As seen in Family Wealth Report: ESG Customization

The following article was originally published in the June 3 edition of Family Wealth Report.

ESG Needs Customization

As demand for ESG grows, and without consistent reporting standards, finding truth and balance in what's on offer is challenging for investors and fund managers. This publication is pleased to include this commentary from Archer that looks at frictions in the market as ESG develops and approaches wealth managers can take to get beyond basic screening and encourage the next growth phase - customizing ESG products to reflect indiividual investors' values. The author of this article is Fran McCartan, who is VP Business Development at Archer. As ever, the editors of this news service urge readers to respond if they wish to do so. They can email [email protected] and [email protected]

Investors around the globe have a growing affinity for investment products that reflect their personal values and beliefs. More than $12 trillion¹ are held in socially responsible investments in the US. This figure has grown approximately 38 per cent from $8.7 trillion in 2016 and now represents nearly 25 per cent of all investable assets in the country, according to US SIF. And demand for ESG investments is only expected to continue growing, especially among younger investors who will inherit $32 trillion² in the coming years.

With this evidence of growing demand, many asset managers have sought ways to produce ESG portfolios that highlight their intellectual property and unique investment approaches. At the same time, criticism has begun to emerge around the ubiquity of the ESG moniker, and a dearth of consistent measures for determining whether a portfolio is actually “ESG” focused. The investing public is becoming increasingly aware that not all ESG products are created equal.

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To date, the industry has primarily leveraged negative screens to reduce exposure to investments that fail to align with investors’ values. For instance, a manager can reduce a portfolio’s exposure to companies that sell tobacco, harm the environment, or produce firearms. This is an adaptation of the practice of applying restrictions to an existing portfolio to comply with an investor’s requests – don’t buy “sin stocks” for example. One study³ concluded that more than 20 per cent of all invested assets globally exclude companies in this way. While this provides a way to accommodate individualized portfolios based on investor need, it falls short of providing a portfolio that emphasizes exposure to companies that are positive players in the environmental, social, and governance pillars.

Compounding the difficulty of applying ESG factors to investor portfolios is determining what criteria to use for defining good and bad corporate actors. Without common measures for companies’ impact or effectiveness among the ESG pillars, more companies have begun offering their research and ratings. While providing options for asset managers to select the data provider they prefer, the challenge then becomes one of how to efficiently apply data to individual portfolios.

In all, ESG portfolios provide opportunities for growth but come with ground-level challenges when implementing them. In order to meet client demand for investments that are personalized to truly align with investor core values, investment managers must go beyond negative screening when implementing ESG.

Combine positive and negative tilts
Negative screening is an excellent first step in implementing ESG. But many investors want to go beyond avoiding a few bad actors. They also want to allocate more of their holdings to companies that closely align with their values and advance their personal agendas. New capabilities allow investment managers to concurrently apply positive tilts for good actors while reducing exposure to the investor-perceived negatives. For instance, a manager can tilt away from fossil fuel producers while skewing toward organizations working to mitigate climate change. By doing this, investment managers deliver personalized portfolios that best reflect the preferences and beliefs of their investors.

Integrate leading ESG data
As demand for ESG has grown over the years, so has the number of providers that specialize in company research and ESG data aggregation. However, while the evaluated ESG pillars are consistent, the measurement standards are the intellectual property of the researcher and vary across suppliers. This presents a challenge to investment managers attempting to accurately reflect an investor’s values into a portfolio. Due diligence is needed to identify and leverage the right data when building and maintaining portfolios.

Leverage ESG at scale
Delivering a truly customized ESG offering that meets clients’ demand for personalization will certainly win investor loyalty. But cost-effectively scaling the offering across thousands of accounts presents operational challenges. New model marketplaces are bringing together portfolio managers, distributors, and research to enable the construction and distribution of custom ESG solutions. The process leverages technology that allows ESG tilts to be applied to manager-provided model portfolios to support individual investor demand. As model portfolios are updated, ESG overlays are applied and the end product is dynamically adjusted and ready to implement across investor accounts, providing a clear path to cost-effective distribution.

ESG the right way
Integrating an ESG offering that satisfies the customization needs of investors while enabling cost-effective scale for investment firms may have seemed impossible. But new technologies and partnerships across the industry are combining to overcome obstacles to scalable success.

Footnotes:

1. $12 trillion: https://www.ussif.org/files/US%20SIF%20Trends%20Report%202018%20Release.pdf
2. $32 Trillion: https://www.businessinsider.com/interview-with-ubs-paul-donovan-on-millennials-and-inequality-2018-1
3. https://www.schroders.com/el/sysglobalassets/digital/insights/2018/thought-leadership/demystifying-negative-screens---the-full-implications-of-esg-exclusions.pdf