So-called “socially responsible investing” has been around since the ancient days of religious restrictions in usury. The strategies have evolved, of course, and today, some 30 percent of managed assets in the institutional space operate under some kind of socially responsible mandate.
It’s not always because of some tree-hugger mandate, but rather a growing realization that exposure to non-financial factors like an over-reliance on the carbon economy or subcontractors that exploit their labor force exposes companies to real business risks that aren’t usually factored into traditional valuation models. Capitalism may be the engine of the economy, but it’s a society’s values that influence the direction it moves, and there is plenty of research beginning to show that funds slightly outperform when consideration of these non-financial factors are brought into an asset manager’s investment process.
Yet despite some 250 mutual funds and exchange traded funds that bring these strategies to the retail channel, financial advisors and clients haven’t embraced them. According to the Fuse Research Network, 51 percent of advisors don’t use them at all. On average, only 4 percent of advisors’ client portfolios are in these kind of funds—suggesting the few advisors who use them are dabbling, not jumping in.
Marie Chandoha, the CEO of Charles Schwab Investment Management, speaking at Schwab’s IMPACT Conference earlier this month, suggested two reasons for the lack of traction in SRI funds: Values are subjective and vary from investor to investor. There is too much variety there to effectively build a single investment fund that can reach the scale needed to keep costs low.
But for advisors looking to differentiate their practice, there is an opportunity in using the strategies, according to Marcus Velasco, a managing director with Nuveen’s Wealth Management Services team, during a presentation at the Schwab IMPACT Conference. Once investors understand what it is, and advisors understand that it doesn’t necessarily mean sacrificing performance to put client money into these strategies, there is a ready market of clients in every region of the country.
“I don’t see this done. (Unlike institutional managers), no one has a third of their clients in this space,” he said. “Everything rolls down to the retail side. If you are the one doing this in your region, I guarantee you you’ll be the only one. And once word gets out, people will come to you.”
Velasco said it was important to overcome two big myths around SRI: That there is no demand and that performance suffers.
According to Velasco, 74 percent of investors say they are more likely to work with advisors that can match the market’s performance with a fund designed to make an impact on society. Yet 61 percent of investors say their advisor hasn’t discussed responsible investing with them, he says.
That’s largely because advisors themselves aren’t clear on what it is, he said.
First, the confusion over nomenclature: What Nuveen calls “responsible investing” can be seen as an umbrella for the variety of approaches. Asset managers may exclude certain companies from a portfolio for an alignment with an investor’s personal values (like no gun manufacturers, no coal companies or a larger exposure to non-carbon producing businesses). Or it may mean deliberately directing investments towards particular projects designed to impact an area of concern—think “green bonds” in the fixed income space, or investments in businesses meant to give an economic boost to those living in poverty, like microloans.
But more recently, asset managers use screens around a firm’s environmental, social or governance rankings. Several services, including MSCI and Sustainalytics, calculate scores for every publicly listed company around a multitude of factors, including things like a firm’s carbon emissions, its use of water, the way it treats its workers, how it polices its subcontractors and the composition of its corporate governing structure.
The idea behind this is less about investing alongside personal values, but with a belief that non-financial factors like a firm’s extreme use of limited resources, like water, or using subcontractors that exploit workers, are a business risk that should factor into a firm’s valuation.
Asset managers using ESG screens will “give these companies a higher discount rate because it’s a riskier business,” Velasco said. “That’s how it can build a better portfolio and returns going forward.”
Morningstar uses Sustainalytics data to assign one to five “globes” to mutual funds as a snapshot of that portfolios exposure to ESG factors, he said. And there is evidence that even firms without ESG mandates that happen to score higher on the ESG criteria outperform funds with more exposure to ESG risks. These factors are “good strong determinants of performance going forward,” he said.
Velasco said it is fairly conclusive that funds that invest with ESG filters do tilt towards a “small, steady performance advantage,” he said, citing research by TIAA Global, Deutsche Asset and Wealth Management, and Morgan Stanley’s Institute for Sustainable Investing. “The underperformance myth is old,” he said.
For advisors, a chance to talk to prospects about their values, and how to tie that into their investments, is a great way to open a conversation.
“Don’t assume that clients know that this can be done. Part of our job is putting things in language that our clients can understand … the real challenge is explaining it to clients,” he said.
One idea is to freely offer a “portfolio analysis” using some of the tools available from MSCI and others to evaluate a prospect’s current portfolio and make them aware of the deficiencies. “Do you know your portfolio pollutes a lot,” would be a good opening for the increasing number of clients who care about the environment, he said.
Advisors should ask prospects what volunteer organizations they work with, and read those group’s mission statements to get a feel for what is important to them.
Monitoring the impact of the investments generates good touchpoints for future conversations with the clients, and can also deepen connections to a client’s spouse and kids—the ones who will ultimately inherit the money.
“Eventually, there is going to be an expectation that retail clients have a focus, or at least some knowledge, of this space,” he said. “Make this something you’re known for.”