The sustainability challenge in advice

The growing appetite among people globally for ethical and sustainable investment and the increasing focus by regulators on these issues are highlighting the need for financial advisers to educate themselves on the choices available to their clients.

Even amid the pandemic, client interest in sustainable investment has surged in the past year, fuelled by news of devastating bushfires in Australia, California and elsewhere, record global temperatures, disappearing polar icecaps, coastal flooding and dying reefs.

But with clients often overwhelmed by sustainable investing jargon or by issues such as cost, transparency and the impact on investment returns, there are both challenges and opportunities for advisers in educating and steering their clients to effective solutions.

Later, we will look at the strategies available to advisers in dealing with the rising demand for sustainable investment solutions, but first some background:

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INCREASING DEMAND

You do not have to look far to find compelling evidence of the growing global appetite for sustainable investment, both among individual and institutional investors.

A 2019 study by research firm Cerulli Associates found that 56% of US retirement plans surveyed showed a preference for investing in companies that are environmentally and socially responsible. That percentage rose to 63% among participants aged under 40.

Within Asia Pacific, a separate Cerulli study found varying levels of interest in sustainable investing, with Australia and Japan ahead of the rest of the region. As with the US study, this survey showed the greatest interest is coming from millennials.

Looking specifically at Australia, Cerulli estimated mutual fund assets in sustainable investments rose 23% year-on-year to $66.8 billion in 2019, a trend the study attributed to increasing awareness of climate change among Australians.

Morningstar data show that 35 new sustainability investment retail mutual funds were launched in Australia in 2019, with environmental, social and governance (ESG) integration being the dominant strategy

But the demand is not just at the individual level. Surveys reveal a growing number of asset managers are paying greater attention to how companies in the portfolios they manage attend to material ESG risks.

Between January and April 2020, consultancy firm Greenwich Associates interviewed more than 500 institutional investors and found an increasing focus on ESG considerations, with governance still at the forefront, but with social issues rising since the pandemic began.

REGULATORY FOCUS

Pressures are also coming at the regulatory level, both in Australia and overseas. 

Locally, the Council of Financial Regulators – comprising the Reserve Bank of Australia (RBA), Australian Prudential Regulation Authority (APRA), the Australian Securities and Investments Commission (ASIC) and the Australian Treasury – has established a working group on climate change to ensure mounting climate risks are effectively managed by financial institutions.

“Climate change will have a broad-based impact on Australian financial institutions and therefore clearly poses risks that are systemic in nature,” the RBA said in its financial stability review in October 2019.  

Separately, the new Code of Ethics for financial advisers introduced this year by the Financial Advice Standards and Ethics Authority (FASEA) has focused attention on advisers’ responsibilities in relation to recommending ESG investments.

Standard six of the code requires advisers to actively consider each client’s broader long-term interests and likely circumstances, which some experts have taken to mean that clients should be questioned about their investment preferences around sustainability and ethical issues.

WHAT THIS MEANS FOR ADVICE

For advisers themselves, this can be a particularly challenging and complex issue. But equally, it offers enormous opportunity for those prepared to get up to speed on the considerations so that as fiduciaries they can serve their clients better.

If anything, investors are more interested in sustainability than their advisers. A Morgan Stanley survey found that while nearly 80% of individual investors had expressed a strong interest in sustainable investment, more than 60% of advisers had shown little or no interest.

Of course, this contrast may reflect the fact that advisers generally are older on average than the wider population and tend to be more conservative. But given the evidence above that demand is being led by those under 40 and given the pending intergenerational wealth transfer, advisers who ignore this trend do so at their peril. 

In fact, it is hard to downplay the size of this opportunity. Wealth-X’s 2019 report ‘A Generation Shift: Family Wealth Transfers’ estimated that by 2030 about US$15.4 trillion ($21.74 trillion) of global wealth owned by those with US$5 million or more will have been transferred to the next generation.

KEEPING IT PRACTICAL

Against that background, a pathway for advisers is a practical one – offering clients a framework for thinking about sustainability. For instance, are the clients primarily concerned about social and environmental outcomes, with financial objectives secondary, or are financial outcomes their priority, with the social/green issues secondary?

This preferences framework can be a good entry point for discussion around the frequently cited main concern about sustainability, which is the now-rejected notion that adopting such a strategy must involve compromising long-term returns.

Extensive research from the academic community and Dimensional’s own empirical studies on this topic have not found any compelling evidence that companies with lower greenhouse gas emissions have either higher or lower expected returns than companies with higher emissions (this is once you control for exposure to known drivers of expected returns – such as size, relative price and profitability in equities and forward rates in fixed interest).

The message for clients from this is that there does not have to be a trade-off between sustainability issues and returns. In fact, an approach that thoughtfully integrates ESG while maintaining a focus on robust drivers of expected returns within a broadly diversified investment strategy can offer similar expected returns to an equivalent strategy without an ESG focus.

Of course, clients who want to invest sustainably can normally talk at some length about why they want to do so. But the ‘how’ this can be done is where the adviser’s expertise comes in and can be seen by clients as a real source of value as they navigate the ESG maze. 

For instance, the client may favour a strategy that invests only in those companies believed to have a strongly positive impact on ESG issues. In this case, the adviser could point out that such an approach can sacrifice diversification and introduce idiosyncratic risks that reduce the reliability of investment outcomes.

Ultimately, the message from the adviser should be that pursuing ESG goals does not have to be at the expense of sound investment principles.

MAKING IT EASIER

Even if sustainability options are not core to an adviser’s offering, it still makes sense to include them among the available options and to showcase the firm’s expertise with a position paper. The important point in your offering is to show clients that they have choices and to demonstrate the trade-offs involved at each stage. 

From a communication standpoint, advisers can do well if they adopt a story-based approach that minimises data, avoids overly gloomy scenarios or overtly political language, sets achievable goals, highlights transparency and demystifies jargon.

The big picture goal should be to make sustainable investing easier for clients and to show them how best to connect their social and environmental values to their investment goals.

The demand is there, the solutions are available and advisers have a key role to play. 

Nigel Stewart is a founding director of DFA Australia and chair of wealth management firm Stewart Partners.