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By Jan-Carl Plagge, head of active-passive portfolio research, Vanguard Europe and Fong-Yee Chan, head of ESG strategy, Vanguard Europe.
The ESG universe is expanding rapidly, with assets in ESG-focused mutual funds nearly tripling over the past five years, from £58bn in 2017 to £158bn in 20211. The number of ESG products on offer to investors has also more than doubled from 116 to 242.
The topic of ESG investing or sustainability is now raised in around one in five conversations between advisers and their clients2 and our research suggests it is the area where advisers would most like to develop their knowledge and skills. In a survey of advisers by Research in Finance for Vanguard, 56% selected ESG investing as their main development area and 71% said they would value a framework for thinking about the topic3 .
As the number of ESG funds and strategies continues to grow, it is important to remember that the most appropriate option for each investor remains highly personal. There is no one-size-fits-all approach and it is helpful to establish a client’s goals and how different strategies might address their objectives before deciding on a suitable approach.
Vanguard has developed a four-stage framework to help advisers and investors navigate the ESG landscape and determine what―if anything―investors should do about adding an ESG investment option to their portfolios.
The first step in the framework is to define what ESG related issues, if any, your client may want to address with his or her investment and what objectives your client has for each issue.
There are a whole host of ESG issues, such as fossil fuels, water use and conservation, the use of weapons and board diversity, and the investor may have different reasons for wanting to address them. They may have certain values, such as religious or ethical beliefs; they may want to bring about real-world change, such as reducing carbon emissions; they want to generate a financial benefit, such as investing in renewable energy companies that may be undervalued by the market; or, finally, they may have external requirements (such as regulatory requirements) to adhere to certain ESG-related criteria.
These objectives may vary by issue and are not mutually exclusive. Some investors may be interested in multiple objectives.
There are also many different ESG investment products available, most of which use four common underlying strategies. They can employ ESG integration (the inclusion of material ESG information in investment analysis and decision making), as is often employed by active funds; ESG screening and/or tilting; stewardship (the promotion of effective company governance through activities such as engagement and voting) and impact investing (targeted investments with the dual objective of generating a financial return and some positive ESG-related impact).
Where ESG products apply portfolio screening, there are both exclusionary and inclusionary approaches. Exclusionary screening excludes companies from the investment universe based on specific ESG-related criteria, while inclusionary funds select only those companies that meet certain criteria. Tilting, on the other hand, under- and overweights companies, rather than excludes or includes them, based on sustainability themes or ESG-related criteria. Products may use a combination of both approaches.
Whichever strategy an investor chooses, advisers should consider the extent to which it addresses the client’s objectives relative to the ESG issues they want to address. The impact that the strategy has on traditional portfolio characteristics such as asset allocation, risk, cost and potential return should also be considered.
ESG investing should not be a reason to pay higher fees or adopt a higher-risk strategy. Keeping costs low, taking a long-term approach and having a globally diversified portfolio apply just as much to ESG as any other form of investing.
The final step in the framework is to reassess the ESG choice regularly. The ESG landscape is changing rapidly and the solutions available – as well as the client’s objectives – may change over time.
Four-step process for ESG decision-making
Investors around the world are increasingly interested in ESG investing and different approaches continue to proliferate. An objective and practical framework for ESG decision-making can help investors and their advisers make well-informed decisions while keeping in mind Vanguard’s four core investment principles: goals, balance, costs and discipline.
1 Source: Morningstar, as at 24 January 2022. Open-ended mutual funds domiciled in the UK classified in ‘sustainable funds – overall’ category; fund flows and AUM use oldest share class available.
2 ESG Tracker Study Update, NextWealth, October 2021. Survey conducted in July and August 2021.
3 Research in Finance survey of 153 UK investment specialist advisers conducted from 23-25 November 2021.
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