Consider this hypothetical conversation:
Representative of Mega-Investors Limited: “So, Mr. Collie, I would like to talk to you about your sustainability preferences with regard to the assets we invest for you.”
Me: “Super. I believe that, as investors, we have a responsibility to pay attention to the impact of our decisions.”
Rep: “We at Mega agree. So what are your preferences?”
Me: “Well, I have a few questions for you. What is your approach to materiality? Which ESG factors are most likely to affect financial performance? How do you measure that? What environmental and social impacts do you track and how do you measure them? How can I tell … (carries on for a while) … and the relative effectiveness of divestment versus engagement for example?”
Rep: “Errrr. Let me get back to you on that. And remind me again how to spell ‘cryosphere’.”
_________
Conversations like that (well, maybe not exactly like it) might soon become common. That’s because the European Union’s MiFID regulation dictates that investment firms need to carry out a suitability assessment when they give advice or make a portfolio management decision. And under a new rule due to come into force later this year, that suitability assessment will need to take account not only of the client’s investment objectives, but also of their sustainability preferences.
That’s a lot of client conversations about sustainability. And those conversations will have implications for product strategy, reporting and more besides. Their impacts will be felt well beyond the EU, because once firms develop the capability to engage more effectively with clients on sustainability in one region, what they learn will guide their approach everywhere.
It’s a two-way conversation
In order to properly articulate their sustainability preferences, clients will need information. Most will not come ready-armed with the list of questions I pose the Mega-Investors Rep at the top of this piece, and, in practice, firms will want to guide the conversation. Essentially, clients need to know what choices they have and they need to know what the impact of those choices would be, in both financial and non-financial terms.
This means that, if done well, the conversation will simultaneously be (a) the client communicating their sustainability preferences to the manager, so that the manager can build those into their advice and management processes and (b) the manager communicating their process to the client so that the client can identify which products, if any, are the most appealing.
Distinguish between exclusion and impact
When discussing preferences, it’s helpful to distinguish between the preference to manage one’s impact and the preference to avoid a particular sector. One client, for example, may prefer their investments to be aligned with a goal of lower greenhouse gas emissions. There are several ways the manager might pursue this objective: stock selection within the energy sector; targeted divestment; supporting renewable energy companies; engaging with company management, and so on. But if the client’s preference is to simply exclude fossil fuel companies from the portfolio, then only divestment achieves that.
Exclusion ties the manager’s hands more than impact, so exclusion preferences can only be incorporated up to a certain point before the portfolio management process is compromised. It’s common for firms to build in a limited number of exclusions – such as cluster bomb or biological weapons production, for example – but these normally relate to a very small part of the investment opportunity set.
Impact is a far broader conversation. The industry is still grappling with the challenges of assessing impact: materiality, data availability, consistency, greenwashing. Measurement is imperfect at best. So firms need to communicate their approaches clearly, but honestly, and help the client to connect the dots from preferences to portfolio decisions to real world impact.
Once you know the client’s preferences, what do you do with them?
Greater insight into clients’ preferences implies a responsibility to take account of them in the portfolio management process. It’s hard to argue that fiduciary duty precludes ESG objectives being used as tiebreakers in investment decisions if clients themselves say otherwise, for example. Similarly, it’s hard to argue they can be used as tiebreakers when clients say they can’t. Many clients will want ESG objectives to be taken into account to the extent that is possible without compromising financial goals. Some clients may want their sustainability goals to be pursued even when that involves a tradeoff with financial goals. Others may prefer that non-financial impacts receive no consideration in the investment process.
And this is complicated further by the wide range of topics that might come up. Sustainability is not just about climate change and fossil fuels. Some client preferences may focus on controversial weapons, others on abortion and contraception, others on more transparency around lobbying.
As firms learn more about the preferences of their client base, product line-ups will evolve. And this process will be happening across the whole industry, in turn redefining norms and resetting client expectations. It’s an iterative process. This creates a challenge for firms: how to meet the wide range of client preferences in an evolving landscape?
A tiered menu structure for the product menu
One way to think of this is as a two- or three-tiered menu structure (something that will perhaps sound familiar to those who have worked on defined contribution plan design).
The first tier (analogous to the target date fund that serves as the default option in many defined contribution plans) is the firm-wide approach to sustainability, i.e. a one-size-fits-all approach that offers the best fit to the preferences of the greatest number of clients.
Then there will probably be a range of other options, designed to satisfy the needs of as many as possible of those whose preferences the core approach doesn’t capture. Firms will need to find a balance between keeping the list of options manageable, while offering enough flexibility to cover the wide range of client preferences. Because investment processes differ widely, there will be a lot of different versions of what that balance should be.
The third tier represents full customization. This is never easy. But some firms may decide it’s worth finding a way to offer full customization of the portfolio to match the client’s sustainability preferences. Implementing that will require some hard thinking, perhaps based around the idea of a sustainability budget. But what seems like a stretch today may become more feasible in time.
When asset managers talk to clients about sustainability preferences, change will follow
In short, when the EU’s new requirement to take account of sustainability preferences comes into force, the conversations it sparks will have knock-on effects. Of course, sustainability is already a hot topic for every asset management firm, and ESG agendas are pretty full, even without this extra boost. But the client voice is about to become a bigger part of that story.