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The rapidly increasing demand by clients to access environmental, social and governance (ESG) strategies is a plus for advisors on multiple fronts.
For example, owing to ESG still being in its formative stages as a widespread, easily accessible investment concept, it's a great conversation starter with clients of varying demographics. Additionally, ESG, with the already built in client demand, is an excellent avenue for advisors to add value for clients because ESG scoring isn't uniform.
There always the old standbys of ESG funds not holding alcohol and tobacco stocks and excluding shares of civilian firearms makers. However, as the appeal of virtuous investing increases, definitions are expanding, providing advisors with an outlet to navigate investors through what's quickly becoming a confusing landscape.
Another way of looking at this scenario is that clients should want to avoid ESG risk and that's something advisors can certainly help with – if they know where to look for ESG risk in the first place.
Some Expected and Surprising Sources of ESG Risk
“Morningstar Indexes recently examined a variety of investment approaches as represented by Morningstar equity indexes. The analysis applied company-level Sustainalytics ESG Risk Ratings and Carbon Data to explore this question for its investor clients,” according to the research firm.
The Morningstar inquisition turned up some interesting points. For a dividend-oriented portfolio may carry 20% more ESG risk than one that doesn't emphasize payouts.
That may not be surprising because the industrial sector is a primary sources of dividends and dividend growth among domestic stocks. However, the sector accounts for 9.6% of the MSCI USA Extended ESG Select Index. Additionally, it may be reasonable to quibble with that Morningstar assertion because technology is an increasingly prominent part of the U.S. dividend equation and that sector is usually overweighted in traditional ESG benchmarks.
“There are so many different facets to sustainable investing that investors need to consider for their portfolio that it can be a difficult road to navigate,” said Dan Lefkovitz, Morningstar index strategist. “For our study, we applied company-level ESG risk insights from Sustainalytics to our broader index measures for a more holistic portfolio-level view on ESG. This led to some interesting and, for potentially for some, unexpected results.”
Among the more surprising tidbits in the Morningstar study is that an ESG portfolio can be roughly 10x as carbon-intensive as the broader global equity market. That's not a data point to be cheered, but it could be indicative of more market participants getting hip to issues such as the intensity of rare earths mining (those materials are used in an array of renewable energy products) and the fact that electric vehicles use quadruple the amount of copper of traditional automobiles, among others.
Other Important Points to Mention to Clients
The Morningstar survey contains other relevant points advisors should bring up to clients, including the facts that value- and size-oriented strategies can introduce investors to elevated ESG risk. Given the sector makeup of many traditional value strategies – a lack of technology exposure – that's not surprising. As for small caps, well, many are struggling to reach profitability and may not be prioritizing ESG as of yet and many broad small-cap funds aren't heavily tilted toward tech, either.
The Morningstar study also mentions the utilities sector, high dividend and low volatility funds as being carbon-intensive. Obviously, that's a potential sore spot for some clients because many love high dividend and low volatility concepts, many of which feature heavy allocations to the utilities sector.
However, it's possible this point changes for the better with time because the utilities sector, to its credit, sees the writing on the wall and is evolving to become a player in the renewable energy landscape.
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