VitalityInvest recently sat down with Defaqto’s Danny Luggah to hear about the key considerations for financial advisers when it comes to carrying out due diligence around sustainable investments.
To help intermediaries navigate this rapidly growing area[1], the ESG Explored series from VitalityInvest delves into various aspects of the financial advice process around Environmental, Social and Governance (ESG) funds – from fact-find and suitability to regulation.
Crucial to this are considerations around researching sustainable investments and how financial advisers should use due diligence to better understand client needs and justify their recommendations.
To understand this further, we caught up with Investment Consultant, Danny Luggah, who played a key role in designing Defaqto’s detailed ESG Reviews for financial advisers. You can read the interview below or watch the full video as part of the CPD series available on the Vitality Academy and Vitality Adviser YouTube.
What factors do financial advisers need to consider when they are researching ESG funds?
“In the world of ESG there are a lot of terms used – such as ‘green’, ‘ethical’ and ‘sustainability’ – and they all mean different things depending on who you ask. Here at Defaqto, we broadly follow the Investment Association’s (IA) Responsible Investment Framework[2]. That’s because the IA were one of the first bodies to try to standardise some of these terms.
“When it comes to ESG investing, there are four levels that sit as separate parts of a pyramid. At the base is ESG integration, where they are considered as part of traditional financial analysis. The next level is exclusions in funds for certain companies or sectors from the investable universe. After that, there are funds with a sustainability focus, where investment is made in assets with specific sustainability goals or themes. Lastly, at the top of the pyramid is impact investing, which has the intention of achieving a positive, measurable environmental or social impact.
“With that in mind, when we talk about sustainability focus we are talking about actively trying to ‘do good’ as opposed to ‘do less harm’ by owning assets that contribute to positive sustainable outcomes. The main factor here for advisers is understanding exactly what their client is trying to achieve. Some might be looking for broad exposure to sustainability themes, while others might have very specific goals in mind – so understanding the client’s preference is crucial. Another important aspect of this is educating clients so they understand the types of sustainability that can be achieved.”
As sustainability becomes more of a focus for larger corporations and governments globally going forward, how do financial advisers stay on top of this trend when it comes to due diligence?
“As demand for ESG has continued to grow, we’ve seen a lot more options for advisers to choose from. I think this as a result requires a different kind of due diligence as you cannot rely on the quantitative side as much as you can with traditional funds. For example, there is a lot of subjectivity around sustainability. With fossil fuels, we can all agree they are bad for the environment, but the approach fund managers take around them often differ. Some choose to completely avoid exposure to fossil fuel companies, while others argue that by avoiding investment in these companies you cannot help influence change, so they might invest in them so they can participate in company meetings and vote against management if needed. Due to this wide range of approaches, I think it is very difficult to quantitatively assess ESG funds. That’s one of the reasons we’ve chosen to keep our ESG reviews as qualitative assessments. With this in mind, we expect future regulation will help improve consistency around sustainable investing for advisers.”
What do advisers need to do to justify their recommendations to clients when it comes to suitability?
“At Defaqto, we have two interconnected forms of communicating ESG research to clients. We have our research tool Engage which is used by thousands of financial advisers – this allows them to apply various filters on ESG funds. We also produce ESG reviews, which provide qualitative assessments of ESG-focused funds. For example, we look at the ESG policy of the fund – whether it has any set ESG themes or specific exclusions – and then we look at the underlying investments and how they might match or conflict. When it comes to justifying that choice in the suitability report, it is very important for advisers to understand exactly what their client is trying to achieve in terms of ESG and align their recommendations to this accordingly.”
A version of this article originally appeared on Vitality Insights Hub
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[1] Total global investments in ESG hits $1 trillion (£705 billion), European Sustainable Funds Landscape: 2020 in Review, Morningstar, February 2021
[2] IA Responsible Investment Framework, November 2019
