Your client is keen on socially responsible investing. Here’s how you can help.

Socially Responsible Investing

The past year has ushered in a resurgence of societal awareness. Public calls for greater racial, gender and economic equality have gained momentum in the wake of a global pandemic that has prompted people to reevaluate their lives, their principles and their priorities.

For an increasing number of people, such concerns extend to their investment portfolios. But identifying socially responsible investment options can be a tricky endeavor. ESG (environmental, social and governance) scores provided by ratings agencies or analysts can help, but criteria vary. Other factors of what constitutes socially responsible can get blurry or even be outright misleading.

This is where a financial advisor can play an especially meaningful role for a client. The advisor can help identify stocks, bonds and funds that meet an individual’s own criteria and help pull back the veil on how those ESG screening determinations are made. Perhaps most meaningful, advisors can help clients clarify their own expectations and strike a balance between the ethical choices clients want to make and the investment objectives they want to meet.

Although gaining in popularity, ESG investing presents obstacles for the investor to overcome.

ESG investing comes of age

ESG investing traces its roots to the 1970s and gained momentum in the 1980s and 1990s, according to Morningstar. But interest has surged in recent years.

According to Deloitte, the percentage of investors who applied ESG principles to at least a quarter of their portfolios grew from 48% in 2017 to 75% in 2019.

In 2021, the growth was even more pronounced. “Funds fitting Morningstar’s definition of environmental, social and governance investing took in $51.1 billion in net asset flows last year, marking not only a fifth consecutive annual record but a figure more than double the $21 billion worth of 2019 net flows,” Investment News reported in March.

Even the Biden administration is buoying the market. In June the White House issued an executive order directing the Labor secretary to consider rescinding rules that would have kept investment advisors from considering ESG criteria within workplace retirement funds.

The trend is expected to only grow, in no small part because of millennials. Now the nation’s largest generation, having surpassed the baby boomers, millennials are in line for the Great Wealth Transfer, where $30 trillion is expected to be passed on through inheritance.

And they have strong opinions on societal issues. Younger Americans – millennials and adults in Generation Z – stand out in a new Pew Research Center survey particularly for their high levels of engagement on climate change.

For advisors, the issue isn’t whether their clients will invest in ESG funds and the like. Rather, the issue is how to best match their client’s socially responsible expectations with a still-smart investment strategy.

ESG funds and scores lack transparency

One avenue for investors is to consider ESG-specific stock and bond funds and how other funds and stocks rank on ESG scores.

A host of brokerage houses, including Vanguard, Fidelity and others, offer designated ESG mutual funds and exchange traded funds. Benchmark providers like S&P Global and other analysts provide ESG scores on individual companies.

Advisors can show clients interested in socially responsible investing the multitude of options available. Such benchmarks provide a good place to start.

What’s critical for advisors to tell their clients, however, is that socially responsible investing can be a gray area on many fronts.

Even the terms are open to interpretation. Some in the industry distinguish between socially responsible investing (SRI) and ESG investing. Others don’t.

“ESG,” Nerdwallet notes, “is a system for how to measure the sustainability of an investment in three specific categories: environmental, social and governance. Socially responsible investing, ethical investing, sustainable investing and impact investing are more general terms. Often, ‘socially responsible investments’ are judged using an ESG-based grading system.”

Brokerage and analyst criteria on what constitutes socially responsible or ESG investing can vary, and some score-producing methodologies are proprietary, so neither investors nor their advisors can get a crystal clear understanding of just how the companies evaluated purportedly are doing the right thing.

A 2020 report by the U.S. Government Accountability Office noted this lack of an industry standard. “Disclosure on an ESG topic may depend on its relevance to a company’s business,” the report said. “Additionally, differences in methods and measures companies used to disclose quantitative information may make it difficult to compare across companies.”

Indeed, ESG screening can be a bit of a wild card, a fact not lost upon the financial services industry. As noted in a 2020 report by the Organisation for Economic Co-operation and Development, “there is a growing awareness from within the industry that ESG investing practices need to evolve to meet the expectations of its users and to sustain trust.”

A third factor that can prove frustrating for investors with the best of intentions is what the industry refers to as “greenwashing,” the representation of some fund or company as more ESG focused than it actually is.

A glaring red flag, Investment News noted, is when funds add generic ESG-themed statements to prospectuses or rename funds to suggest a green theme without altering the actual investment strategy.

Bonds are not immune either. “The shades of green really start to get fuzzy when it comes to fixed income,” Investment News noted, “where investors and portfolio managers must make decisions about green bonds being issued by otherwise non-green companies, and vice versa.”

Navigating the ESG terrain without missteps can prove difficult. And even when the ESG characterization is sound and true, one factor remains that still must be met. The stock or bond should be a good investment.

How advisors help clients make smart ESG choices

Advisors can help clients in their pursuits of socially responsible investing in three key ways: Identifying what criteria matters most, identifying what companies or funds best match up with that criteria, and correlating those choices with the client’s investment objectives.

Each client, of course, will have their own criteria for what matters most. But the advisor can help clarify their interests. What does the client value? What matters most to them? Is it environmental factors such as climate change or alternative energy? Is it social factors such as fair treatment of minorities or labor standards? What about governance factors such as executive incentives or political contributions?

ESG is a broad category. Helping the client zero in on their own values can help guide their investment decisions. Understanding the client’s motivations can help. Fidelity, as one example, has identified four ESG mindsets that reflect how investors think. They help provide a baseline for client conversations.

  • Impact seekers want to invest their money to make a measurable impact in the world.
  • Alignment seekers want their investments to align with the causes they support.
  • Expression seekers want their investments to make a statement about issues that are important to them.
  • Security seekers want their investments to secure their financial future and are wary of making changes based on non-financial factors. They will only consider these issues if they can help improve financial returns.

Socially responsible investing is easier said than done, chiefly because where does the investor want to draw the line? Say your client does not want to invest in chemical or pharmaceutical manufacturers; what about the retailers who sell those chemicals? Say your client does not want to invest in petroleum companies; what about the trucking companies who consume so much fuel? And what about the companies that supply parts or services to those chemical manufactures and petroleum companies? Where in the supply chain is the client comfortable in drawing the line between what’s acceptable and what’s not?

With this threshold in mind, the advisor and the client can set out researching funds and companies. As noted earlier, ESG-rated funds and scores can serve as a guide. Scores of ESG data providers offer scores and research based on company disclosures. Some use artificial intelligence to measure ESG performance. Prospectuses, of course, can offer a good deal of insight but aren’t universally above skepticism.

Still, legwork and patience can yield a host of investment options. Perhaps the most challenging task remaining is matching those investment choices with a client’s investment objectives. Index funds, for instance, are prized by conservative investors who seek low management fees and fair returns, yet a small-cap index fund likely may include a pharmaceutical company, as one example. Actively managed funds, on the other hand, might steer an investor clear of an unwanted company, but the management fees typically are higher.

And much like any fund, because it exists doesn’t necessarily make it a good investment. The need for portfolio diversification is one concern. Technology and healthcare stocks, for instance, skew more favorably on ESG scores, whereas international stocks may score worse yet present tremendous value opportunity for the investor.

ESG criteria may limit an investor’s exposure to such opportunities. “The imposition of a broad screen or rating scheme based on non-traditional investment considerations is likely to have unintended effects on underlying exposures,” a 2020 research report by Northern Trust said.

ESG funds do show promise. A 2019 Morgan Stanley study showed no financial trade-off in returns of ESG funds compared with traditional funds, and ESG funds demonstrated lower downside risk. Yet many advisors remain lukewarm until a long-term trajectory is better established – which some would argue is the role the advisor should take when doing financial planning for their clients.

ESG investing in many ways is still in its infancy, and the surge of investment interest and opportunities in recent years have spurred calls for policymakers to take a more active role in regulatory guidance.

Advisors, meanwhile, have a valuable part to play. Socially responsible investing can be a challenging endeavor for even the most astute investors. Advisors can help their clients get a better understanding of their own ESG criteria and how to best fit those criteria within their investment objectives.


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