Wealth Management & ESG Disclosure Requirements

Wealth Management & ESG Disclosure Requirements

Early last year, we posted a short article titled, “ESG and Wealth Management – Taking Off Or Stalled?We think it’s already time to revisit the topic.

First, let’s state a key underlying assumption that is not necessarily embraced across the entire wealth management space:  incorporating environmental, social, and governance (ESG) factors into the investment process is worthwhile—not because it is fashionable, but because it gives investors and the companies whose stocks and bonds comprise the investment universe a better understanding of material risks and opportunities. Who wouldn’t want wealth managers to use that information? After all, those risks and opportunities can affect investment returns. 

ESG in wealth management gets complicated

But applying ESG-related information to wealth management it is not a trivial undertaking, and can be frustrating for a number of reasons (whoever said this would be easy was misinformed). Definitions of what E, S, and G cover can be inconsistent from one source to another, the terminology, which is still evolving, is full of insider short-hand and acronyms (Scope 1, 2, and 3? SFDR? See our article about Alphabet Soup), and company disclosures range from inconsistent to practically non-existent, depending upon the current state of regulations in a given market.

And add to that legitimate concerns about greenwashing. Most investors understand the concept of sustainability, and that the long-term health of individual companies and entire economies are linked to things that ESG-based analyses and scores attempt to capture. That includes fighting climate change, protecting biodiversity, attracting and retaining a quality workforce, protecting customer data, and many others. Long-term investors will prefer companies that pay attention to these things, and greenwashing arises from the temptation to take advantage of investors’ interest in ESG without actually doing the work.

Reinforcing the potential of sustainability-focused investing while fighting greenwashing requires transparency enforced by meaningful regulatory requirements, such as those now in force in the EU. These requirements mean wealth managers have to educate themselves about the ESG world, explain these concepts to their clients, incorporate their clients’ ESG-related preferences into investment decisions that also meet each client’s wealth-planning needs, and offer competitive risk-adjusted returns. That’s a tall order (we had a hard enough time just stating all of it in a coherent sentence). 

A real-life example

Here’s a real-life example of the challenges wealth managers face in this arena. On a recent hike in the local mountains we struck up a conversation with a woman who became quite animated when we explained that we are involved in ESG and investing. She said that she has told her advisor that she wants to invest in funds that focus on climate-friendly companies and was dismayed to find that some of the funds in her portfolio hold positions in companies involved in fossil fuels. She does not want to invest in those types of energy companies but does want to invest in companies that are involved in clean energy.

We explained that sometimes wealth advisors do not have enough information about what clients mean by “climate-friendly” to choose appropriate funds. We wondered (not out loud) if a thematic fund might be best for her, but those are likely to be high beta funds, which may not be a great fit for someone of her age and limited risk appetite. That brings us to the main point of this article: sustainable investing is a challenge for the wealth management industry, and assessing client preferences is a big part of that challenge. A new disclosure requirement in the EU makes this mandatory.

The EU boosts transparency for ESG-based investing 

Warning: this attempts to condense volumes into a few sentences—those interested in the details are encouraged to use the hyperlinks provided. Regulations in the EU are giving a boost to sustainable investing while making asset managers and wealth managers more responsible for understanding and backing up ESG-related claims. The European Commission’s Sustainable Finance Action Plan (SFAP) both supports sustainable investing and aims to make sustainability a regular part of risk management. Importantly, it also emphasizes transparency by introducing sustainability-related disclosure requirements through the Sustainable Finance Disclosure Regulation (SFDR), which lists activities that qualify as “sustainable” through the EU Taxonomy.

New ESG-related requirements for banks and investment firms in the EU are now in force under the MiFID II regulatory framework. These firms are now required to integrate sustainability when assessing whether or not certain investment vehicles are suitable for a given client. They also have to monitor investment products on an ongoing basis to make sure they continue to adhere to whatever ESG promises they make (to fight greenwashing).

Key points of the ESG updates to MiFID II 

This article from Deloitte lays out timelines and discusses what the ESG updates in the MiFID II framework mean in practice, along with some of the challenges they pose. According to Deloitte, MiFID II ESG amendments require investments firms and wealth managers, to:

  • Determine whether an investment product – including sustainability factors and its risk/reward profile – meets the target market’s/client’s needs;
  • Regularly review whether a given investment product remains consistent with the target market’s/client’s needs, including sustainability preferences;
  • Describe how sustainability factors are considered in providing investment advice;
  • Determine and incorporate clients’ sustainability preferences for transactions recommended or executed;
  • Obtain information about clients’ sustainability preferences as part of their investment objectives;
  • Include and demonstrate that sustainability factors have been included in the firm’s policies and that procedures used to evaluate the nature of financial instruments selected for clients are properly understood;
  • Illustrate in suitability reports how services provided meet clients’ expressed sustainability preferences;
  • Ensure that including sustainability factors in providing advice and managing portfolios does not lead to greenwashing or mis-selling, or misrepresenting investments as qualified to meet sustainability preferences when in fact they do not;
  • Maintain records of any changes in clients’ sustainability preferences.

There are various challenges with implementing these requirements. In our view, addressing them may seem straightforward but can be quite difficult. Here are just two examples:

Educating clients and client-facing staff on ESG – Under these regulations, investment firms have to educate their clients and their client-facing staff on ESG investing. That means explaining what ESG investing means (we invite you to peruse and use OWL’s Insights to help with that, maybe starting with this one), and providing clear definitions of what the individual E, S, and G pillars encompass so that clients can make informed decisions. 

There are many sources out there that provide content that can educate clients on ESG investing. But given that this area is still evolving (it’s not like explaining internationally-recognized accounting standards) it is important to be careful in choosing sources of information. Look for reasons a content provider might be subjective or have a particular agenda.

Determining clients’ preferences about ESG investing – Educating clients about ESG investing is the first step; determining their preferences is another. As our encounter on the hiking trail illustrates, asking someone, “do you want to invest in clean energy companies” is not the same as asking “do you want to avoid investing in companies that have any involvement with fossil fuels, even if that decreases returns in the short-term, and do you want to invest in a clean energy fund whose performance may be quite volatile?” This is not simply a matter of putting all of a client’s money in Fund X because it advertises itself as an ESG fund, while avoiding funds that do not have ESG in their name (the latter could actually have very strong sustainability profiles). 

We suspect there will be many lessons to be learned in the coming months/years as banks and investment firms in the EU implement these requirements. Overall, we believe regulatory moves to increase transparency and education about ESG-based investing is highly beneficial. As with most things, the devil is in the details.
OWL has in-depth data, tools, and expertise to help wealth managers objectively evaluate funds with respect to ESG exposures in a way that incorporates each individual client’s preferences. Contact us to learn more.