Constructing ESG portfolios to achieve both performance and impact

Wealthy families are increasingly demanding investment portfolios have an ethical dimension, meaning the wealth management industry needs to ensure it can deliver on its ESG promises.

Environmental, social and governance (ESG) investing has been gaining momentum for nearly a quarter of a century. But the nature of this fast-evolving discipline has changed dramatically.

Before the turn of the millennium, creeping legislation increasingly required institutions to disclose ‘socially responsible’ investment (SRI) criteria. Swedish pension schemes, concerned with ethical violations, began dropping companies such as Coca-Cola and Chevron from their portfolios. In the US, however, Calpers, the largest pension plan, was riven by divisive debate about whether to drop investments in armaments, tobacco and gambling stocks, which preceded today’s politicisation of ESG investing.

The most popular strategy in those days was confining environmentally or socially nefarious stocks to an investment ‘sin bin’ through negative screening. But this gradually evolved to locating companies with a more positive environmental track record. Investment managers started to seek engagement with a broader range of firms to encourage better behaviours, often through using voting rights to prompt positive changes.

Today, the impetus has transferred to the family office and wealth management sector, increasingly rivalling the institutional space for creating impact around ESG criteria. Paul Kearney, responsible for strategic growth at the ARC consultancy, and previously head of private banking at Kleinwort Hambros, talk about “three layers” of engagement around ESG.

“The first one is how you build your portfolios and the second is how you operate as a company,” says Mr Kearney, whose firm provides advice to 150 wealthy families. “But also increasingly important is how you are engaging with your clients to make sure they understand the impact of the ESG approach.”

The latest Russian invasion of Ukraine in February 2022 accelerated wealthy families’ changing attitude to the ethical nature of portfolios. “If you think about the world before the war in Ukraine and after that, there was a period of 24 months [leading up to the invasion] when a lot of investors were divesting portfolios of fossil fuel businesses to meet the green agenda,” says Mr Kearney.

After the invasion, those families which missed the commodities and energy boom re-evaluated the cost of ESG criteria. “I think a lot of families are still calibrating how you navigate return, and which ESG criteria you want to apply,” he adds.

Another milestone was the 2022 judgement handed down by the UK High Court in the ‘Butler-Sloss’ case. This paved the path for families excluding investments not aligned with the seminal 2015 Paris Agreement, which aims to restrict global warming, reduce greenhouse emissions and improve approaches to climate change. Potential exclusions account for more than 50 per cent of the equities universe, says Mr Kearney.

“This has had a big impact on the wealth management industry,” encouraging a “radical” stance in “adopting much tougher ESG criteria in selecting your portfolio”, implemented at the level of choosing individual underlying funds. “You've now got to build a model that actually walks the walk,” he suggests.

Despite these changes, many families are struggling to embed ESG criteria in their governance principles. “One manager recently sent me their ESG statement, but it was a bit of a word soup,” recalls Mr Kearney. “It sounded nice, if a little opaque. It met the goals of having an ESG policy, yet was impossible to determine if the policy would actually be powerful and impactful.”

Implementing an ESG framework

Younger generations are particularly interested in drawing up a set of ESG principles, suggests Roman Pfranger, responsible for asset allocation and ESG planning at Kaiser Partner Privatbank, a Leichtenstein-based wealth manager overseeing €6bn in invested assets. But this is not always as straightforward as it seems.

“In the wealth management industry, you have a kind of magic triangle,” he ventures. “If you want to implement some sort of ESG framework, it’s either at the expense of liquidity, risk or returns. This is something that requires a really honest conversation with the client.”

This conversation can help shape the assets included in contemporary portfolios. “The most direct impact on the environment can be made by private rather than publicly listed assets,” suggests Mr Pfranger. “But it depends on the individual client and their understanding of ESG. It’s really a distinction between having a meaningful positive impact and avoiding a negative one.”

This is one sector where it appears there is room for specialist boutiques, as well as universal banks. “It is quite interesting to see how asset allocation has changed when you talk to clients,” according to Nicole Curti, CEO of Capital Y and president of the Alliance of Swiss Wealth Managers, speaking after the FT Wealth Management Summit held in London at the beginning of November 2023.

“Today, the discussion I have with the next generation clients is much less about asset allocation – although this is still important as it makes 80 per cent of your performance ultimately – but what really matters to them is not only the performance, but the performance and the impact their investments can have on our world, our planet and our life.”

Accompanying the client for this asset allocation “journey” is becoming increasingly central to the wealth manager’s role, particularly when it comes to participating in unquoted investments. Real estate projects, says Ms Curti, will now typically include a green angle, such as smart cities, where waste management is handled in an environmentally efficient fashion. “I think that’s where boutique firms can really play a role.”

Malaise in the ESG space

Despite the eventful history, most players agree that all is not well today in the ESG sphere, which may have reached a temporary impasse in growth of enthusiasm and assets. “Some clients do say there has been a little bit of malaise in the ESG space during 2023, with perhaps some challenges from a performance perspective,” reports Matt Shafer, head of international distribution at PGIM, with a mandate to boost the uptake of the $1.3tn US giant’s funds among European wealth managers. “Are we getting to a point of saturation around ESG, with so much client education on the topic, that people want to move on to something else? The topic has ebbed and flowed, but we need to keep talking about ESG, so that we don’t undermine its importance to client portfolios.”

ESG is still discussed at the majority of meetings the fund house has with European clients, says Mr Shafer. “It is part of every RFP, of every investment and operational due diligence process. But the thickness of the lens depends on which part of the world you are in. Clients in Asia want to have a good understanding of the ESG journey in Europe and the US. A lot of them think it has been easy. But the journey has never been easy and it’s definitely not complete.”

Persuading families in Hong Kong and Singapore to stick with investing according to ESG principles can be challenging, he admits. “You can’t just drop it,” says Mr Shafer.

“This is not a trend or a fad. It is now a strategic part of asset allocation and portfolio construction for our clients. We believe in it and it is here to stay. But it remains a moving ship.”

Political polarisation

Geographical divergence around ESG is, however, a major trend. “ESG is more of a topic in Europe than America; and within America, it’s more of a topic in California than Texas,” says Steven Fradkin, president of wealth management at US firm Northern Trust, managing $350bn for wealthy families.

“In Europe, people are more positive to these trends, particularly led by institutional investors in the Nordic region, and I don’t even sense there’s a lot of controversy about what they want to do,” he says, admitting the situation is very different on his home turf. “The US is big and complex. We talk about it like it’s one country, but Texas and San Francisco are very, very different places.”

He laments the “extremism on all sides” which has made ESG a toxic topic in some quarters. “I think we all agree that we want clean air, clean water and our children to be able to inhabit this earth. Any way we can find towards that is a good thing, but there are debates about pace,” says Mr Fradkin.

He describes some nuanced conversations, with even surprisingly liberal families doubting diversity-led investment policies. “When people questioned ESG policies, I assumed before I talked to them that they would be a typical ‘Trumper’, red-faced, neck-bulging, outraged client and I was wrong,” he recalls, smiling. Sometimes investment policies around diversity would be questioned by “ecologically thoughtful”, society-conscious family firms, run by female-majority boards.

“What we’re seeing from clients, broadly speaking, is a pullback and more questioning,” a potentially healthier situation at a time when some investment houses are falsely branding products as ESG-compliant, says Mr Fradkin.

This debate may eventually lead to a renaissance in ESG, he believes. “The thinking will be tighter, the rationale will be crisper, the products will be more credible, and hopefully, if so, there will be more of an embrace from our clients.”

A detailed conversation to determine portfolio parameters should use facts and common definitions, “with no judgements attached”. Currently, he says, “if you’re on the left wing of political thought, you’re pro-ESG, even if you don’t know what it means, and if you’re on the right wing you’re against it. The truth, of course, lies somewhere in the middle.”

Emerging market priorities

But not all wealth managers are convinced of this positive story for ESG investments. Indeed, a vocal minority believe the trends to both private markets and ESG funds are voiced only by investment houses with an economic interest in promoting these investments.

“If I were to sum it up in three words, clients want to spend less money, less energy and less time on preserving their wealth. Everything else, with all due respect, sounds like a made-up story,” says Yevgeni Agerd, CEO of Welrex, a London-based digital wealth manager, featuring luminaries from Citi, BlackRock, BNY Mellon, ABN Amro and Lloyds Bank on its board.

“To be honest with you, I have a similar feeling about ESG.”

Not only is clients’ faith in large corporates, and their ability to influence any ethical behaviours “fairly faint”, but there is also a certain realism among industrial families, based in the developing markets where most of Mr Agerd’s clients live.

“If you talk to people from the key emerging markets about the importance of ESG, they will throw it right back at you: ‘Hang on, you are in the developed world and have been enjoying the benefit of exhausts and pollution from day one. In our countries, we have no other choice.’”