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Commentary

What Advisors Need to Know About Learning Clients’ ESG Preferences

Research shows that investors can incorporate their ESG preferences and also earn strong returns.

Mutual funds focused on sustainable investing attracted strong flows in 2019—more than $20 billion in assets in the United States, which is more than four times the flows in 2018, according to Morningstar data.

These numbers indicate that the interest in sustainable investing is not a passing trend.

Rather, it’s becoming more mainstream, as investors from all demographic groups report interest in incorporating sustainability into their investment choices. Morningstar’s behavioral research team found that 72% of the U.S. adult population expressed at least moderate interest in sustainable investing. This group spanned all generations and genders, though women and millennials had slightly higher rates of interest. 

All investments have impacts on the environment and society, and investors increasingly want to know about these impacts and what they mean for their investments. First, investors want to know how these impacts align with their values. Second, investors increasingly want to consider long-term environmental, social, and governance risks such as climate change when they make long-term investments. However, investors do not fall into exclusive camps of being focused on either values or risk. Rather, many investors care about both aspects to varying degrees simultaneously. 

Here’s what advisors need to know about ESG investing and why they need to take clients’ ESG preferences into account. 

Investors Can Incorporate ESG Preferences into Their Investment Strategies and Also Seek Competitive Returns
Investors may be interested in sustainability but, of course, they also still strive to realize competitive returns. Fortunately, a growing body of evidence suggests that using sustainable investments generally has not reduced risk-adjusted returns to date. In a recent study, Morningstar researchers found that investors that focus on companies with positive ESG attributes generally do not sacrifice returns, although there may be a small ESG premium in the U.S. And according to a U.S. Government Accountability Office meta-analysis, 88% of studies of the relationship between ESG factors and financial performance have found that using ESG information does not reduce financial returns. 

In short, picking investments that score better on ESG metrics at the margin or as a tie-breaker could be a reasonable strategy for investors who want their investments to reflect their values. 

However, there is no guarantee that this relationship will continue in the future. Advisors have a responsibility to communicate this potential risk, as they would any risk. For example, one risk might be that as more investors are looking for companies that perform well on ESG metrics, they might increasingly pay a premium to invest in them, which could reduce future returns. A strict adherence to ESG criteria can also lead to large sector, market-cap, and geographical deviations from the market. At a minimum, investors weighting toward ESG preferences are making an active bet (whether they realize it or not) that the market has not fully priced in these factors, which may or may not pan out. 

Two Approaches to Incorporating ESG Preferences into a Portfolio
Investors with nonfinancial objectives fall into two categories: avoiders and amplifiers. However, these are not mutually exclusive concepts and investors can pursue both approaches at the same time. Because of the nuances of these approaches, it’s important for financial advisors to understand what exactly their clients mean when they indicate an interest in sustainability:

  • Avoiders steer clear of investments in companies or industries that engage in controversial business activities or produce negative environmental or social impacts as a cost of doing business. For example, avoiders might purchase funds that screen out issuers using animal testing, selling controversial weapons, or mining coal. These avoiders may, of course, also be deciding on financial grounds that companies involved in certain controversial activities are not well-positioned for the future.
  • Amplifiers seek out investments in companies or sectors that create a positive environmental or social benefit. For example, amplifiers might look for companies focused on getting better access to medicine; helping people adapt to climate change; or developing new technologies to reduce carbon emissions such as electric vehicles, clean power technology, or green building products. Since these investments could help address the medium- and long-term challenges of adapting to a warming world, investors could have high returns expectations for these investments, or be motivated by a combination of financial and nonfinancial objectives.

Evaluating Long-Term Risks, Including ESG Risks, Is Fundamental to Investing
Beyond values, ESG factors are key risks to corporate sustainability, and these risks are as important as any other ones facing companies. Just as businesses cannot ignore material risks from new competitors or changing technology, companies cannot ignore material risks that climate change—or government regulation to curb it—might present to their production capacity. They cannot ignore the risk that their employee health and safety practices might lead to a dearth of willing workers if labor markets tighten, or the risk that their management team may not be properly incentivized to focus on long-term results. 

Different companies have different material ESG risks, and different industries have a range of exposure levels to different types of ESG risks. But the long-term profitability of any investment can be undermined by unmanaged ESG risks, which means that considering these risks cannot be a check-the-box exercise.

Because ESG risks are relevant for long-term investing, they should be considered as part of security analysis. Failing to do so can lead to an overestimation of a security’s fair value. And financial advisors need to ensure their clients understand ESG risks just as they explain the way factors like interest-rate risk, default risk, currency risk, stock market risk, or sector-concentration risk could affect their investments. 

A New Focus on Clients’ ESG Preferences
As investor interest in ESG investing continues to grow, advisors cannot ignore ESG investing. Even for investors without strong ESG preferences, advisors need to consider ESG risks and communicate those risks to clients just as they would any other risk in a portfolio.

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