My 3 takeaways from the ISS Advisor Survey

End of Week Notes

Expect more ESG clients, reconsider performance assumptions, and recognize that all ESG funds are not alike

For financial advisors in the U.S., client demand for sustainable investments is growing. As a result, nearly half of advisors now use ESG investment products and nearly all of those who do so expect to continue investing in ESG, most of them at higher levels.

So says an Institutional Shareholder Services (ISS) report released this week based on a July-August survey of 779 U.S. advisors.

Of the advisors surveyed, 45% said they currently use ESG investment products and 55% intend to invest more money in ESG in the coming year (another 33% expect to invest in ESG at about the same level). Nearly a third (31%) said more clients are bringing up the topic with them, about half of them clients under 40.

Advisors reported concerns over performance and greenwashing. Two-thirds of advisors who use ESG investments believe they perform better (20%) or the same (46%) as non-ESG solutions. By contrast, only 30% of advisors who do not use ESG investments believe they perform better (2%) or the same (28%).

Two-thirds of advisors agreed that knowing that an ESG investment actually uses ESG criteria is important or extremely important.

1. Be prepared to address your clients’ sustainability concerns

Most advisors should expect client demand to continue to grow for the simple reason that more people in the world today have sustainability concerns. They are applying these concerns in many decision-making contexts of their lives (consumer decisions, employment decisions, where to live, etc.) and so it only follows that more people want to do this within the context of their investments.

Given that more people are now personally experiencing extreme weather events driven by climate change, it is perfectly sensible for clients to ask about how well their investments are protected from climate risks and whether they are exposed to investments that could benefit from the transition to a low-carbon economy. Given that more and more people, as workers, want to work for companies in the COVID/post-COVID era that treat their employees well and practice higher levels of corporate social responsibility, it only follows that, as investors, they will ask about whether this is reflected in their investments.

As an advisor, you should be prepared to address these concerns. The best way to do it is to discuss these issues proactively with all of your clients. Most will appreciate that you have anticipated their concerns, which builds trust. Twice this summer, I’ve been contacted by friends highly interested in ESG who have advisors that have never mentioned the topic to them, but who didn’t feel they had enough knowledge to bring it up themselves. They were disappointed and unsatisfied with their advisors. They felt their advisors were out-of-touch. A head-in-sand approach is certainly not the best way to attract and retain younger clients.

2. Take another look at performance

Advisors are right to be concerned about the performance of any investments they recommend to their clients. Although its antecedents go back to the 20th Century, sustainable investing is a relatively new concept and many sustainable funds have short track records. By contrast, the non-ESG investments advisors use tend to have more familiar investment approaches and longer track records spanning different market environments.

That said, keep this in mind: Sustainable funds are, first and foremost, investments that seek to deliver competitive financial performance while also seeking to generate positive outcomes for people and planet. As investments, they apply a sustainabilty lens to many tried-and-true investment styles. It is hard to disentangle the effects of the ESG approach with the effects of the underlying investment style.

That’s why I recommend a straightforward approach to performance assessment. Simply compare the performance of sustainable funds to all the other funds that share the same Morningstar category. Just as is the case in the broader universe, you’ll find that some sustainable funds perform better than others, but overall, there is no escaping the conclusion that sustainable funds perform just as well as other funds, if not better.

To give yourself greater confidence in sustainable funds overall, take a look at the distribution of star ratings across sustainable funds and compare it with all funds. Technically called the Morningstar Rating, it is a measure of a fund’s past risk-adjusted performance relative to its category. A fund’s most-recent three-year performance weighs the most heavily, but as funds’ track records extend over time, their five-year and ten-year performance is also factored in. Star ratings for each category are normally distributed, such that only 10% receive five stars and one star, 22.5% receive four stars and two stars, and 35% receive three stars. Star ratings are updated at the end of every month.

As of the end of August 2021, the distribution of the star ratings of sustainable funds available to U.S. investors was considerably better than those of the overall universe. Sustainable funds were twice as likely to have 5 stars (20.7% v. 10%) and only one third as likely to have 1 star (3.4% v. 10%). Nearly 55% of sustainable funds earned 4 or 5 stars compared with only 32.5% of the overall universe. This extreme positive skew won’t last forever, but it’s hard to argue that the actual risk-adjusted performance of sustainable funds has been worse than those of other funds.

3. Know what approach or set of approaches a fund is using to address sustainability

Advisors cannot assume that all sustainable funds are doing the same thing in their application of sustainability features. In fact, it’s best to understand sustainable investing as a range of fairly distinct approaches, including the following:

In conducting due diligence on a sustainable fund, ask which approach or combination of these approaches are employed. Funds should be providing this information, but if you can’t find it, that’s a red flag. It doesn’t necessarily mean the fund is greenwashing, but it is an indication that the fund is not providing the level of transparency it should be bringing to the table.

Making clear to your clients what approaches a fund is using will clarify investor expectations. Most concerns about greenwashing stem from a mismatch of expectations. As examples, here are three questions I’m hearing fairly often:

Q> Why are there fossil-fuel companies in my sustainable fund?

A> Because this may be a fund that does not exclude fossil-fuel companies; it does, however, use Active Ownership to push such companies to lower emissions and transition to renewable energy.

Q> Why isn’t Tesla in my portfolio?

A> Because this may be a fund that focuses on ESG Risk, and Tesla’s corporate governance, product governance, and treatment of workers raises serious concerns that could affect the company financially.

Q> Why do the holdings in my ESG fund look a lot like those of any old fund?

A> Because this may be a fund that focuses on ESG risks and opportunities; in so doing, it finds these firms are managing those issues well and happen to be great investments. It employs Active Ownership to address any issues that do arise.

It’s only natural that more of your clients will want to talk about sustainability. Be proactive with them. Don’t worry so much about performance, in general, but subject individual sustainable funds to the same level of scrutiny you use for any fund. And understanding a sustainable fund in terms of the range of approaches it employs will go a long way towards aligning your client’s expecatations with their sustainable investment.

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