Three reasons why ESG can no longer be ignored by financial advisers

With regulation on the horizon and investment sands shifting, it is becoming increasingly difficult for financial advisers to avoid incorporating Environmental, Social and Governance (ESG) funds into their Centralised Investment Proposition (CIP). Prema Sohun, Technical Marketing Manager for VitalityInvest, tells us why.

The popularity of sustainable funds has exploded in recent years. A change in mindset towards ESG investing has led to a significant increase in net flows – in the nine months up to September 2020 they reached £7.1bn, nearly four times the £1.9bn seen for the same period over 2019¹.

Against this encouraging backdrop, however, advisers are seemingly falling into three distinct categories. According a recent report from the lang cat², financial advisers are either on board with sustainable funds or have an existing process in place (73%); they are just starting to understand the market (24%) - or they’re really not that interested at all (10%). 

Clearly the main reason why financial advisers can no longer afford to ignore ESG funds is because it makes good investment sense. And the majority are evidently taking advantage of their potential to outperform traditional risks³. However, the key question for those who are not yet interested is not only why they should be incorporating ESG into their suitability discussions – it is: why they should be doing it right now. Here are three reasons.

1. Regulation is on the horizon

The world has already seen requirements change for governments and corporations, through setting net-zero targets and new standards to do business. The FCA also recently issued its strongest statement of ESG so far by releasing a set of set of guiding principles for fund managers on the design, delivery and disclosure of ESG and sustainable investment funds⁴. And while uncertainty still exists around what exactly new regulation on the horizon will look like, there is an expectation in the market that it is only a matter of time until the FCA issues further guidance aimed specifically at financial advisers.

The UK may look to borrow from EU regulations, which require client ESG preferences to be addressed when recommending products. It is also likely that advisers will need to have a greater understanding of the underlying methodology used by product providers for exclusions and around impact, for example. There are already current UK requirements which imply that ESG issues should be discussed with clients. COBS 9⁵, for instance, requires firms to take ‘reasonable steps’ to ensure suitability and to obtain the ‘necessary information’ regarding investment objectives, both of which could include ESG considerations. Acknowledging that additional regulation is inevitably on its way therefore presents an opportunity for financial advisers to get ahead of the curve. Now is the time to fully understand the market, formulate a factfinding process and decide which factors are most important to address when it comes to due diligence, background research and client suitability.

2. Be part of the conversation

In a paper by AKG⁶, nearly a quarter of investors have independently reviewed their investments to ensure that ESG factors are incorporated, and over a fifth have done so with the support of an adviser. As the notion of sustainable investing has grown even further in 2021, there has also been growing interest in bonds that focus on ESG factors with 43% of advisers seeing an increase in client demand⁷.

Where some advisers might be seeing what they deem to be a lack of ESG demand, this may be because they are waiting for clients to mention that they want to invest in a way that doesn’t negatively impact broader society or the environment. Another way for advisers to gauge client interest is to ask clients about sustainability during the factfinding process or annual review. This will help determine whether it is core to their values and if it should form part of the portfolio.

3. ESG could be critical to the future of your firm

While members of all generations are now showing an interest in ESG⁸, we can turn to millennials who were the original drivers of its growth – thanks to their values-driven approach to finance. Not only are millennials putting pressure on their elders to review their investments, according to a report by the Financial Times in 2020, they are also more likely to choose (63%) a fund manager based on their approach to ESG⁹.

For adviser firms or individual IFAs considering their sales and marketing strategy to attract a younger client base and fuel a strategy that stands the test of time, ESG funds are likely to be a natural solution. But advisers will need to do more than just offer a core/satellite approach – we can expect ESG to be central to client investment considerations going forward, and potentially even become the default CIP. Therefore, to help safeguard the success of future business, advisers should also be considering the impact of their own firms on environmental, social and governance factors – from the top down. Truly embracing ESG requires an authentic and long-term approach, that is defined by a firm’s set of foundational values that trickle throughout every aspect of a business.

Sources:
1. Investment Association
2. Crossing the ESG Event Horizon, 2021
3. S&P Global April 2021: https://www.spglobal.com/marketintelligence/en/news-insights/latest-news-headlines/esg-funds-beat-out-s-p-500-in-1st-year-of-covid-19-how-1-fund-shot-to-the-top-63224550
4. https://www.fca.org.uk/news/news-stories/guiding-principles-on-design-delivery-disclosure-esg-sustainable-investment-funds
5. https://www.handbook.fca.org.uk/handbook/COBS/9/?view=chapter
6. The Future of Advice – Beneath and Beyond (July 2020)
7. ftadviser.com/investments/2021/07/07/growing-client-demand-for-esg-bonds
8. https://www.investopedia.com/demand-for-esg-investments-soars-emerging-from-covid-19-pandemic-5193532
9. Boring Money