Sustainability Preferences – The Third Dimension
At the heart of sustainable finance regulation in Europe is the assumption that with increased disclosures, investors will make more informed decisions around the incorporation of sustainability in their investment strategy.
The reasoning is that if more people understand the sustainability impact of their investment options, they will naturally move their money in favour of more sustainable investments. This is a big assumption.
First, it assumes people will take the time to understand their investments and how sustainability can be incorporated. We live in an attention economy where everyone wants the answer now. The financial illiteracy challenge is in part down to how the subject of investments is communicated but individuals must also bear responsibility.
Warren Buffett, one of the world’s most successful investors, regularly reminds people that: “the best investment you can make is in yourself”. Individuals should invest the time to learn the basics of investing and how sustainability can be incorporated. Collectively, this would go a long way in helping to reshape the financial system.
The second part of the equation is than even where people take the time to understand their investments and why sustainability matters, will they care enough to make sustainability a priority within their own investment strategy and hence align to investments that are genuinely pursuing a responsible investment approach? I remain optimistic that with the right education people will take sustainability seriously within their investments. They will also be better equipped to decipher between marketing and reality.
On April 21st, The European Commission announced the adoption of “an ambitious and comprehensive package of measures to help improve the flow of money towards sustainable activities across the European Union”. The package includes six amending Delegated Acts on fiduciary duties, investment and insurance advice, which they claim “will ensure that financial firms, e.g. advisers, asset managers or insurers, include sustainability in their procedures and their investment advice to clients”.
Notably, under investment and insurance advice they state: “when an adviser assesses a client’s suitability for an investment, they now need to discuss the client’s sustainability preferences.” This has been a feature of recent sustainability regulation and advisors need to adapt quickly.
Many people care about sustainability and appreciate the importance of a secure future, but they often don’t see the connection with how they spend or invest their money. We are not yet at a point where clients have a reasonable understanding of their sustainability preferences. Most are at the early stages of making the connection between sustainability and investing. This is why financial advisors have such an important role to play.
The role of a financial advisor is to align preferences with solutions as part of helping clients to achieve their financial goals. Until recently, the focus has been on ascertaining a client’s risk and return preferences as part of aligning them with the most appropriate investments, classified according to a risk/return framework. The inclusion of sustainability preferences is an additional dimension that financial advisors now need to incorporate into the advisory process.
Based on my interaction with financial advisors on my Responsible Investment Advisor (RIA) course (through the Responsible Investment Institute), advisors are also at the early stages of this evolution. There is a lot for advisors to get their head around, in terms of responsible investment in general and how can it be practically applied. Most importantly, advisors need to augment their key policies and frameworks, including the firm’s investment policy, the client questionnaire, the fund selection process, the fund categorisation framework, and engagement policies.
The ability to ask the right questions is key to correctly defining the sustainability preferences of a client. Advisors need the requisite knowledge to be able to ask the right questions, both of the client and also of the underlying investment managers with whom they choose to align. In creating the RIA course, the objective was to deliver the knowledge and practical frameworks needed by advisors, but the value derived by advisors will depend on the meaningful application.
Including sustainability preferences in the advisory process makes sense. Over time, we will wonder why it wasn’t always part of the discussion.
Vincent McCarthy, CFA
Source: Press release – 21 April 2021 – Sustainable Finance and EU Taxonomy: Commission takes further steps to channel money towards sustainable activities