How suitability has changed for ESG investing

23 October 2020

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In the latest episode, Ryan Medlock, Senior Investment Development and Technical Manager joins Mark Greenwood, Director of Compliance Services at SimplyBiz to discuss how advisers should be building ESG considerations into their centralised investment propositions as it's going to be a really significant theme for the next few years.

Imogen Tew:           

Hello, and welcome to the FT Advisor podcast. The podcast series brought to you by FT Advisor. This is a special edition sponsored by Royal London as part of the Responsible Investing: The New Normal series. ESG investing has boomed in popularity over recent years as fears over climate change have led investors to consider the impact of their money and as a growing number of millennials have begun investing. Fund Houses have been quick to respond to the ongoing trend, but the complex nature of a client’s ESG choices, the sometimes contradictory and flawed rating systems and fears of greenwashing have created a confusing and challenging maze for advisors.

As popularity increases and regulation tightens around ESG investing, what is in store for advisors when discussing such products with their clients? I’m Imogen Tew, senior reporter at FT Advisor and joining me today is Ryan Medlock, senior investment development and technical manager at Royal London and Mark Greenwood, director of compliance policy at SimplyBiz. Welcome to you both and thanks very much for joining us.

Ryan Medlock:        

Thanks Imogen. Great to take part today.

Mark Greenwood:   

Thanks Imogen. It’s a pleasure to be here.

Imogen Tew:           

So, if we start off with where we’re at with this at the moment. What requirements are there for advisors to take ESG into account during the suitability process? Ryan.

Ryan Medlock:        

Well, I think it’s probably worth noting that the European Securities and Markets Authority do currently state that it’s best practice to capture ESG considerations within suitability assessments. We actually carried out some research at Royal London during the summer and that research actually highlighted that 77 per cent of advisors are already doing this so I think it is happening on a significant scale at the moment. Obviously, you’ve got these new MiFID II rules and when they come into effect, that’s effectively going to formalise this best practice and force advisors to capture their client’s sustainability preferences within that assessment.

I think that move is very much going to inject ESG further into the heart of the financial advice process. We know that when these rules come into effect, advisors will need to determine whether one of two investment products should be integrated into their client’s investment strategy. You’ve got what’s called an Article 8 investment, so that’s a product which promotes environmental and social characteristics. Then you’ve got something that’s called an Article 9 investment, so products which have a sustainable investment objective.

We know that these rules come in to play 12 months from when the final rules are actually published. I think clearly, it’s going to go much, much further than just planting a couple of additional questions in the fact find. I think obviously, advisor research and advisor due diligence processes are going to need strengthening to fully capture this consideration.

Imogen Tew:           

Sure. Mark, do you think this means that the days when advisors could simply ignore ESG and still provide suitable advice are over?

Mark Greenwood:   

Well, I think it’s interesting with Ryan’s comments there. As he quite rightly says, the ESMA guidelines published in May last year state that it’s good practice for firms to collect information on the client’s preferences in ESG factors. We’re starting to see a pattern of that happening. I think it is fair to say if we go back in time, possibly historically advisors have tended to ignore ESG considerations, I think for two reasons really. Probably because they thought better returns were available elsewhere…

Imogen Tew:           

Sure.

Mark Greenwood:   

…in the standard market and the mainstream market. I think equally because the range of those type of funds was fairly limited. As Ryan said before, I think we’ve got a take-up of firms that are now asking these questions in the fact-finding stage before this MiFID amendment comes in. The MiFID amendment will certainly make it mandatory for advisors to introduce ESG considerations into their suitability assessments so that’s going to formalise this best practice, but we’re seeing a thirst for knowledge in this area.

We’ve been running some events ourselves and we’ve got another round coming in November this year and the PFS are looking at doing an ESG qualification, so I think there is a thirst for knowledge from advisors. I do think what you mentioned before, due diligence is probably the main area that we get questions on, on our compliance help desk around ESG investments.

Imogen Tew:           

Ryan, you were just saying that you don’t think just slotting a few questions into the fact find is going to be enough to cover this regulation. Do you have any tips either of you for what advisors can do to make sure they’re getting to the root of their client’s ESG preferences?

Ryan Medlock:        

Yeah, I mean well Mark touched upon it there in the previous answer. I think there’s a – I don’t want to prescribe it as sort of like a four-step process or put any numbers on it, but I think there are a number of considerations that advisors do need to take into account. I think the first one, as Mark highlighted, factoring a lot of these considerations within research and due diligence processes – that’s going to be really important in terms of looking under the bonnet of the different asset managers that advisors work with to really understand things around how they integrate ESG into their investment processes, what kind of initiatives and codes their signatories to.

There’s a lot of considerations I think from a due diligence and a research perspective. I think a precursor to before advisors go about formally asking questions in fact finds, has to be client engagement on ESG issues. I think that is a really important point and you know, I think a lot of pretty significant events have taken place over the course of 2020 which has perhaps given advisors probably a unique opportunity to engage with clients on ESG issues. If we think about all the specific angles to do with the COVID crisis which present ESG lines. I think there’s an awful lot of opportunities there.

Yeah, again a point Mark said, I think the educational angle and keeping up to date on developments is really important because as we know all too well, over the last couple of years things have been moving at an incredible pace within ESG investing and I dare say over the coming weeks, months, years ahead things are going to continue gathering momentum so I do think it is really important to try and leverage as much information as you can. Fortunately, we are seeing more educational material whether that’s from asset managers, asset owners, as Mark said, professional bodies. There’s a lot more exam and study material coming out and I think all of that is really important.

Imogen Tew:           

Sure. Anything to add there, Mark? What else can advisors do to ensure they are getting to the root of their client’s preferences?

Mark Greenwood:   

Yeah, I think ultimately having that conversation why the client’s attracted to those type of funds. I mean, these proposed amendments – these MiFID requirements go beyond just asking an ESG-type question as we’ve touched on. It’s all about having the processes in place if the client answers yes to that question. I think we are going to have firms thinking about – certainly who have centralised investment propositions, you know these benefits of having a centralised investment proposition. The consistency of approach throughout a firm, but then if a client particular ESG preferences, would they fit that centralised investment proposition.

Will firms deal with that kind of client on an individual client-by-client basis or have an ESG proposition. I think these are the thought processes certainly with firms that I’m speaking to at the moment. These are the kinds of conversations that we’re having internally as firms.

Imogen Tew:           

Sure.

Ryan Medlock:        

I think that’s a really important consideration there. How advisors go about building ESG considerations into their CIPs and their CRPs. I think that’s maybe a really significant theme in the next couple of years.

Imogen Tew:           

What other rules are there which are working to encourage the take-up of ESG, Mark?

Mark Greenwood:   

Well, we’ve got kind of a raft of – so we’ve got new rules that came into force in April this year – the Independent Governance Committees – requiring them to report on their firms’ ESG policies. We’ve got Defined Contribution Schemes and we’ll shortly have to publish reports on how they’ve implemented their policies on integrating suitability risks in their investment decision-making process. We’ve had the FCA basically indicate that they are going to implementing the MiFID amendments regardless or irrespective of Brexit. This is the kind of rules that are around.

I think certainly for the firms that we serve, it’s the MiFID amendments making this mandatory assessment part of the suitability assessment ESG considerations. That’s certainly the one for the firms that we serve that they tend to talk about the most.

Imogen Tew:           

Sure. Ryan, any thoughts there? Are there any other rules you can think of which are working in ESG’s favour?

Ryan Medlock:        

Yeah, well I mean Mark’s obviously hit the nail on the head there in terms of the main rules which I think are really affect advisor firms. I think obviously a lot of what’s happened – as Mark said, there’s an absolute explosion of different regulatory proposals over the last couple of years and a lot of this is being driven from an EU level. You’ve got this, what they call this Sustainable Finance Action Plan and there’s a number of recommendations in that. You’ve got the beautifully titled EU Taxonomy which sounds absolutely horrific, but that’s this classification system for economic activities that meet environmental objectives.

You’ve got the Sustainable Finance Disclosure Regulations and what I find interesting with those is that relative to other pieces of EU legislation, these regulations have got a much more prescribed and strict feel to them and that’s predominantly about disclosing how sustainability risk is integrated in different processes. Obviously, you’ve got the other bits that Mark touched on there. I think taking a step back and thinking about it in the domestic perspective again, we’ve also got this proposed amendment to the Pensions Schemes Bill. If that goes ahead, that’s going to make the UK the first country to align pensions schemes with the goals of the Paris Agreement.

I think when you piece all of that together and look what’s happening at an EU level, look what’s happening domestically, I think it’s fair to say that regulators and policy makers are using ESG to effectively reinject a long-term focus back into investment activity.

Imogen Tew:           

Interesting. Obviously, advisors are at the front end of this with their client. They’ve got all of this regulation going on in the background that is altering how they deal with ESG when they’re dealing with their clients. Ryan, what are the main challenges to advisors from an ESG perspective? What are the main challenges they’re facing?

Ryan Medlock:        

I think probably two of the biggest challenges at the moment, I would say, are probably ESG data and greenwashing. I mean, if I start with ESG data – and by issues with data, I’m talking about reliability, depth, non-disclosure, all that kind of thing. I think it’s going to be really interesting to sit back and observe what kind of effect different measures will have on reporting standards going forward. For example, we’ve got this TCFD initiative, so TCFD passports, the climate related financial disclosures, a horrific mouthful.

Effectively, the TCFD takes the Paris target and tries to operationalise it for the business world because it looks to plan climate risk as a board level and strategic issue. I think that particular initiative is going to have a really positive impact on improving disclosure going forward. I think probably, the biggest challenge for advisors is undoubtedly the threat of greenwashing because, you know, we’re getting new ESG products launched on seemingly a daily basis.

I dare say with these new regulations coming into effect, I’m fully expecting that over the next 12 months, we see more new ESG product launches with the word sustainable in the title. Obviously, that is going to create more choice, but I think it also adds to the complexity and confusion from this perspective. I think from a regulation perspective, the good news is that all the various regulatory proposals are all focused on mitigating the impact and threat of greenwashing. You think back to that taxonomy I mentioned a few moments ago.

Ultimately, advisors will be able to look at a specific fund and actually see how much of that fund invests in taxonomy eligible activities, the disclosure regulations. That is going to drive greater transparency, so I think these kind of measures should hopefully reduce the scope for greenwashing, but again I think advisors are still going to have to capture that consideration within their research and due diligence.  

Imogen Tew:           

Sure. Mark, anything to add there.

Mark Greenwood:   

Yes, certainly when I spoke with the head of our compliance technical team and the amount of calls we get on ESG, the majority of them tend to be around due diligence. I think there’s just almost a lack of agreement or understanding of what ESG investing is. You’ve got this – it’s got its own terminology so sustainable investing, impact investing, socially responsible investing.  Then we move onto what Ryan’s mentioned – that there’s this new phrase greenwashing. Making funds appear to be more ESG by providing misleading claims potentially. I mean, the FCA have come out and said they are going to challenge firms where it sees potential greenwashing.

I just think at the moment, currently the onus is on the advisor to do the due diligence on that fund manager and see if they are actually incorporating ESG into their portfolio selection. When we are talking about the FCA, and we’ll see how this pans out next year, I don’t see the FCA handbook being updated with a set specific ESG rules. I don’t see the regulator going down that route personally. Time will tell, but we’ll – yeah, it’s certainly going to become more prominent, but the due diligence angle is the question that we have. I think you’ve got – well it’s three [letters] – environment, social and governance – and the three are going to be very different.

I think a lot of the times, firms have focused on the g for governance while composition et cetera, that’s quite easy to measure. Sometimes on the environmental and social side, it’s not that easy to measure and quantify…

Imogen Tew:           

Sure.

Mark Greenwood:   

…from a due diligence perspective. Hopefully, that will improve over time.

Imogen Tew:           

Mm. Just to add a bit of colour to this problem that advisors are facing, I’ve spoken to a few who are almost a bit worried that they’re not getting the amount of constant ESG data like you mentioned Ryan and Mark…

Ryan Medlock:        

Yeah.               

…in the due diligence process. They’re really struggling to do the due diligence on ESG funds that they want to do. They can’t get to the level they want to be at and they are worried that this may turn into the next great almost mis-selling scandal if clients feel like they’ve been put in funds that they explicitly didn’t want to be put in just because the advisor was unable to do the level of due diligence that they want to do on other funds on the normal returns equities type basis.

Yeah, it’s just an interesting point that advisors are worried about this. Hopefully, this will be solved in the future. Mark, what about the future? I mean, do you think this trend will continue?

Mark Greenwood:   

Yes, is the blunt answer for two reasons. You know, we’ve seen record asset flows into ESG funds. As Ryan touched on before, we’ve seen a lot of investment providers now having an ESG range that previously didn’t have a – this follow the money. It’s an attractive market at the moment. I think the pandemic has increased investor focus on ESG, so that would be one reason. I think the other reason would be this MiFID amendment is going to require advisors to have that conversation around ESG and I can only see the likely effect of that is increase in assets moving into the ESG sector. I think the blunt answer is yes for commercial and regulatory reasons.

Ryan Medlock:        

I think we’ve also seen – definitely over the last couple of years and probably more so over this particular year, we’ve seen a number of pretty significant societal shifts taking place and clearly there is now much more of a demand to invest in a more responsible manner. Again, you only have to look at the flows into sustainable funds, over even just the summer months of this particular year. Again, I go back to that research that Royal London completed during the summer of this. That research actually highlighted that 82 per cent of advisors are reporting an uptake in interest from their clients on ESG since COVID crisis began.

For me, that demand is only going to increase, and I think obviously with the MiFID rules coming into effect, that’s going to formalise this consideration within advice processes. You know, this focus from a regulatory perspective is very much on better disclosure, greater transparency. Yeah, I think ESG for a lot of people for lot of different reasons is going to be front and centre of our minds and obviously aside from the obvious benefit to society as a whole, it has shown it has the potential to improve long-term financial outcomes for clients. That’s why I think it’s a really important consideration going forward.

Imogen Tew:           

Sure. Is there anything you think advisors can start doing now in order to prep for when this becomes a regulatory necessity? Is there any way they can embed an ESG process into their advice business now? Mark, any thoughts?

Mark Greenwood:   

Yeah, I mean embedded ESG preferences within their client fact finds, within their ongoing reviews with clients. Again, there is a thirst for knowledge out there in this area. We run ESG events at the SimplyBiz group. There’s a lot of other providers running specific ESG-themed events and I mentioned the PFS qualification that’s coming our way. Again, it’s increasing your knowledge, looking at your systems and controls within the firm, fact finds, ongoing reviews, embedding ESG considerations within there and starting that thought process certainly for firms that have a centralised investment proposition of how they are going to deal with clients who have these ESG preferences that may not fit their centralised investment proposition.

Firms that we’re speaking to on a regular basis are starting to have that thought process now and trying to get ahead of the game before these new amendments come in which is expected next year.

Imogen Tew:           

Sure, Ryan?

Ryan Medlock:        

Yeah, I think going back to what I said earlier, if firms aren’t already doing so I would strongly encourage client engagement in this particular area – you know, warming the client up, talking about specific issues. Obviously, the beauty about ESG is that there are a variety of issues and topics that can be related to it so using real-life examples, whatever that be, just to bring the impact of ESG to life. I think, having that engagement exercise can make it a little easier to formally integrate some of the considerations within the wider process.

Yeah, I think as Mark’s touched on – as I was mentioning earlier – it’s clearly much more than just bolting a couple of questions into the fact find. It really is, so I think the sooner that firms start thinking about these considerations and integrating them, I think that will be better for everyone.

Imogen Tew:           

Lovely. Ryan, Mark, thank you so much for joining us.

Ryan Medlock:        

Thanks Imogen.

Mark Greenwood:   

Thanks Imogen.

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