How to select an appropriate ethical investment solution to match a client’s ethical investment values and concerns.
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The adoption of ESG investing has accelerated over recent years, driven primarily through an increased demand by investors applying their values to their investment selection and the uptake by investment managers introducing ESG considerations in their investment selection and portfolio construction.
With an increase in the number of products on offer, the time required to truly understand the ethical nature of each product offering and how that fits with each individual client’s values and preferences can make screening and selecting the right product for clients a difficult and time-consuming process.
The complexity of giving advice in the ethical and sustainable investment space is complicated by the vast array of definitions and terminology used, and a lack of consistency and transparency towards green investing approaches. The comparison of investment products accurately on a like-to-like basis is a difficult task, particularly if trying to then overlay a client’s individual values and preferences.
All of this in the context of recommending a product that also meets a client’s best interest, within an Approved Product Listing, and meeting the financial objectives of the client.
Advisers can take comfort in knowing that by taking the time to build a sound process and strategy for sustainable and ethical investing, this process can support the ease of adoption of ethical investing into their investment philosophy and client service offerings, as discussed below.
Determining what’s most important to the client
According to Russell Investments 2021 Annual ESG Manager Survey, the top 3 most important ESG issues ranked in priority by clients globally were Climate Risk, Environmental Issues in General, and Diversity and inclusion.
From an Australian perspective, a consumer survey conducted by RIAA highlighted the top three social and environmental issues or themes Australians are most interested in supporting via investment as being renewables, sustainable water, and healthcare.
From a negative screening perspective, the top three issues that the majority of wanted to avoid were animal cruelty, tobacco, and weapons.
What’s important to note with ethical investing however is that there is no one size fits all approach. And each and every client’s preferences and priorities are very highly likely to differ depending on their unique values and concerns.
Creating a Tailored Approach
In order to deliver tailored values-aligned advice and investment solutions, Advisers first need to be able to clearly define the ESG components. This means being able to clearly articulate what ESG means, and how it’s measured.
The need to explore ESG factors in greater detail
To recap, ESG stands for environmental, social and governance factors which are the non-financial factors that investors use to measure an investment or company’s sustainability. Put simply, Environmental factors look at the conservation of the world, social factors examine how a company contributes to the wellbeing or their staff and the community, and governance factors consider how a company is managed and operated.
To delve deeper into the ESG factors, commonly investors and investment managers may add another layer to the investment screening process with the application of a positive or negative screening or tilt.
Negative screening or tilts occur where companies and industries are excluded, or held in reduced weighting relative to the market. Most typically, negative screens may include activities or products that cause harm to the environment, company or people.
Positive screening or tilts can be used to include companies or industries, or increase exposure to them relative to the market. Typically they are activities or products that seek to improve the wellbeing of the environment, company or people.
Russell Investments Senior Portfolio Manager, James Hardwood, illustrated this in his example whereby investors and managers can apply either a negative or positive overlay to achieve a similar result. Stating that investors could choose to address the environmental issue of carbon emissions by either applying a negative screen and seeking to avoid investment in companies that rely largely on fossil fuels or that have a high carbon footprint, or conversely applying a positive screen or tilt towards Green Energy by investing in utility companies focused on producing more energy from renewable sources.
The below examples illustrate the impact of positive and negative overlays on ESG practices in more detail:
Environmental factors
Negative screens point to harmful areas such as practices around animal cruelty and fossil fuels and environmental destruction. As well as factors such as the production of palm oil, use of plastics, and other forms of air, water and land pollution.
Positive screens may include factors such as clean transport, clean technology, energy efficiency, recycling, sustainable forestry, sustainable food systems, and circular economy for waste and pollution management.
Social factors
Negative screens may see the filtering out of factors that harm the well-being of others, including alcohol gambling, tobacco, weapons and pornography being the most widely known, but also including other considerations to things that contribute to excessive consumerism, slave labour, human trafficking, and supply chain links, genetic modification and stem cell research practices, links to predatory finance such as payday and buy now pay later lending as well as the consumption of high sugar and junk food.
On the positive side, it may include the promotion of gender equality, and Indigenous rights, diversity and inclusion measures, social innovations, technologies, labour rights and adherence to the UN Sustainable Development Goals.
Russell Investments Senior analyst suggests that “social measures are harder to measure and manage, but are definitely becoming more of a focus for consumers. This is why engagement with companies, meeting with them, and understanding their approach to social issues is more and more important”.
Governance
When it comes to Governance negative screens may include more obvious harmful activity such as bribery, fraud and corruption, but can also explore executive remuneration, such as how much is the CEO getting paid compared to employees, tax avoidance and even evasion. It also covers greenwashing practices.
A positive screening perspective looks at the Board and strategic operations of the company as well as their longer-term view and objectives on sustainability. Transparent disclosure, stakeholder engagement and how the organisation is communicating and working with employees, communities, suppliers and customers, as well as factors such as indigenous consent.
What is apparent is that finding a product to suit everything a client may wish to include or exclude from a values alignment and ethical perspective can be quite difficult. Prioritisation of values and sometimes compromise may be required in order to find the right solution.
Many Advisers have adopted the use of a questionnaire as a helpful tool to ascertain a client’s ethical priorities. Similar to a risk profiling questionnaire, they are essentially a fact-finding tool that will help an Adviser ascertain the key values-based priorities and concerns for their clients and then rank those in order of preference and priority. The questionnaire lists all the ESG issues in the positive and negative which makes it easier for the client to select their priorities and rank them in order of importance. This becomes a useful tool for the Adviser later when it comes to finding an appropriate product that matches the client’s most important ethical values and concerns.
It is important to be realistic and set an expectation with clients that it may be difficult to exactly match or align a perfect product with all of their values and priorities. Advisers should be upfront and transparent around any issues or areas where recommended products do and don’t align with clients’ values and priorities.
James Hardwood advises “The RIAA website to be a useful tool for Advisers to screen for products that match their clients’ ethical preferences and requirements. Both on the negative and positive side”.
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This article was written based on discussions held in the XY Adviser Podcast Ethical Investment Series # 14 hosted by Fraser Jack in conversation with Elizabeth Hatton, James Harwood, Paul Garner, Alexandra Brown, and Philip Moffitt. The full podcast can be found here
References:
RIAA From Values to Riches 2022: Charting consumer demand for responsible investing in Australia
Russell Investments Global 2021 Annual ESG Manager Survey
