ESG Industry Owes Financial and Wealth Advisors an Apology

Individual investors rely on their financial advisor or wealth manager to provide informed, unbiased advice, but with so many ESG investment choices that’s not always easy.

We recently fell into a conversation with a seasoned Financial Advisor (FA) about how he explains ESG investing to his clients. His financial planning expertise is unquestionable and he provides a valuable service. However, our discussion was a stark reminder that despite some sincere efforts, the ESG industry has not done a good job of educating FAs and wealth managers about the many ways ESG investing can be done and how it can serve their clients. On behalf of the ESG industry, we apologize.

A wide range of approaches that all “do” ESG differently

In talking with this particular FA, we learned that the way he talksto his clients about ESG investing suggests that he believes there is just one way to go about it. This particular FA works for a firm that outsources the investment management function to a large asset manager – this is not at all unusual in the industry. He feels he knows enough about ESG investing to advise his clients on the subject because he has read a good deal of information from the asset manager his firm uses on its approach to ESG investing. As a result, his perspective was limited. 

It reminded us of the parable of the group of blindfolded men who each touch a different part of an elephant and draw wildly different conclusions about what they have encountered. ESG or sustainable (or socially responsible) investing can take many different forms and advisors may only be familiar with one or two of them.

Why ESG investing can be like ordering pasta

Switching analogies here, imagine you’re an FA or wealth manager and you take your client to an Italian restaurant for dinner. The client asks the waiter for “pasta.” Perhaps that means something specific to your client, but the waiter is likely to have a few questions. Pasta comes in dozens of shapes (maybe more), and some are right for certain dishes but not others. Does the client want just a simple sauce, or a seafood pasta, or maybe ravioli with many ingredients? 

Let’s stick with the analogy a bit more. Like different pasta shapes, ESG investing comes in various forms. Each one serves a different purpose and produces different results. Investors are bound to prefer some while others may not fit their tastes. FAs and wealth managers can easily find funds that:

  • screen out certain industries whose activities conflict with an investor’s values (note that each fund excludes its own list of industries or companies based on its own criteria) 
  • track an ESG index that uses ESG scores from a specific provider as the basis for choosing the stocks it holds
  • focus exclusively on Environmental issues, or a specific component, like carbon emissions
  • give equal weight to environmental, social, and governance issues
  • seek to have an impact on one or more Sustainable Development Goals[R1] [TG2] 
  • look for companies that are making big improvements in their sustainability practices, even though they may not be among the “best” in their industries
  • integrate ESG analysis into an overall active management approach
  • emphasize certain societal goals (e.g., diversity and equity)
  • invest in emerging-markets countries that are tackling environmental and social issues
  • and so on…

As an FA or wealth manager, you may want to evaluate a variety of ESG funds for your clients but you’ll have to do some digging to see the ingredients used to create them. For example:

  • Some ESG funds are highly diversified and track broad market benchmarks like the S&P 500 fairly closely; others have strong tilts.
  • Funds that only hold companies with the highest ESG scores are likely to be overweight large-cap stocks, as larger companies tend to have more active sustainability programs.
  • A “green” fund may not hold any energy industry stocks, which may be exactly what a client wants, but it may hold utilities that burn natural gas to generate electricity.
  • Actively managed funds that integrate ESG analyses into their investment processes typically use proxy voting to further the fund’s aims; index funds may not.
  • and so on…

The sheer number of possible approaches to ESG investing is a big part of the challenge for FAs and wealth managers. They only have so much time to dig into the various ESG investment options and the industry doesn’t exactly make it easy. More disclosure is needed (for some other insights about this, read other articles ESG Data – Why Is This So Difficult?, and Wealth Management & ESG Disclosure Requirements­. We think you’ll see that OWL tries to help educate FAs and wealth managers on ESG through these and other articles we write).

One last thing before we let go of the Italian restaurant theme. Did the client intend for pasta to be the main course or a side dish? If the client wants to make sustainable investing the “main course” of his or her portfolio, that could mean combining a number of different types of ESG funds, including one or more green bond funds, to achieve the desired asset allocation and diversification. On the other hand, if this is more of a “side dish”, maybe 5 percent of the overall portfolio is held in one or two ESG funds that match the client’s preferences. 

It’s not just a challenge for FAs and wealth managers

Asset managers are eager to promote their capabilities in this arena by providing educational webinars and white papers. Unfortunately, they’re not always helpful. A highly respected asset manager recently promoted a webinar in a way that we think does little to reduce the confusion about ESG investing. The webinar summary says things like:

  • ESG portfolios can create significant tracking error to policy portfolios and traditional benchmarks. Sure, that’s true, if you use funds that exclude entire sectors or rely on ESG third-party scores to choose “good” ESG companies (those funds are likely to be overweight with large cap tech). But there are other choices, such as ESG integration.
  • By definition, ESG investing introduces risk into portfolios as it deviates from the original investment mandate, and therefore, from the originally selected benchmark. In our view, this is another way of saying that a performance benchmark should be consistent with the investment policy statement, and that extends to ESG.
  • The right ESG strategy should match the client’s desired risk and return profile. ESG exposures should not detract from fiduciary goals. There was more to this one but we deleted the rest because it warned about intentionally introducing unexpected risks. We don’t think any FA or wealth manager would do that. The key here is that FAs and wealth managers need to understand how each ESG fund is designed before deciding whether it in fact matches the client’s risk and return profile.
  • It’s imperative to focus on a company’s impact in order to unwind the activities of a company across targeted norms and exclude from the investment universe those firms that fail to meet standards in compliance with a client’s beliefs. Now we’re confused. “Impact” has a specific meaning in the ESG world, but not in the way the word is used here. We don’t know what “unwind the activities of a company across targeted norms” means. The point about the investment universe is well-taken. Bottom line: when clients say “I want to invest in an ESG fund,” FAs and wealth managers need to know what they mean by that.

Another elephant in the room: greenwashing

Last but not least, another ESG challenge advisors face is in addressing concerns about  greenwashing. According to one source, two-thirds of investors are worried that funds’ claims about ESG are not reliable.

On that front, the SEC is moving forward with rules that will target funds whose policiesdo not adequately ensure that its investments align with its stated ESG-related goals. But for now, a U.S. fund can claim to be “environmentally friendly” and that doesn’t really say anything (it’s like a food package that says “all natural ingredients,” which is meaningless). The European Union recently issued its Green Claims Directive that would require traders to substantiate an investment’s environmental claims to consumers. That’s progress but we’re not there yet.

OWL ESG’s data and tools are designed to provide insights, transparency and clarity on all types of ESG issues. Our goal is to help investors and their advisors make informed choices, and to help the companies they invest in to understand how they compare to their peers across various ESG dimensions. Contact us to learn how we can help your business.