Few investment topics are as misunderstood as environmental, social, and governance investing. Because of the confusion, many advisors are still avoiding offering ESG portfolios to clients. It’s a struggle to figure out how to do so. And those that do offer it are often making it more difficult than necessary. Here is our list of the top mistakes advisors make with ESG. Avoid these, and your ESG solution will be a boon to your business, not a burden.
- Confuse ESG With SRI
This is perhaps the most common mistake, and it’s not surprising why. It seems everyone—the media, fund managers and now even politicians—mix these up. But advisors would do well to keep ESG and SRI distinct in their minds, and in their portfolios. Because they are very different.
ESG is risk. It’s what companies face in terms of environmental, social and governance risks.
SRI is taste. It’s what investors care about. The differences are stark, and so are the implications.
ESG asks questions about how a company is doing on energy efficiency, health and safety, board independence, etc. These are not controversial. SRI asks questions about how investors feel about alcohol, tobacco, guns, gambling, abortion, animal rights, etc. It’s safe to say opinions vary greatly here. This distinction makes ESG a lot easier for advisors to implement.
Advisors can build model portfolios with ESG. They don’t need to "tune" the portfolio to the individual client’s values and preferences. With SRI, each client might need their own custom portfolio, and it will take an in-depth discovery discussion on their feelings (and then lots of research into funds and ETFs) to build it.
- Underestimate Client Demand
Most advisors say they only get a few client requests for a sustainable portfolio, so they assume not many are interested. This is a mistake. I’m sure the cashiers at McDonald’s don’t get a lot of requests for pizza. It doesn’t mean people don’t want pizza; it just means they don’t think McDonald’s has it. Don’t put your clients in that position. Make it clear you have an ESG offering.
Dozens of surveys of high-net-worth investors have shown they are interested in sustainability. And they are willing to pay for it. U.S. investors sent $70 billion to ESG funds and ETFs in 2022. In the downturn of 2022, while conventional funds suffered massive outflows, ESG funds were still net positive through Q3. According to Yale’s long-running study on climate change beliefs, 75% of Americans now believe it is a problem and more should be done about it. Especially with the impending wealth transfer, one-third of millennials often or exclusively use investments that take ESG factors into account. If you aren’t offering a sustainable portfolio for these people, they’ll likely go to an advisor that does.
- Use ESG Ratings
Few advisors would make an investment decision based on a stock or fund analyst’s buy, hold or sell rating. It’s too blunt of an instrument. There are other factors to consider. Plus, for every analyst that says this investment is a buy, another one rates it as a sell. These ratings are just opinions.
It’s the same for ESG ratings. They aren’t helpful in making investment decisions. Advisors would be better off using the same research criteria they use for conventional funds and use ESG funds that match their existing investment philosophy. Quite often, advisors can use the same fund managers they use in their conventional portfolios. To determine which ESG funds are the best fit, advisors should examine the degree of ESG tilt to more sustainable stocks in the fund, the level of shareholder engagement and the manager’s commitment to sustainability overall. Just don’t use ratings.
- Feel the Need to Be a Sustainability Expert
Sustainability can be hard. Which plastics can I recycle? When should I replace this old refrigerator with a new energy-efficient one? It’s not always obvious what’s best for the environment. It’s even more difficult to know which companies are better for people and planet.
Advisors are often reluctant to offer an ESG portfolio because they aren’t experts on what makes a company sustainable or what sustainable innovations will be most impactful or most profitable. But advisors do often have expertise in what matters to clients. They are particularly well versed in managing the tradeoffs between risk, return, cost, tracking error, etc. This expertise is exactly what is needed to invest sustainably.
Today, investors have hundreds of sustainable investment options—over 500 ESG funds and ETFs are available in the United States. Choosing between them is like choosing between different value or small-cap funds. How much tilt do you want? How much tracking error are you comfortable with? What are you willing to pay? These are decisions advisors are used to helping clients make.
- Think a Separately Managed Account Is Required
Some clients do want custom portfolios. They might have a problem with tobacco companies, guns, charter schools or animal testing. But these clients are distinctly in the minority—advisors that offer custom portfolios estimate 10% to 20% want an SMA. And to be clear, these are SRI issues, not ESG ones.
Many advisors offer ESG model portfolios, sometimes alongside their conventional models, and rarely need to customize them, let alone build separately managed accounts. Most clients are not experts on sustainability and are more comfortable with the fund manager doing security selection. When I go to a fine dining restaurant, I tend to order off the menu: I trust that the chef has put her recipes together that way for a reason.
If you’ve thought about offering ESG investing to clients but gave it a pass, it might be time to reconsider. More clients want it than you might think, and it need not be as hard as it seems. Don’t be one of the advisors missing the opportunity to offer sustainable investing.
Sam Adams is CEO and co-founder of Vert Asset Management.