Advisors must talk to clients about ESG – or risk losing a generation of investors

Over the last few years, a veritable avalanche of so-called responsible investing products have come to market. By the end of 2020, there were about 140 sustainable products available to Canadian investors, according to Morningstar – mutual funds and exchange-traded funds that consider environmental, social and governance criteria in their investment selection. In the first eight months of 2021, we've already seen 60 more, says Deborah Debas, Responsible investment specialist for Desjardins.

Why the explosion? While the ESG space has seen fitful growth for about 30 years, everything from climate change to wealth inequality to racial discrimination has reached new heights, especially since the pandemic began. As well, millennials, many of whom are just now entering their wealth-accumulation years, are especially concerned about the state of the planet and their society. They know that their participation in the global economy, including in investing, can help shape the future, Debas says.

"They really want to invest with their heart and put their money where their values are," she says. "There's a definite shift in that generation." Surveys show that millennials are twice as likely as their parents to put an ESG lens on their investments. Advisors need to be mindful of this, especially considering that more than 70% of assets tend to change management when passed from one family member or generation to another. If they want to keep that book of business, they have to start speaking the language of younger heirs.

Yet, when Debas meets with people in their 20s and 30s, usually in investor education sessions, one of the most common questions she hears is, "Why didn't my advisor tell me about this?"

Indeed, a Responsible Investment Association survey held in 2020, which polled 1,000 investors across all ages, found that only 28% had been asked by their advisor if they're interested in responsible investing. That's despite three-quarters saying that they want their advisor to talk to them about investments that align with their values.

It's not enough for advisors to respond to their clients' requests for ESG options, she says: they have to be proactive and make their clients aware of the choices they have before the question comes up. That means getting up to speed themselves on the kinds of ESG funds that are out there.

Expanding ESG options

Most RI funds these days fall into one of two categories: core ESG and thematic impact funds. Core ESG funds are similar to mainstream equity mutual funds and ETFs in that they invest in all sectors of the economy, but portfolio managers, when deciding what stocks to buy, will include material ESG criteria in their fundamental analysis. Portfolio managers will also engage with portfolio companies to work on improving their ESG practices. Some might exclude those companies that fail to meet certain standards for environmental responsibility, labour practices and responsive governance.

Thematic impact funds, by contrast, invest in securities issued by companies and other securities that are seen as part of the solution to environmental and social problems. These companies might invest in operations that develop clean technology or produce sustainable energy, or in a completely different asset class, such as green bonds, which, in addition to generating interest income, provide measurable environmental benefit.

How an advisor builds a portfolio that includes these funds will depend on what the clients want to do with their money. How does ESG fit into a client's overall strategy? Is the ESG lens meant to reduce risk (by avoiding controversial companies) or boost returns (by focusing on growth companies in sunrise industries)? If the client wants to align their investments with their values, what are those values and which funds would make the best match?

Whether they invest in core ESG, thematic impact funds or both will depend in part on the person: do they prefer to push for change from within or outside the economic establishment? If you're not investing in legacy industries, Debas points out, you don't have any influence on how they go about their business.

Reduce risk without sacrificing potential returns

One of the tougher questions Debas hears from investors – in part because everyone has a different definition of what’s responsible – is "How can I be sure my fund is 100% responsible?"

"The short answer is, you can't," she responds. Responsible investments span a spectrum. "Our view is not about investing in perfect companies; it's about investing in solid, robust companies that have very good ESG practices that they're also willing to improve up." As shareholders, ESG funds often use their voting power to further influence the companies' practices in the right direction.

Investors, she says, need to ask questions and make sure that what they’re looking into really is ESG-committed – versus simply marketed as ESG – is focused on the transition to a sustainable economy and can back up their impact claim with clear objectives and transparent reporting.

One positive message advisors can convey to their clients is that the history of ESG investing to date shows that it at least matches the performance of the broader markets and tends to reduce risk by avoiding companies vulnerable to controversy. "What we see is that these ESG practices are not expenses; they're investments a company makes in itself that makes it more resilient. You get a return on that in terms of goodwill, an increased client base, client retention and reputation," Debas says.

At the same time, ESG funds tend to be no more expensive to own than others in the same asset class. The additional work of vetting companies on ESG criteria gets absorbed in the overall management fees, Debas says. "There's no compromise to be made in risk, return or price to pay, in our view."

Ultimately, there's no good reason advisors shouldn't be talking to their clients about ESG. "Your clients are interested in it and you should be too," she says. "A lack of questions does not mean a lack of interest. It's the advisor's job to bring up ESG options."