Wealth managers face challenges to make sustainability default setting in portfolios

Investors’ increasing desire to contribute to solve the world’s biggest sustainability challenges, together with more stringent regulation, which aims at improving transparency and reducing greenwashing, are key growth drivers for sustainable and impact investment solutions. These strategies have expanded rapidly in recent years across a wide range of asset classes, sectors and regions and are set to represent a growing share of client portfolios.

Fifty-five per cent of private banks believe that, in five years’ time, at least 50 per cent of client assets will employ environmental, social and governance (ESG) criteria to evaluate companies in which they invest, or will invest in firms that generate positive impact (Fig 1).

This is a key finding from the seventh annual PWM Global Asset Tracker survey, conducted earlier this year, canvassing asset allocation views from 52 chief investment officers and market strategists at institutions managing a combined $15tn in client assets.

Twenty per cent have already made sustainable investments their default or preferred investments in global clients’ discretionary portfolios. Fifty-four per cent are planning to do so within five years (Fig 2).

For an institution, adopting this default strategy offers several benefits. These include better risk management, greater ability to meet evolving client preferences and playing an important role in mobilising private capital to address sustainability challenges and opportunities.

But this journey requires considerable preparation and presents many challenges. These comprise limited availability of sustainable solutions in certain asset classes, poor ESG data coverage and quality and lack of standardised terminology across the financial services industry. Continuous training and education for advisers and private clients as well as time required for systems change also need to be factored in.

Before taking this step, it is crucial to have the “right products in place” and educate all employees, especially front office staff, but also in partnership with third party organisations and professional bodies, explains Vincent Triesschijn, global head ESG and sustainable investing at ABN Amro.

The Dutch bank started offering ESG investment solutions as default options to new clients in 2018 in its home market, and in 2019 across Europe. Its sustainable portfolios are “very diversified” across all asset classes, claims Mr Triesschijn, but in certain areas such as private markets, “it takes a lot of effort and is quite labour intensive”.  Efforts seem to have paid off. Only 20 per cent of new clients are today opting out of the bank’s sustainable portfolios.

UBS, the largest global wealth manager with more than $3tn in client assets, made ESG investments its preferred solutions for clients seeking to invest globally almost two years ago.

“Sustainable investment mandates have been one of our fastest-growing portfolio solutions in recent years, and we expect this rapid growth to continue,” says Andrew Lee, global head of sustainable and impact investing at UBS Global Wealth Management. Discretionary sustainable portfolios will represent a larger and larger share of UBS’s overall discretionary offering, and similarly so for its advisory offering, he adds.

Sustainable discretionary portfolios have generated “comparable, and over certain periods, better financial performance” for clients compared to equivalent conventional exposure, even though commodities and alternatives are not integrated into the bank’s sustainable strategic asset allocations yet.

The reason for the exclusion is that in these two areas sustainable investments are less developed today compared to other asset classes.

“Within alternatives, the universe of credible sustainable hedge funds is still relatively limited, which can present challenges in achieving sufficient diversification,” says Mr Lee.

To ensure that its sustainable portfolios can navigate volatile market environments or are inflation-protected, UBS “works to address these gaps through tactical trades or identifying alternative exposures”.

Some asset classes, like equities and specifically ‘ESG leader strategies’, already have very well-developed solutions options. However, there is more to be done in making sustainability a core driver of investment strategies and processes in many of these areas, believes Mr Lee.

There is also “room for further development” of sustainable solutions across multiple areas within fixed income, beyond corporate bonds and thematic green, social and sustainable bonds.

By contrast, sustainable or impact investing solutions are generally “reasonably available” across some parts of alternatives, namely venture capital, growth equity, real assets, and infrastructure. Although there are often still constraints around scale, established, institutional quality offerings in certain asset classes, or geographic differences in the development of investment solutions.

Limited resources

For a firm, making sustainable solutions their default strategy is a “genius thing to do” to achieve their sustainability targets, states Cara Williams, global ESG strategy lead at Mercer.

It can be argued there is some psychological resistance from individuals to opt out from a default solution.

However, what is critical, she says, is to create portfolios that “take ESG factors into consideration as much as feasible”, and to remain focused on asset allocation and portfolio diversification.

A key obstacle for private banks is limited resource and expertise. Except for large Swiss private banks, most banks’ manager selection teams are “too small and overstretched”, she says.

Moreover, ESG is a new skill set to be acquired, with evolving regulation being an additional challenge.

Even firms exclusively focused on sustainable investments tend to be reliant on managers coming to them. “It's very often quite a reactive process and I question whether they are catching the breadth of product available on the market, which would meet the criteria they're seeking.”

In addition to leading data providers like Sustainalytics and MSCI, new firms are entering the market providing measurement and insights on managers, with investment consultants such as Mercer also offering ESG focused qualitative analysis. More consolidation is expected in this space.

Some institutions prefer not to offer default sustainable solutions to all new clients yet.

“First and foremost, we want to engage with clients, find out their preferences and then offer them products that best meet their needs,” says Daniel Wild, chief sustainability officer at Bank J. Safra Sarasin, which offers customers both sustainable and traditional mandates. “It’s all about transparency and information to the clients, so they know what they can expect.”

This approach is in line with the upcoming EU MiFID directive, which from August will make it mandatory for individuals to express their sustainability preferences, while requiring the provider to understand them and offer suitable products.

It is debatable, though, whether all customers will be able to decide whether they want to exclude ‘bad’ companies, prefer investments that integrate ESG factors or focus on impact products, in line respectively with articles 6, 8 and 9 of the regulation. Even more difficult will be for them to indicate what percentage of their portfolio must be impact oriented versus sustainable, and for providers to implement it.

Mr Wild expects a period of “trial and error”, until the industry finds an agreement on how to conduct client discussions, as private bankers’ and clients’ education improves.

The new normal

The move towards default sustainable solutions is unstoppable, though. “ESG will no longer be optional: what was once an ethical discussion has now become an economic reality,” states Muriel Danis, global head of product platforms and sustainable solutions at Deutsche Bank International Private Bank. More than just an investment trend or theme, “ESG will soon become the ‘new normal’.”

Deutsche bank’s large scale multi-asset mandates across booking centres in Emea and Asia-Pacific have already been aligned with ESG, while its strategic asset allocation approach is going to transition to ESG by the end of this year.

Sustainability is increasingly a differentiating factor for private banks. “We see strong client demand, with a growing number of our clients and prospects identifying ESG expertise as a competitive advantage,” says Ms Danis.

The bank currently excludes commodities and alternatives from its ESG portfolios “due to lack of data and investment options” that meet its criteria, but challenges are found in other asset classes too, like emerging market debt, high yield debt and even sovereign debt.

Data is integral to measuring sustainability progress and impact, but gathering and distributing this data is still fraught with problems. First, there are no clear standards or regulations governing ESG rating providers and their methodologies. “The harmonisation of ESG data standards are the first step on the journey to greater transparency and comparability,” believes Ms Danis.

Second, the data coverage and quality need to improve. Data providers rely heavily on publicly disclosed information from companies, which historically has not been available or entirely complete on ESG topics. With the non-financial reporting directive and upcoming corporate sustainability reporting directive, this will improve “dramatically” but still has a long way to go on specific asset classes, such as alternatives.

Finally, impact focused data is in limited supply and high demand, she adds. “Clients are interested in the real-world impact of their investments and while there have been some developments on carbon emissions and with UN sustainable development goals alignment, there is more work to be done, especially on topics such as biodiversity and nature as capital.”

Trade-off

Fahad Kamal, CIO at UK private bank Kleinwort Hambros, part of the Société Générale Group, believes the two investment strategies the bank offers, the ‘classic range’ and the ‘responsible range’ will converge into one in a few years. But some hurdles must be overcome first.

The exclusion of commodities and alternatives from sustainable portfolios is an issue, especially in volatile times. “Gold is an important risk mitigator for us, offsetting equity risk in our classic strategy, especially in a world where government bonds no longer play that role,” says Mr Kamal.

While sustainable gold funds are emerging, the sector needs to evolve further.

Low correlated and defensive hedge funds, used in classic strategies to offset equity risk, are also excluded from the bank’s responsible portfolios. As a result, these portfolios tend to be “slightly more volatile, with less offsetting characteristics in equity drawdowns, which is a challenge,” he says.

“We are very focused on having ESG credentials across our book. But today there is a clear trade-off between what would be a perfect investment decision and what would be a perfect ESG decision.”

Erika Karp, chief impact officer at Pathstone, one of the largest independent advisory firms in the US with $35bn in client assets, believes that ESG analysis is a “lens” which improves the risk adjusted return of a portfolio, regardless whether investors regard themselves as sustainable or not.

She believes it is not hard to find sustainable strategies across all asset classes, including hedge funds, credit and distressed credit, private equities, real assets, as well as long only. “We can find solutions that integrate ESG and embrace the idea of sustainability, but you must be skilled to know how to do it, and still achieve market rate returns.”

Reporting to clients about sustainable investments is also critical. ESG rating systems available on the market may be simple, but “most often not sufficient”. The firm has created its ‘access impact proprietary framework’, to help align client portfolios with the UN’s sustainable development goals.

Moreover, most advisers still do not know how to engage with their clients. Their conversations should start from simple questions such as ‘what do you care about?’, ‘what are your values?’, ‘what makes you angry?’, or ‘what delights you?’ and then offer suitable products.

But the issue is there is still a widespread, unjustified fear amongst advisers that they may “be breaching fiduciary duty”, who wrongly believe sustainable investing may underperform conventional investment solutions, reports Ms Karp.

Yet, institutions that have embedded sustainable and impact strategies in their core offering may attract more assets, especially given the multi-trillion-dollar wealth transfer looming. 

“It is most likely that sustainability-conscious next gen inheritors will be looking at these new types of service providers," predicts Adam Rein, co-founder of CapShift, a US-based impact-focused advisory firm. "Default ESG mandates are going to be a marketing tool to pull in assets for these firms, and to show their ability to embed sustainability more deeply than their competitors.”