Environmental, social and governance (ESG) factors cover a wide spectrum of issues that traditionally aren’t part of financial analysis, but are increasingly being considered by investors.
Factors might include how corporations respond to climate change, water management, the effectiveness of their health and safety policies, how they manage their supply chains, how they treat their workers and whether or not they have a company culture that builds trust and fosters innovation. Investors may also consider whether investments meet global standards for sustainability reporting (GRI) in transparency and accountability.
How is ESG influencing growth?
As little as two years ago, there were few references to ESG in the offering documents of traditional funds. But times have changed. The turbulent events of 2020 — the global pandemic, weather extremes, the movement for racial justice in the US and its contentious presidential election — underscored the importance of sustainability concerns to investment managers and strengthened the rationale for investors to manage their money in a sustainable way.
Within the next decade, millennial and Gen Z generations will be the largest asset holders globally, and younger generations are also influencing responsible investing. According to research from The Economist Intelligence Unit (EIU), 76% of younger (born 1965-2000) generations in the UK say it's increasingly important to consider ESG factors when investing, compared to 37% of older (born post-1965) generations.
How is sustainable digital wealth evolving?
In March 2021, EU rules aimed at addressing ESG concerns - the Sustainable Finance Disclosure Regulation (SFDR) - came into effect. While the SFDR has not been adopted by the UK, it could still apply to UK firms that market funds into the EU under National Private Placement Regimes, or where EU firms delegate a portfolio or risk management to a UK-based fund manager.
SFDR aims to make the ESG profile of funds more comparable and better understood by investors.
It introduces a wide range of ESG-related mandatory disclosures to help inform investors about sustainability risk and ESG due diligence applied to financial products. Investors in ESG funds should receive this information both before investing and during the life of their investment, through periodic reports and information made available on their advisor’s website.
European investors still tend to prioritise ESG more than their global counterparts. A recent investment industry survey showed that 61% of Europeans rate it as of high importance, compared to 33% in Asia Pacific and 24% in North America.
Sustainable funds outperformed their conventional fund peers in 2020, and seeing the value in supporting relevant issues, existing funds are rebranding as ESG-focused, adding terms such as sustainable, ESG, green, or socially responsible investment, to their fund title.
For example, JP Morgan has "recently made improvements to our ESG integration process and have incorporated new data points including reviewing the United Nations Global Compact (UNGC) severe violators list". As a result of the change, two stocks have been removed and replaced with “names [that] are attractive investments with better ESG credentials."
ESG criteria are also important to firms when selecting external asset managers – as 77% of investors in Europe strongly agree - and top accounting firms (EY, PwC, KPMG and Deloitte) are starting to respond to growing client budgets for developing net-zero emissions plans and other sustainability initiatives.
Investors increasingly link corporate attention to ESG values to business resilience, competitive strength, and financial performance. A Harvard Law School post notes: “The world’s largest institutional investors and pension funds have stated their faith in the potential of ESG to unlock shareholder value and to make companies and markets more sustainable. Their support has afforded ESG investing and operating principles added legitimacy and credibility.”
What does the future hold for ESG wealth management?
While some investment fads come and go, the trends driving the need for sustainable business practices are here for the long haul.
The EU’s Sustainable Finance Disclosure Regulation will come into effect in March 2022, compelling wealth managers in continental Europe to document sustainability factors and the associated risks for their clients.
Many funds now indicate in their prospectuses that ESG factors may be considered at some point in their investment process. And this looks likely to continue, given the ESG commitments most asset managers are making and the potential for outperformance of ESG funds.
While there's a long-held misconception that investing in companies with sustainable business practices means lower investment returns, portfolio managers that embrace sustainability investment factors have significantly outperformed their peers.
In a survey by financial consultants bFinance, the majority of investors agreed that ESG integration will be associated with outperformance over the next 20 years. Reasons for this included that ESG-oriented firms were “better companies”, had a long-term approach, avoided poor practices and governance, and were more likely to deal with climate and stranded asset risks. Respondents did strike a cautious note though, saying that future outperformance or diversification could be eroded by mainstreaming.
Recent experience shows ESG stocks seem to be more resilient during bear markets. While most asset prices took a beating during the initial phase of the COVID-19 pandemic last year, ESG investments did better than most. Analysis by US financial services company Morningstar, showed that in the month through mid-March 2020, 66% of ESG funds ranked in the top half of their categories.
"Lots of portfolios that have high ESG scores perform more strongly financially," says David Storm, head of multi-asset portfolio strategy at RBC Wealth Management in London. "Invariably the companies that do well on ESG measures are better quality.”
Why sustainable digital wealth management is here to stay
Investors want products that fit with their values, and companies will do well to provide them. With the increasing push from the younger generation towards responsible investing, wealth managers need to match their clients’ investment horizons.
Embracing ESG investments can help future-proof portfolios against changes in the global economy. Moving from fossil fuels to renewable energy is obvious, but an increased use of artificial intelligence (AI) and new technology to help care for an ageing population and keep the environment clean, are future trends that will also benefit investors.
Wealth managers will find that accelerating interest in ESG investing brings both challenges and opportunities. With clients more interested in their portfolios reflecting and supporting the issues they care about, they need to ensure that client dialogue includes both an ethical and a risk management level.
Last December, some of the world’s largest asset managers stepped up their efforts to achieve net-zero carbon emissions across portfolios by 2050, with the launch of the Net Zero Asset Managers initiative. The initiative, signed by big names such as Fidelity International, Legal & General Investment Management, Schroders and M&G, will ultimately mean divestment from companies that are unable to meet the net-zero target.
BlackRock has since followed suit, stating that a lack of progress to meet the 2050 target would result in a vote against management across its index funds and a potential exit in active portfolios.
Simon Gallo, managing director at sustainable advisory business Mainstreet Partners, says the end goal will be for investors to see how their portfolio scores, not only in relation to financial performance, but also in ESG terms.
“At some point it’s going to be pretty obvious who is doing a good job and who isn’t. We are moving to full transparency, where any investor will be able to talk to multiple wealth managers and identify who is doing the right thing,” he explained.
Although integrating ESG into a risk management framework across the client lifecycle can be a challenge for investment firms, an integrated ESG-ready solution will increase operational efficiency and client engagement.
The message is clear: ESG must be fully integrated into the investment conversation, rather than viewed as a separate adjunct to the primary investment strategy.
For more information about how Nucoro can help shape an ESG proposition for your firm, get in touch.