Advice: The Sustainability Challenge

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 advisors to educate themselves on the choices available to their clients.

Even amid the pandemic, client interest in sustainable investment has continued to surge, fuelled by news of record global temperatures, disappearing polar icecaps, coastal flooding, dying reefs and overwhelming consensus among scientists of the need for urgent action.

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 advisors in educating and steering investors to effective solutions.

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

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 2021 report by Morningstar found that global sustainable fund assets almost doubled in the six months to the end of September to reach $US3.9 trillion. Some 88% of this total is in Europe, where new sustainable finance disclosure regulations took effect last March.¹

Within Australia and New Zealand, sustainable fund inflows totalled $US1.86 billion in the third quarter of 2021, the second largest inflow on record. Assets in Australasian sustainable funds reached a record $27.2 billion in the same period.

But the demand is not just at the individual level. Surveys reveal a growing number of institutional investors are paying greater attention to climate change.

At the COP26 climate conference in Glasgow, UN climate envoy and former Bank of England Governor Mark Carney announced that banks, insurers and investors with $130 trillion at their disposal had pledged to put fighting climate change at the centre of their work.

Carney, who assembled the Glasgow Financial Alliance for Net Zero, estimated $100 trillion in investment would be required over the next 30 years to cut greenhouse gas emissions to a level consistent with keeping the rise in the average global temperature to 1.5 degrees Celsius.

With interest in sustainable investment growing and product launches accelerating, pressures are also coming at the regulatory level, both in Australia and overseas.

Locally, a working group of the Council of Financial Regulators is seeking to improve the quality, consistency and breadth of climate risk disclosures to help improve investors’ ability to assess financial risks associated with climate change.

In an attack on so-called ‘greenwashing’, ASIC, a member of the working group, is undertaking a review to establish whether ESG-badged products are true to their label. This is consistent with similar efforts being carried out by regulators in the US and European Union.²

Separately, the Code of Ethics for financial advisors introduced by the Financial Advice Standards and Ethics Authority (FASEA) has focused attention on advisors’ responsibilities in relation to recommending ESG investments.³

Standard six of the code requires advisors 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.⁴

For advisors themselves, then, 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.

Against that background, a pathway for advisors 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 advisor’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 advisor 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 advisor should be that pursuing ESG goals does not have to be at the expense of sound investment principles.

Even if sustainability options are not core to an advisor’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, advisors 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 advisors have a key role to play.