Dialogue bubble with five stars, customer satisfaction concept
iStockphoto.com / Just-Super

Take a trendy investing craze, combine it with overzealous marketing from fee-squeezed asset managers, and throw in a generous dash of populist sentiment denouncing elites and their woke climate agenda. The result? A challenging environment in which to make certain recommendations.

Whether you call it responsible investing, sustainable investing, ESG or something else — and however you perceive it — you can’t ignore it. In a TD Wealth survey conducted last fall, 62% of affluent and younger emerging-affluent Canadians said they intended to pursue sustainable investing over the next year. For the year to July 31, an ESG index fund had the second-largest inflows among ETFs listed in Canada.

“Our research shows that end investors are interested in ESG and want to have a conversation with their advisors,” said Marcus Berry, vice-president, ETF specialist, with Invesco Ltd. in Vancouver.

Regulators encourage as much. Know-your-client and suitability guidance from the Investment Industry Regulatory Organization of Canada suggests clients be given the opportunity to express their investment needs and objectives, including ESG criteria.

Choosing a product based on such conversations may be challenging, though, because ESG investing means different things to different people. Investor misconceptions, arising in no small part from a lack of standardized ESG disclosures and objective measurement in the space, are a real concern.

“Client expectations often differ from the products that asset managers are putting out there,” said Tim Nash, president of Good Investing Financial Planners Ltd. in Toronto.

For example, clients should understand that the secondary market isn’t the place to change the world, Nash said: “They can have a much higher impact through philanthropy and [private] impact investing.”

“There’s no product you can invest in that will suddenly solve problems,” said Adam Murl, vice-president, retail research and lead solutions architect, with Guardian Capital LP in Toronto. A solar energy company, for example, could have ESG issues related to waste or labour. ESG investing is “messy,” and companies’ improvements on ESG factors can be “two steps forward, one step back,” Murl said.

Still, corporate ESG initiatives and work on disclosures are evidence of progress, he said. He suggested investors assess a company’s plan to improve its sustainability over time, understanding that progress will likely occur over years, not quarters.

As the industry evolves and ESG information improves, investors will be able to make more informed investment decisions, Murl added.

In the meantime, what’s a financial advisor to do? Murl suggested six steps to help your clients choose an ESG fund.

1. Educate yourself and your clients

To begin, brush up on the industry’s myriad terms, such as impact investing, inclusionary versus exclusionary investing, and green bonds.

“You want to be fully prepared before starting your [product] research; otherwise, you could be greenwashed away with the tide,” Murl said.

That research will also come in handy as you help clients define their preferences and expectations. So too will the disclosure-based identification framework released earlier this year by the Canadian Investment Funds Standards Committee (CIFSC). It categorizes funds according to their responsible investment approaches as stated in regulatory documents.

The CIFSC framework will “help guide the advisor, using the right terminology,” said Pat Dunwoody, executive director of the Canadian ETF Association, which is a CIFSC member. Because clients may be challenged to articulate their ESG preferences, advisors may want to send them the CIFSC categories ahead of a meeting, she suggested.

She also suggested an easy first question to ask a client, even one who hasn’t expressed interest in ESG: Are there sectors you want to exclude or support? Typically, Nash said, “the number one expectation that clients have is around negative screening.” They want to completely divest from fossil fuels, for example. (To ensure client understanding, consider discussing divestment’s lack of real-world impact, if impact is important.)

An index ESG ETF that is rules-based and transparent offers simplicity, Berry said: “It can be quite easy to identify what is the objective of that strategy, and does it match the client’s goals and values.”

Whatever your client’s preferences, accept them, Nash said. “If you don’t listen to [clients], they’re going to leave.”

2. Define your objectives

This step is about where the client falls between social and financial outcomes, Murl said. For example, do they want to allocate 5% of their portfolio to high-impact investing, even if that means sacrificing some returns? Or does a financial goal, such as retirement savings, take precedence? Place funds along a spectrum, Nash suggested, with a broad-based ESG index fund at one end (minimal screening, light ESG tilt) and more constrained funds at the other (strict screening, heavy ESG tilts).

The more a fund’s mandate is constrained, “the more trade-offs there are relative to that standard benchmark,” Nash said. Those trade-offs could include less diversification, less exposure to energy, higher fees and potentially lower returns.

“Communicate the trade-offs, because sometimes there is a bit of a misalignment,” Nash said. For example, the client may have a strong preference for a thematic fund, such as cleantech, but have a low risk tolerance. A potential solution could be a higher allocation to fixed income.

3. Start screening

Create a list of fund options using a tool that screens for ESG criteria.

For a given fund, Nash considers a couple of rating companies’ ESG scores as well as metrics such as the percentage of revenue from fossil fuels.

Rating agencies vary in their scoring methodologies (just ask Elon Musk). While ratings shouldn’t be the sole basis for choosing a fund, they help place funds on the spectrum, he said.

4. Check under the hood

Look at the top holdings of the funds on your list to check if they align with the fund’s messaging. “If you’re investing in a cleantech ETF, you better see a bunch of solar and wind companies at the top of the list,” Murl said. “Otherwise, it’s just marketing.”

Differentiation from the index is another factor to assess. If a fund has the same top holdings as the index but with higher fees, the client may be better off owning the index ETF and donating the money saved on fees to charity, Murl said.

5. Evaluate ETF basics, including cost

Assessing cost is always important — ESG fund or not — given its impact on returns.

Research shows that ESG funds often have higher fees, Murl said, so investors must assess whether a higher fee makes sense given their desired outcome. For example, some funds use a portion of fees to invest in social outcomes, he said.

Comparing a fund’s cost to that of its peer group or non-ESG equivalent can provide context, he said.

Murl also suggested using limit orders and comparing the bid/ask spreads of different ETFs with similar exposures, which may vary significantly. “No point in giving this return up if you don’t have to,” he said.

6. Assess whether the manager walks the walk

Consider whether the manager is actively engaging with companies to enact change.

“When we’re having these conversations with CEOs and their boards about their emissions and supply chains, we’re leading to better outcomes over time,” Murl said. “Best-in-class operators will be transparent about their activities and produce annual engagement reports along with proxy policies and responsible investing guidelines.”

Investors can further consider the asset management firm’s commitments, such as carbon emissions goals. Likewise, “asset managers that are serious about ESG will have similar goals and policies,” Murl said. “By doing some research here, you can better ensure the fund company is aligned with your values.”

Click image for full-size chart

Decision tree showing the steps to choose an ESG ETF

Framing clients’ ESG preferences

The Canadian Investment Funds Standards Committee categorizes funds according to six non–mutually exclusive responsible investment approaches:

  1. ESG integration and evaluation (e.g., ESG index funds, ESG rules-based funds)
  2. ESG thematic investing (e.g., cleantech funds)
  3. ESG exclusions (negative screening)
  4. Impact investing (e.g., funds that intend to generate a measurable social impact)
  5. ESG-related engagement and stewardship activities (e.g., funds with managers that vote in support of climate-related proposals)
  6. ESG best-in-class (positive screening; e.g., ESG leaders funds)

Avoid these two mistakes during ESG discussions

1. Shutting down the client conversation or being prescriptive about values: “As advisors, it’s not about our values and what we think,” Nash said.

2. BS-ing the client: “Be comfortable telling a client, ‘I don’t know,’” Nash said. “Clients don’t necessarily need an advisor who is an expert in this field; however, they need an advisor who’s willing to learn and work with them.”