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Consumers increasingly want to align personal values with their investment portfolios. In response to the growing demand for values-aligned investments, the number of funds that incorporate environmental social and governance (ESG) factors has more than doubled since 2010, according to the U.S. Forum for Sustainable and Responsible Investment. Unfortunately, many advisors are discovering how challenging it can be to create the alignment their clients seek.

Complexity in ESG investing is found in multiple dimensions. The growth in the number of offerings creates one dimension of complexity, with another dimension created by wide variations in approach among seemingly similar ESG-oriented offerings.

In addition, clients don’t have a uniform set of ESG priorities. In some cases, the priorities of one client may be diametrically opposed to the priorities for another client. Consequently, advisors accustomed to managing a standardized set of model portfolios may find that standardized models often will not satisfy values-motivated clients.

Answering the following six questions will help advisors address the inherent complexity associated with ESG investing:

1. What is the client’s objective?

Defining the client’s investment and ESG objective is an important first step in creating a manageable universe of potential investments. Some clients prioritize avoiding stocks or segments of the market that are inconsistent with their personal values. “Screening” to exclude certain securities is the way that many clients seek to achieve moral alignment between personal values and portfolio investments.

Alcohol, tobacco, gambling and weapons companies are among the most-requested exclusions to client portfolios. Clients focused on climate change often select fossil fuel free investments in which fossil fuel energy and utility companies are screened out of the portfolio. Low-carbon frameworks are also popular. Low carbon strategies reduce the carbon footprint of the portfolio relative to the broad market by excluding companies that have significant carbon reserves and greenhouse gas emissions. Low-carbon strategies may include some energy and utilities companies, an important distinction with fossil fuel free strategies.

Solutions-oriented strategies are also popular among climate-focused investors, investing in companies helping to address global warming and other climate-related issues. Diversity is another important theme for ESG-oriented clients. According to Calvert, only 25% of board members and an even lower percentage of executives at S&P 500 Index companies are women.

2. What types of ESG investments provide alignment with client objectives?

Screening-based investment strategies may be appropriate for clients focused on avoiding certain companies or industries and are comfortable with the risk that the excluded securities outperform unconstrained investment alternatives.

Investment strategies that integrate ESG ratings may be appropriate for clients interested in portfolios that seek to include companies with “positive” impact and exclude companies with “negative” impact. Investment strategies that incorporate ESG ratings may include some “good houses in bad neighborhoods,” such as fossil fuel companies or utilities perceived to have a more climate-friendly business. Some investment strategies integrate ESG into the investment process but may override ESG considerations for a stock perceived as having strong upside potential.

Mutual funds and ETFs satisfy the needs of many clients, but customized separately managed account solutions are increasingly available and may help satisfy more complex client needs.

3. How does the investment manager integrate ESG considerations into their investment process?

There are a wide variety of approaches to integrating ESG considerations. There is considerably more ESG data available today than was the case a decade ago. Eighty percent of S&P 500 firms didn’t report ESG data in 2011, according to the Governance and Accountability Institute. Today, more than 85% report on ESG data.

Some investment managers rely on third-party rating firms such as MSCI and Sustainalytics to provide ESG ratings; others do their own ESG research. Investment managers that do their own ESG research sometimes have a dedicated team that evaluates ESG considerations; others have one integrated team that examines ESG considerations as a component of the fundamental research process.

There may not be a right or wrong way to approach ESG research, but it is important to understand the source of ESG data used by the investment manager, how ESG considerations are communicated within the organization and what role ESG plays in the portfolio management process.

4. What factors determine whether a company is “good” or “bad” in ESG terms?

Distinguishing between “good” and “bad” companies from an ESG perspective may be every bit as subjective as determining the value of a company’s stock. A study from MIT Sloan School of Management showed that correlations between ratings from leading ESG rating providers are low. The MIT study is an indication that there isn’t a “universal truth” regarding which companies are “good and bad” from an ESG perspective.

Consequently, an ESG portfolio created from ratings from one third-party provider may deviate dramatically from an ESG portfolio created using the ratings from another third-party provider. Investment managers that create their own ESG ratings are also likely to diverge with one another. There are a variety of reasons that explain the lack of consistency in ESG ratings. Some rating methodologies may attribute more weight to metrics relating to climate issues, others may prioritize labor practices or diversity. Raters may also use different indicators to measure the same attribute. In addition, investors debate whether the “level” of ESG quality provides the strongest signal or whether trends in ESG quality provide a more relevant signal for future stock market performance.

Advisors should understand the primary drivers behind the ESG approach of the investment manager and seek alignment between the investment manager’s approach and the client’s ESG priorities.

5. How does the manager influence company management?

Proxy voting, engagement with management and shareholder resolutions are the most common mechanisms for influencing management behavior. Investment managers should be able to provide specific examples of how they influence company management by sharing proxy voting records, impact reports and engagement summaries.

6. What are the performance expectations for the investment strategy?

It is important to evaluate both the ESG and the investment capabilities of the investment managers under consideration. Some firms excel at evaluating environmental, social and governance (ESG) considerations and in acting as shareholder advocates; others shine at evaluating traditional financial metrics. It’s rare to find investment managers who are outstanding at both ESG evaluation and traditional financial analysis.

It is also important to evaluate the potential performance trade-offs associated with an ESG strategy. For example, many climate-focused ESG strategies have benefited this year from having below-index exposure to energy stocks and higher than index exposure to technology stocks. A rise in oil prices or reversal of technology stock momentum could be detrimental to the relative performance of climate-focused ESG strategies.


Daniel S. Kern is chief investment officer of TFC Financial Management, an independent, fee-only financial advisory firm based in Boston.

Prior to joining TFC, Daniel was president and CIO of Advisor Partners. Previously, Daniel was managing director and portfolio manager for Charles Schwab Investment Management, managing asset allocation funds and serving as CFO of the Laudus Funds.

Daniel is a graduate of Brandeis University and earned his MBA in Finance from the University of California, Berkeley. He is a CFA charterholder and a former president of the CFA Society of San Francisco. He also sits on the Board of Trustees for the Green Century Funds.