Adviser education key to solving 'ESG paradox'

Call it the "ESG paradox." About 80% of advisers report that clients bring up environmental, social and governance factors in investment conversations, according to research from InvestmentNews. But despite the investor interest, only about 35% of advisers incorporate ESG factors when creating portfolios for their clients, and only about 17% of the clients of those advisers actually have ESG-oriented investments in their portfolios. What's going on? According to the recent InvestmentNews​ Innovators in Investing webcast, the disconnect — and perhaps the key reason why investing according to ESG principles isn't taking place to the degree that investor interest might suggest — is the result of adviser discomfort with the area, largely due to a self-acknowledged lack of expertise. "Knowledge is really standing in the way," said Matthew Sirinides, InvestmentNews senior research analyst. "Only if an adviser thinks ESG investing is important, and they feel knowledgeable about it, are they likely to use it, even if clients are driving the conversation and asking for it." Advisers are likely to feel they already have a basic understanding of the "E" and "S" aspects of ESG investing, whether or not they agree with the idea of evaluating a company's securities based on corporate stances on global warming or gun control, for instance. But it's in the "G," or governance, area where things typically get fuzzy. "Governance is a complex issue," said webcast panelist Max Mintz, chief investment officer of Common Interests, a hybrid firm that focuses on socially responsible investing. "It depends on the company you're talking about, the sector of the economy you're looking at and on the subsector within that. The governance issues for a bank, for instance, are different from those of an auto manufacturer." Abdur Nimeri, senior investment strategist at FlexShares Exchange-Traded Funds, agrees that governance is complex. "We view anything that inhibits the voters' ability to interact with management or that insulates management as a negative signal, because strong corporate governance typically drives the environmental and social elements," he said.

Risk control

For many advisers, however, investing in companies that offer corporate governance or environmental and social policies that some may consider to be "better" is a moot point if returns fall short of investments that disregard ESG factors. Today, the conversation has shifted, according to Marguerita Cheng, chief executive of Blue Ocean Global Wealth, who shares the view with other panelists that an ESG approach provides a welcome layer of risk control and need not come at the cost of performance. "Being profitable and doing good or having good corporate governance are not mutually exclusive," she said. "In fact, organizations that have good corporate governance actually are often more profitable, because there's not as much risk built in. People aren't giving up anything in this situation." Advisers and investors also should remember, said Mr. Mintz, that ESG investments are not an asset class, nor does ESG investing replace appropriate asset allocation, which he notes accounts for 90% of a portfolio's performance. "ESG doesn't change that," he said. "It's not something magical that replaces everything we already know. It's an additional data set that we can add on top of the techniques we already use." (More: ESG funds boosted by women and millennial investors) Each of the webcast participants noted that the data and analytic tools now available to fund managers and index creators enable ESG-oriented mutual funds and exchange-traded funds to offer more refined products.

'Better screening'

"In the early days of socially responsible investing, energy may have been excluded from a portfolio, which would affect performance," Mr. Mintz said. "Today, if some investors don't want fossil-fuel exposure, for instance, they don't have to have it. But if they want exposure, today's better screening lets us invest in energy companies that score better on ESG metrics." More advanced screening also enables investors with a conservative orientation to invest along ESG lines in ways that don't conform to the field's traditional liberal stereotype. "While there are elements that are very important for liberals and conservatives separately, there also are a lot of areas where there's significant overlap," Mr. Nimeri said. Another innovation is that many ESG-oriented funds now are available for the Asia-Pacific region, the home of 50% of the world's population, according to Ms. Cheng. "Typically, American investors tend to be under-allocated in the international and emerging-market space, and these are areas where the environment part of ESG is becoming increasingly important," she said. "While there is much to know about ESG investing," Ms. Cheng added, "providers are always happy to speak with advisers and to share white papers, webcasts and all kinds of information. Asset managers are aware that advisers and clients have questions, and they want to help."

Evan Cooper is a freelance writer.