There's a growing segment of investors who want their portfolios to reflect their personal values. A recent study showed that 81% of investors want their advisors to discuss this kind of alignment. But, despite this trend, many advisors are not talking to their clients about such opportunities even though a product landscape has evolved significantly to provide personalization tools.
This trend—loosely defined as the environmental, social and governance approach—is also extending beyond portfolio personalization and creating real impacts. Investors pursuing a sustainable philosophy have affected corporate behavior—more than 90% of S&P 500 companies now voluntarily report on some aspect of sustainability and many have set sustainability targets. Sustainably minded investors have even shifted the composition of the boards of global companies like ExxonMobil.
Despite the increase in client demand and the proliferation of investment choices and products, many advisors still are not taking advantage of this opportunity to build their business. In fact, advisors often represent the industry's most significant stumbling block. Those who aren't willing to address the demand for ESG risk losing clients to advisors that are embracing sustainable investing, particularly upon generational wealth transfer. Multiple studies have indicated that both women and younger investors are likely to be seeking a portfolio that aligns with their values.
Concessionary Compromise
There is a common misperception that incorporating ESG values into a portfolio or choosing ESG-oriented investments means sacrificing performance. According to a Morningstar study of ESG index performance over the five-year period ended Dec. 31, 2021, 80% of Morningstar ESG indexes with five-year histories outperformed. In addition, during the same period, 88% of Morningstar ESG indexes with five-year histories lost less than their broad market equivalents during down markets as measured by the downside capture ratio.
While the vast majority of ESG approaches could do well over time, investors should be aware that excluding large numbers of companies and sectors from the investable universe will likely result in increased tracking error. There's no guaranteed return for ESG stocks or promise that investments will be "safer" in these vehicles, but the premise that socially responsible companies lag in performance is a myth. The ESG category is broad enough that advisors should be able to find ways to drive returns while maintaining a portfolio that reflects the client's stated values.
Addressing Client Priorities
The primary role of a financial advisor is to provide personalized guidance on the best investment approach to meet a client's goals—a process that is best achieved when advisors take the time to ask the right questions to understand their priorities. These detailed conversations enable advisors to deliver a portfolio that matches those values.
Because ESG values can be very personal—one client may prioritize environmental issues while another values diversity—it's important that these programs are not viewed as a commodity or one-size-fits-all solution.
It is unfortunate that ESG has been politicized of late, but it is important advisors set aside their political views or the views of their firm. After all, this is about personalizing portfolios to best align with a client's values and advisors should be facilitating, not impeding, this goal.
Defining "Good" and "Bad"
There is no industry standard for a "good" or "bad" ESG and client criteria are diverse and subjective. Even the largest ESG data providers cannot agree on a universal definition.
Identifying and researching investment opportunities is challenging, making it even more important to listen to the client's objectives. While the process has become easier for advisors, it still takes time to understand sustainability themes and become familiar with the tools available to evaluate different investments. That kind of commitment can make some advisors shy away from these opportunities.
Advisors may want to avoid making recommendations based on an ESG data provider's "pillar score" and pre-defined ESG labels and instead make investment recommendations based on the client's priorities. This could mean suggesting a stock or a fund that prioritizes addressing climate change but does not focus on workforce engagement or corporate governance. Let the client guide these investment decisions and personalize their portfolio to mirror the client's values.
Addressing Demand—Building a Future
The ESG space is constantly evolving and lowering the barrier to entry. Not only are new trends emerging, but so are new products and assets. Advisors can provide tailored services and portfolios. Thanks to ESG reporting technologies, advisors can now provide clients with impact reports that compare a client's ESG portfolio to a specific benchmark like the S&P 500 or Russell 1000. For example, an advisor could show that they are able to significantly lower exposure to carbon emissions in an ESG portfolio versus simply owning the underlying benchmark index.
ESG is an opportunity for advisors to better serve their clients by aligning portfolios with what clients care about most. Let clients' values determine where to make investments, and the result should be sustainable for all.
Bud Sturmak is Head of Impact Investing at Perigon Wealth Management. His comments are presented solely for informational purposes, and nothing herein constitutes investment, legal, accounting or tax advice, or a recommendation or solicitation to buy, sell or hold a security.