Ethical, ESG (Environmental, Social and Governance), Impact, Sustainable: you’ll have heard of at least one of these but it’s not always clear what they’re being used to describe. In fact, they’re all different types of investing with some form of ethical or moral investment preferences.
Traditionally, we’d call this ‘ethical’ investing, as it was first introduced by product or fund providers including an ‘Ethical Fund’ in their fund list. However, this area has grown a lot over the last decade or so, and as it’s grown, it’s become more complex and nuanced.
Its popularity is also increasing, partly due to investors becoming more socially and environmentally aware, but also as a result of some of the myths about this type of investing being debunked as managers and analysts have gained more experience of it.
Generally, these funds still tend to be more expensive than mainstream investments that have no ethical overlay, however, the ever-growing choice of funds means it’s now possible to achieve good diversification at the same time as investing ethically. You don’t necessarily need to sacrifice returns either. In fact, doing social and environmental good is now considered good for business; it’s trendy, and fashion makes money. It’s expected that post-Covid economic stimulus could include incentives for companies that can help the UK to meet net zero by 2050.
There are some new rules in the pipeline that will mean all advice firms will have to embed ethical investing into the whole advice process. MiFID II’s development will include a new regulation that increase advisers’ obligations in a few very important ways:
- The fact finding process must be amended to include identifying clients’ ESG preferences in a meaningful way – it’s not enough just to ask “are you interested in investing ethically?”. You will need to be able to understand exactly how they want to invest. For example, avoiding tobacco companies at the same time as confronting climate change.
- You should find out the client’s main objectives, time horizon and risk profile first before going on to consider ethical preferences. This helps to avoid or address any conflicts between the two areas. If you can’t achieve both, it’s ok to suggest a compromise, as long as this is fully explained and understood.
- Recommendations must reflect both financial and ESG investment preferences. This is already considered good practice by many but will become necessary very soon.
- The adviser must explain how each investment recommended reflects their objectives and investment preferences, which is an extension of ‘reasons why’ best practice.
- If any parts of this process aren’t included, the advice will be deemed unsuitable.
You can read the full Regulations here.
What do you need to do?
Following Brexit, the FCA is expected to update COBS to include all of this. We don’t know exactly when yet, but it’s likely to be sometime in 2021, which makes this year a great time to start thinking about how we can all change our processes to make sure we comply with the new rules.
Many advisers are already doing this, at least to some extent, but even they may need to check that their approach and record-keeping are fully compliant. In reality, it should simply mean adding another step to the ‘know your client’ process and making sure your recommendations address that too. It would also be worth doing some reading about this area of investing and the various individual preferences your clients might have in order to ensure you can have a full and frank discussion about what they really want to achieve and then make recommendations that take this into account.
Of course, just because your client has these preferences doesn’t mean you must be able to provide a solution that complies with them. These objectives may be at odds with their other goals, for example, and you can always refer them to a specialist if they’re looking for something you can’t offer, such as a bespoke solution.
If you have any concerns about this, or want some help with your process, get in touch.
We’ve already started to include this in our usual sense-checking process, where we identify a mismatch between an ESG objective being mentioned and a traditional portfolio being recommended.
We’ve also been able to help clients to articulate their approach to this area and ensure it’s followed through where relevant. Much like the due diligence reports we produce for some clients, it can be very helpful to have a separate ESG investment process document that explains what this all means and how you apply it in your business. Not only would this help to demonstrate compliance with these rules, but it’s also a great way to engage with your clients. Plus, if your reports can refer back to it, we can keep them as clear and short as possible for you!