The Uncertain Future for ESG in Wealth Management

But what I found most significant in the GSI review was the growth of ESG in retail wealth management. While the percent of ESG assets for asset managers was up 44%, the percentage gain in retail wealth management was 92%. And, if the demographics hold true, that trend should accelerate as younger, more ESG-conscious investors come into the market.

But while retail wealth management is showing the most robust growth for ESG, it is a relatively new player on the field compared to asset managers. Not surprisingly, most of the large ESG ratings providers focus their attention and product on asset managers, which is where they currently derive most of their revenue. The problem for retail wealth managers is that their needs are different than those of an asset manager.

I will discuss those differences, why they are important for retail wealth managers, and how to bridge the gap.

What the wealth management profession needs is:

1. Standardization
2. Customization
3. Transparency

Standardization

With many ESG rating agencies and no unified view of what ESG means, it is no surprise that there is a wide range of ratings approaches that result in a divergent ratings scores. This is workable from the standpoint of an asset manager who is looking to use ESG ratings to create an ESG fund to sell to ESG clients, either at scale via an ETF or in size to a large institutional investor.

The problem when it comes to retail wealth management is that everyone has a different idea of what ESG means to them and how it should be measured. One rating agency will assign a company a very good ESG score while the other assigns it a much lower score. This leads to confusion on the part of the retail client.

As an example, one ratings company might rank a particular oil company poor on environmental impact because it is not nearly as clean as a typical public corporation. Another ratings company might rank it highly because it is the cleanest of the oil companies and it wants to cater to people who want a sector-neutral portfolio.

Different ratings companies might also weight their E, S, and G pillars differently when compiling an overall ESG score. And there is also a wide variety of data sources used, collection and normalization policies, and scoring algorithms.

Ultimately, it may take legislation or regulation to bring standardization to ESG ratings and methodologies, but that may not be likely in the immediate term nor effective in the long term. In fact, even if we could find a workable regulatory structure around ESG that standardizes the process, there is no guarantee that all countries would come up with uniform guidelines. We have to assume for the short term that we will work with a lack of standardization.

This puts a particularly heavy burden on wealth advisors to understand the methodologies, differences, and what works best for any given client. And as we know, particularly heavy burdens are just what advisors are trying to avoid in their effort to scale their services.

There are several firms at work looking to bring a more standardized product to market. One example is OWL ESG, a firm that is attempting to account for the many different ratings methods by using a consensus approach similar to earnings estimates. According to OWL, using a consensus-based approach allows individual ratings to inform each other to hopefully achieve the best “compromise” among the different views. This results in less deviation in the rankings and a potentially more useful result to a larger number of clients. Benjamin Webster, co-founder and CEO of OWL ESG, explained it to me, “Academic research has shown that a consensus of experts is a better predictor than even the best expert individually. Using a consensus-based approach, along with hundreds of independently sourced data sources, we believe we can produce ratings that are more stable and credible than a non-consensus method.” (Disclosure³).

This would be less of a problem if ratings providers were transparent about the calculations and results. But this is often not the case. Little raw data or results are presented either in the interest of simplicity or intellectual property. The ratings could even be subjective or the result of machine learning, where the people running the calculations sometimes don’t provide transparency.

Hopefully, as time goes on and this pain point becomes more pronounced, more firms will build innovative solutions that help address this problem. Until then, it is up to the advisor to understand how the ratings are being calculated and how that plays into their clients’ desires around ESG. This makes transparency a gating factor for ESG ratings.

Customization

One of the largest differences between the way retail investors want to consume ESG and the way asset managers deploy ESG is mass customization. Everyone has different passions when it comes to ESG. Some people care deeply about global warming but are not very passionate about having independent directors on the board. Some may emphasize inclusion over human rights while others might do the opposite.

One approach asset managers have taken to mitigate this issue is to focus on creating bespoke ESG funds for large institutions using their specific set of passions as a guide. Given the size of the investments these large institutions make, it is economically feasible to create specialized one-off portfolios even though that is not a scalable process.

Other asset managers have created unified ESG mutual funds and ETFs, which they can then sell directly to the public at scale. The problem with this approach is that the asset manager needs to assume that everyone has the same idea about what ESG means to them, which is not the case. But it does make ESG easily accessible to the public at a low cost. Some firms are creating smaller funds that focus on the individual aspects of ESG. This might allow individual investors to select from those more focused funds and create a mix that is closer to their passions.

Ultimately, the direction ESG needs to go in retail wealth management is mass customization. Advisors need to be able to tailor a portfolio to a client’s unique set of passions. In fact, it is already happening with the proliferation of thematic ESG ETFs.

Since the customization needs to consider a client’s values, it needs to happen at the advisor level. Understanding a client’s needs and developing a solution is an advisor’s superpower. It’s no different with ESG. But advisors are also looking to leverage their time as best they can, so this means the process needs to be quick, easy, and intuitive for an advisor to do. Advisors need a well-designed, intuitive to operate, and flexible software solution that blends seamlessly into an advisor’s workflow for proposals and reviews.

Is such a solution too good to be true? I think it is. But that is the direction the industry is going. A lot of innovative firms are thinking through problems like this. I am hoping it won’t be long. If you have a solution that you think fits the bill, let me know in the comments and I will be delighted to hear about it.

While the mass customization process is mainly a software and user-experience problem, the underlying ESG ratings also need to mechanically accommodate mass customization. Fortunately, most ESG ratings providers start by determining the E, S, and G “pillars” and then aggregating those values to an overall ESG score. This allows clients to indicate their preference for certain pillars and the advisor can use that information to craft a portfolio that emphasizes those same pillars. Most, but not all, ESG ratings providers publish the scores for their individual pillars. Some even publish scores for the sub-pillars underneath each pillar.

But a problem is that many ratings companies include a “current controversy” score. This is intended to penalize companies that are either in active or recent litigation, or otherwise in the press in a negative way regarding ESG.

This is a good thing from an overall ESG rating standpoint. But if you are going to go to a custom-blended pillar approach, you need to map any controversy back to the pillar it relates to so that only that particular pillar is penalized. Otherwise, an advisor might select against an investment that scores well on the client’s passions but is being penalized for a controversy the client does not care about. I have seen some ratings scores that can easily be mapped, but some are less so.

The more granular the pillars are, the more flexibility and control the advisor has. But there needs to be a balance between granularity and noise. That balance can be tough to get right. Ideally, ratings pillars and sub-pillars would be structured so that the software solution providers can rapidly tweak and test to find a compromise that fits best with the retail wealth advisors they are servicing without having to get direct support from the ratings provider on a constant basis.

Intuitiveness

I have a deep belief that everything presented to a retail wealth client needs to be done so in a way that can be understood intuitively, even if that client has no financial training whatsoever. This means metrics the clients can understand. Only when clients or prospects understand something can they move forward with confidence. Of course, this is easier said than done, but it should be the goal of any advisor or wealth-tech provider.

ESG ratings are in good shape in terms of simplicity of presentation. Most providers either use a numeric or tiered scale to indicate which companies do a good job at a certain metric. Typically, this is aggregated to the stock or fund level and presented as evidence to the client that the proposed investment is more in line with their values than others.

The 1-100 numeric scale is popular across wealth management both for ESG and for risk tolerance. Any client or prospect can instantly understand that a proposed portfolio is superior to their current one simply because their portfolio has a score of 40 and the proposed portfolio has a score of 70. This is an elegant solution.

The one problem, as with any arbitrary 1-100 score, is that some clients may not be able to put that score into context. For example, they may understand that something ranked 70 is better aligned with their values than something ranked 50, but it is unclear how much better. Is it 40% better aligned? Probably not since the scale is typically a relative instead of an absolute ranking. This can be a problem if an advisor is trying to accept a slightly less aligned portfolio that fits the client’s financial goals in a dramatically better way.

Innovation will likely save the day on this front as well. One firm already working on putting context and transparency around ESG is YourStake.org. It uses AI and other methods to determine the impact of key metrics that clients might care about. So instead of saying portfolio A is rated a 50 and portfolio B is rated a 70, you can generate reports that say things like, “Switching from portfolio A to B contributes to the saving of approximately 55,000 sea turtles.” Some clients may find that a more compelling argument. It even has an online questionnaire that helps guide the advisor to which metrics the client is likely to care about. (Disclosure⁴).

I reached out to Gabe Rissman, president of YourStake.org, for comment. He said, “We hear from advisors that people don't know how a score translates to what's actually going on in the world. And clients often ask ‘How can my portfolio be a 9 out of 10 when there are fossil fuel companies in my portfolio?’”

Whether it be with the assistance of new, innovative fintech firms or through an advisor’s due diligence, advisors should be prepared to put context and transparency around the numbers should clients request it. Clients only trust you if they feel they don’t have to trust you.

Will fintech be the answer?

As an added challenge, since ESG is not a purely financial concept, clients may feel that they have a better grasp of what needs to be done to improve the world than their advisors, which makes for a tricky situation. In fact, for a truly passionate values-based investor, the role of the advisor needs to be that of a tailor, crafting a portfolio that attains their financial goals while adhering to their ESG desires in a verifiable way.

The solution to these issues will be technology. That is not a bold prediction given the role technology has played in solving problems across all industries, particularly retail wealth management over the last several years. Hopefully, technology firms will continue to develop solutions to better equip advisors for ESG in a scalable, cost-effective way. In the interim, for advisors who are looking to use ESG as a differentiator for certain clients, they need gird themselves and prepare for the issues at hand.

Kendrick Wakeman, CFA, is the founder and managing partner of qSpur, a consultancy operating at the intersection of finance, technology, and people. Prior to founding qSpur, he was the founder and CEO of FinMason, a financial technology company that built one of the world’s largest and most scaled investment analytics platforms. He has over 30 years of institutional investment and technology experience across a broad range of asset classes and has developed, built, and run institutional-level analytics and risk management programs at both large and small financial institutions.

^{1 I use the term “ESG” to signify what is a diverse set of values-aligned investing principles. The term is well known, easy to say, and even easier to type. But regardless of whether you are talking about investing for environmental impact, social change, or faith-based investing, the challenges of deployment in retail wealth management are similar.}

^{2 This narrative has been challenged.}

^{3 The author is not affiliated with OWL ESG and is not being compensated for this article. The author is an advisor to First Rate Ventures, the corporate VC arm of First Rate Inc. First Rate Ventures has an investment in OWL ESG. Neither First Rate Ventures nor First Rate are compensating the author for this article.}

^{4 The author is not affiliated with YourStake.org nor is being compensated to write this article. In the past, the author has done consulting work for YourStake.org.}

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