How to build an ethical or sustainable client portfolio

A recent political development may mean advisers will have to be far more aware of their clients’ needs in these areas.

“On 24 May, the European Commission unveiled its first sustainable finance package,” Hortense Bioy, director, passive strategies and sustainability research, manager research at Morningstar acknowledges.

“Advisers could be required to ask their clients about their preferences concerning the environmental and social impacts of their investments and integrate these in the product selection and suitability assessment process.”

So if and when the question does come, what can advisers do? How should they be prepared to help to build a portfolio which incorporates environmental, social and governance (ESG) concerns?

Product availability

Firstly, advisers need to know what products are available to their clients.

Julia Dreblow, founder of sriServices and Fund EcoMarket, suggests there are now more than 40 providers of ethical or socially responsible investing (SRI) portfolios, some of which offer multiple ethical approaches, as well as multiple risk levels.

“For advisers or businesses looking to develop their own proposition, two sets of information are required: standard financial analysis (that which would be used to construct any portfolio), and information on ethical/SRI fund strategies,” she explains.

“Reliable information on a fund’s ethical, social and environmental strategies is essential as it ensures the portfolio can be clearly explained to clients and guards against potential mis-selling risks.”

Historically, one of the barriers to wider adoption of this type of investing by both asset managers and by investors themselves has been the confusion around the various definitions.

Perry Rudd, head of ethical research at Rathbone Greenbank Investments, admits: “There’s a problem around the terminology used in this space and descriptors such as ‘ethical’, ‘sustainable’, ‘responsible’ are often used interchangeably.

“This is wrong, as there are clear differences between the approaches, though much overlap too, hence the challenge.”

He urges advisers to ensure they have a “good grasp” of the range of definitions so they can fully assess the products or services they are considering for their clients.

This is why it is crucial to establish with the client just what they mean by ‘constructing a sustainable portfolio’.

Both advisers and their clients should be ready to ask questions - advisers should be asking clients what they want, and clients should be aware of their own preferences, or at least be armed with questions about some of the different options available to them.

Amanda Tovey, investment manager and head of SRI at Whitechurch Securities, says: “Clients need to consider whether they want to take a positive approach, such as impact investing, where they look to invest in companies which are making a positive contribution to society and the environment - by their very nature, this often leads to exclusion of key areas clients may wish to avoid, such as tobacco production and arms manufacturing.

“Or whether they wish to start from a more negative screening position, where they define the key areas they do not wish to invest in and build a portfolio from this base which can then include a positive overlay if required.”

Triodos Bank recently published its Annual Impact Investing survey, conducted among 2,020 UK adults, which shows investors are generally fairly clear in their minds about which industries they would rule out investing in:

• Manufacturing or selling of arms and weapons - 38 per cent
• Worker/supply chain exploitation - 37 per cent
• Environmental negligence - 36 per cent
• Tobacco - 30 per cent
• Gambling - 29 per cent

Ms Dreblow suggests advisers can help clients to navigate this area of investing by offering supplementary fact finds to explore their areas of interest.

“There are many ways this can be done, but essentially the options are around either selecting the ‘styles’ of fund that are most likely to be suitable - and refining a fund search as required - or presenting clients with a list of issues that might interest them and finding fund options from there,” she says.

Ms Dreblow believes drilling down into detail may not always be necessary.

“Many clients will simply say they want ‘sustainability issues’ to be taken into account, or they ‘want to avoid tobacco companies’, for example,” she says.

“It can, however, be essential for clients with specific needs, as fund strategies vary significantly.”

Ms Bioy points out exclusions from portfolios are an important consideration because of their potential impact on performance.

“Excluding certain sectors may affect your portfolio performance over short periods of time,” she warns. 

She says there are a number of questions clients should ask themselves, even before they approach their adviser about building a portfolio of ESG funds:

• What’s my goal?
• What am I trying to achieve?
• Do I want market exposure with an ESG tilt?
• Am I looking for some sort of ESG alpha?
• Do I want to make an impact and invest in a thematic or impact fund, like gender diversity or renewable energy?
• Where will these funds fit in my portfolio? 

“Some funds are suitable as core holdings, others aren’t because they are more concentrated and narrower, and those are only suitable as satellite [holdings],” she comments.

Overcoming the challenges

There are a number of challenges both advisers and investors may have to overcome as part of this process though.

Ms Bioy considers: “The challenge for investors today is assessing how sustainable their investments really are. There are tools out there investors can use.”

Morningstar launched its own sustainability rating two years ago, as a way to help investors evaluate their portfolios using ESG criteria.

Advisers face other challenges too, as Jason Hollands, managing director of business development and communication at Tilney Group notes, saying it “provides an added dimension of complexity into the fund evaluation, selection and monitoring process, on top of the normal due diligence required to understand how a manager runs money and approaches risk management”.

There is also the question of asset class, as Mr Hollands details.

“Building a diversified ethical portfolio provides additional challenges, as the level of product choice, while reasonable in equities, is much more limited in certain other asset classes and consistency of approaches across different fund companies is hard to find,” he explains.

Mr Rudd concludes: “The range of available options is growing, but is still limited relative to traditional investment.

“It’s certainly possible to create a well-diversified portfolio for the majority of clients, but if they have very specific interests or concerns, a bespoke portfolio management approach may be the better option.”

eleanor.duncan@ft.com