Environmental, social and governance (ESG) is now mainstream. Regulatory directives echo this change. The European Commission has proposed amendments to MiFID II and the Insurance Distribution Directive (IDD) to make a consideration of clients’ preferences on ESG topics a mandatory part of advisers’ suitability process. Pension scheme trustees also face new obligations – the Department for Work and Pensions has outlined ESG requirements which they expect trustees to implement by 1 October this year. These include trustees disclosing the risks of their investments, including ESG, and clarifying the extent to which members’ views, including ESG, are considered when planning investments.
Meanwhile, the FCA has expressed its views that advisers must respond to the increasing demand for sustainable and green investments, acknowledging it’s an area of huge growth.
But this world of investment is a jargon-filled minefield; ESG, SRI, sustainable, impact, ethical, green, faith-based…the list goes on. Advisers too are navigating this quagmire of confusion – different investment managers use different terms for their processes and fund objectives.
The industry has acknowledged the problem and is working towards consistency – the Investment Association (IA) is currently striving to agree industry-endorsed standard definitions. In the meantime, we’re keen to help clear up some of the confusion.
Multiple terms, two key approaches
While the terms and options are many, two fundamental and very different approaches are at play:
- Environmental, social and governance (ESG) integration: This is about integrating consideration of ESG risks and factors into the overarching investment process. It allows managers to analyse a company’s approach to better manage risk and to aim to generate sustainable, long-term returns. It’s about financial assessment and risk management across all funds – so it’s relevant to all investors, not just ‘ethical’ investors.
- ESG integration is also often referred to as responsible investment.
- Sustainable investment or ‘values-based’ investment: We use this term to cover the many different types of funds that aim to combine achieving a financial return with a specific non-financial outcome. Funds investors choose to align to their wider view of the world, and which can suit their ethics, values, or desire to do good.
On one hand, you have a fundamental, arguably critical, addition to the process for risk assessment. On the other, you have individual funds focused on accommodating or promoting specific outcomes in addition to their core remit of aiming for a positive return for investors.
ESG can highlight problems missed by more conventional risk analysis
Essentially, ESG is a good indication of a company’s overall quality. Investment managers use it to assess the financial health and risks of a company based on the actions they take (or don’t take) around environmental, social and governance factors. This could include identifying:
- disconnects between financial performance and employee remuneration
- poor management of supply chains or natural resources
- the impact of production activities on local communities and climate change
This analysis helps managers to spot issues on the horizon, so they can work with companies to fix or even avoid these. Or, in the case of active managers, to move money out of companies that are resistant to change.
If managers understand how companies manage ESG factors – and therefore any associated risks these companies may face – they can better value what they’re investing in. In turn, this can help them achieve better risk-adjusted returns for investors. Remember, your clients’ investments could go down as well as up and they may get back less than was paid in.
Sustainable funds for clients with specific requirements
Sustainable funds tend to reflect overarching themes or specific ethical requirements, so are a way for clients to match their investments to their values.
Themes and requirements may include:
- avoiding companies that produce tobacco or weapons, or that test on animals (negative screening)
- investing according to certain religious values (faith based funds such as Shariah)
- seeking out investment in companies intending to make a positive and measurable contribution to the environment or society (positively screened or impact funds)
- using elements of each of these, sometimes in combination with more standard assets.
A simple way to look at a big difference
ESG integration is an ‘across the board’ process, while sustainable/values-based investing is a type of fund or investment. You could think about it this way. Is your client looking for:
- an investment manager who has a robust process to help manage risk and return across all funds?
- an individual fund or range of funds that target a specific values-based theme or outcome?
Platforms are responding
The increasing regulatory focus on meeting clients’ preferences for responsible and sustainable investments adds to the already considerable burden on advisers’ time and resources. The good news is that some platforms are developing technology that will make it easier for advisers to deliver individual investment solutions in the most efficient way.
Jargon-buster for your clients
As we’ve mentioned, terminology is used in different ways by different providers and managers, and it’s likely to evolve.
In the meantime, we try to be clear about the different approaches so that advisers and their clients can begin to better understand these areas of investing. We’ve produced a summary you can use with clients.
The information in this article should not be regarded as financial advice. Please remember that the value of investments can go down as well as up and may be worth less than originally invested. Information is based on our understanding in August 2019.
Standard Life accepts no responsibility for the information contained in the websites referred to in this article. This is provided for general information only.
The views expressed in this blog should not be regarded as financial advice.