What Is ESG investing? Here's What Advisors Need to Know.

Environmental, social, and governance—three guiding principles that investors are using to grow their wealth and make a positive impact on the world and their communities.

ESG investing is highly popular today, but it's not a new concept. In fact, 18th century Methodists may have been the first practitioners of ESG investing in the United States, as they avoided investing in businesses that produced alcohol and tobacco or encouraged gambling. The modern conception of ESG investing, however, was first formed in a 2004 International Financial Corporation (IFC) report called "Who Cares Wins."

At the time, roughly $6.5 trillion of assets were managed by investment companies incorporating an ESG focus. Since then, assets managed by such organizations have ballooned to $80 trillion. 

So, what is ESG investing to your clients? Should you be paying more attention to investment strategies designed with ESG factors in mind? And how can incorporating an ESG component to your service offering improve your practice?

What Do Investors and Financial Advisors Think About ESG?

Survey after survey makes it clear that investors are highly interested in ESG investing. One found that 72 percent of investors wanted to explore ESG investing with their financial advisor. Another found that 95 percent of millennials—a generation that advisors should seriously consider targeting—are interested in sustainable investing.

But there's a disconnect.

Eighty-seven percent of investors report that their advisors haven't broached the topic of ESG investing. According to research by Cerulli Associates, the reason why advisors aren't discussing this approach with their clients is because they don't believe there's enough demand:

• Fifty-eight percent of surveyed advisors indicated that a perceived lack of demand was a significant factor preventing them from pursuing ESG advisors
• Another 14 percent reported that it was a moderate factor

What's Behind This Delta?

There's a reason why so many investors want to ask the question: What is ESG investing? There are a lot of misconceptions, myths, and half-truths out there that muddy the waters for investors.

For example, some might think that ESG investing is a fad. All we have to do is look back to our Methodist friends in the 18th century to see that this is patently untrue.

Others might argue that ESG investing is too political, but there really isn't evidence that any one political party is more attracted or repelled by ESG investing than the other. And even if this were the case, financial advisors would still be missing out by not satisfying a demand from a significant portion of their client base, regardless of its political connotation.

Most commonly, however, is the belief that ESG investing yields lower returns compared to investing strategies conducted without regard to ESG factors.

There is, of course, never any guarantee that a given strategy will yield the desired returns. But there's good reason to argue that focusing on ESG factors can improve a business's resiliency, reputation, and bottom line. In fact, the IFC report that popularized the modern concept of ESG investing (appropriately titled "Who Cares Wins") makes this very argument:

The institutions endorsing this report are convinced that in a more globalised, interconnected, and competitive world, the way that environmental, social, and corporate governance issues are managed is part of companies' overall management quality needed to compete successfully. Companies that perform better with regard to these issues can increase shareholder value by, for example, properly managing risks, anticipating regulatory action, or accessing new markets, while at the same time contributing to the sustainable development of the societies in which they operate. Moreover, these issues can have a strong impact on reputation and brands, an increasingly important part of company value.

Financial advisors may know that these beliefs don't add up—but what matters is that financial advisors believe that clients believe these myths. As we've shown, the vast majority of investors want to know more about ESG investing. Thus, they either do not believe these misconceptions, or they aren't relevant to the reasons why they're curious about ESG in the first place.

How to Implement an ESG Component in Your Practice

Before incorporating ESG strategies amongst your client portfolios, you'll want to have a few pieces in place.

1. Understand the Diversity of Motives

Like all other forms of investing, ESG investing isn't a one-size-fits-all concern. Your investors will come to you with different desires and goals, though they may not have the right words to describe them. As their advisor, your job will be to identify and clarify those goals.

Some investors will be interested in ESG for the general cause—they want to put their money to work in a way that doesn't harm the planet or communities while still earning a return.

Other investors will have highly specific goals in mind, such as only investing in companies with net-zero carbon emissions, or investing in companies that focus on ethical supply chain practices. You'll have to do a bit more homework with these clients to ensure their investments truly meet their principles.

Still, others will want to pursue ESG investing because they believe it's the key to better returns. These clients might not care so much about the specific ESG factors at play in their portfolio—it's more of an added bonus to their hoped-for performance.

But most likely, any given investor will have some mixture of these and other goals. Thus, it's important to do some thinking about what options are available, what goals are likely, and what your specific clients seem to be interested in.

2. Make a Communication Plan

When exploring any new feature in your practice, it's a good idea to construct a simple messaging plan around how to communicate the new development to your clients.

Even if your clients are very curious about ESG, they'll likely still have some questions for you and may hold some misconceptions. A client highly motivated to invest in a way that has a desirable social impact may not realize, for instance, that they don't necessarily have to expect lower returns than if they invested without considering ESG factors.

3. Do Your Due Diligence

As is the case when incorporating any new investment strategy into your clients' portfolios, you'll want to conduct rigorous due diligence.

There are many thousands of ESG investment options available—you'll need to assess your client base and identify the ones that are most likely to serve their needs. Try to evaluate the investment manager's governance style and whether ESG factors play a large role for them, identify investment strategies with specific goals (like net-zero carbon emissions), and most importantly, avoid investment strategies that are brandwashing. Plenty of investment strategies describe themselves as ESG-oriented, but their holdings may not reflect that statement.

How to Do This at Scale?

Investment management is already a time-consuming part of a financial advisor's day, so it may seem daunting to incorporate yet another factor into your investment management operations. And, if including an ESG aspect to your service offering works as intended and attracts more clients and more AUM to your practice, how will you manage those assets and clients at scale?

Outsourcing investment management may be the key to successfully scaling—but that's just one potential benefit advisors realize by outsourcing. Learn more about what outsourcing can do for your practice in our blog, How Outsourced Investment Management Can Improve Your Practice.