora of useful materials that advisors can turn to as they seek to expand their sustainability practice. The Forum for Sustainable and Responsible Investment (US SIF) offers online and in-person training services, to help advisors get a handle on key sustainability concepts. The more authoritative advisors can be in discussing these concepts with clients, the more prepared they will be.
The upcoming wealth transfer between baby boomers and millennials, which will see some $30 trillion change hands in North America alone, presents a compelling business case for advisors to become sustainability thought leaders. To do so, they must feel confident answering the questions outlined above and guiding their customers toward a flexible solution to their values. Advisors have the opportunity, if they choose to take it, to engage existing and prospective clients alike in exploring the issues that matter to them. Most of all, they should not shy away from these conversations — because that’s when the potential for a deeper, richer client relationship presents itself.
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