[Exclusive Research] ESG and Diversity & Inclusion Strategies: A Look Ahead[Exclusive Research] ESG and Diversity & Inclusion Strategies: A Look Ahead

Younger investors are more likely than members of previous generations to say strategies built around ESG and diversity and inclusion principles are important.

The looming $68 trillion wealth transfer from Boomers to their heirs is one of the main arguments for why advisors need to better understand the next generations’ values. As this survey finds, advisors may want to review their stance on ESG and diversity and inclusion strategies, as younger generations have a much more positive view of these themes than their Boomer counterparts.

In fact, advisors report that Millennial and Gen Xer clients are more than twice as likely as Boomer clients to believe that ESG is “very important” to an investment strategy. Meanwhile, women are more than three times as likely as male clients to say the same. A similar pattern plays out when considering the importance of diversity and inclusion strategies, albeit with a less pronounced difference.

As the makeup of advisors’ client base skews increasingly toward younger generations, advisors would do well to pay attention to shifting views about ESG, diversity and inclusion, and other thematic investing strategies. Moreover, the fact that women are assuming control of an ever-larger share of private wealth underscores the importance of this shift in client preferences.

Advisors expect allocations to thematic strategies in general to increase slightly over the next two years, with allocations to ESG strategies experiencing a larger boost.

The greater interest in thematic investing among the next generation of clients has already caught the notice of many advisors and firms. Three in four advisors invest client assets in thematic funds, primarily on a case-by-case basis—although 12% of advisors use thematic funds across their entire client base.

Advisors generally anticipate an increase in their allocations toward this type of investment strategy. The increase is substantial in relative terms—a 50% increase over the next two years—but not in absolute terms, as advisors are estimating allocations to increase from 10% to 15%. ESG strategies are set to experience a larger increase—from 11% in 2020 to 18% in two years— perhaps because ESG strategies enjoy wider recognition and have a longer track record than other thematic investment strategies.

In general, advisors are most likely to report using thematic funds in the portfolios of their Millennial clients or younger investors, which aligns with the survey’s findings around who wants ESG and diversity and inclusion themes. High net worth clients also use these investment strategies frequently, hinting at the potential benefits they have in terms of generating growth and performance in a portfolio.

Advisors are most likely to use thematic strategies to diversify client portfolios or to target specific sector or asset classes.

ESG and other thematic investing strategies have potential roles to play in portfolio design beyond simply aligning clients’ investments with their values. Well over half of advisors report using thematic investing to add diversification. Given that ESG stocks tend to be less vulnerable to certain types of risk, they offer potential benefits from a diversification point of view. Advisors were also likely to use ESG and other thematic strategies for asset class-specific purposes, which makes sense as themed funds can help investors cut across sectors or more traditional groupings of stocks or bonds.

Nearly a third of advisors use thematic investing to generate alpha. This fact is noteworthy given the long-standing view that ESG investments generally underperform the market. However, recent analysis of 745 European-based ESG funds using data from Morningstar2 shows that this long-held belief may not be true. It would seem at least a third of advisors surveyed have already embraced the performance potential of thematic funds.

Advisors rely on industry ratings when making up their minds about ESG funds, although performance still has a big influence on advisors’ opinions of fund managers.

As ESG and other thematic strategies gain importance in the eyes of the next generation of clients, advisors will need to develop the strategies necessary to evaluate their investment options. The survey suggests that the Morningstar Sustainability rating is one of the top tools used by advisors to evaluate ESG strategies, with 22% of advisors saying it is a “very important” factor in their consideration.

Morningstar developed this tool to gauge the risks that environmental, social and governance factors may have on a particular investment strategy. A one-globe rating means a fund or company is vulnerable to potential ESG factors, while a five-globe rating means the fund represents a lower risk due to these influences. The Morningstar rating appears to be a useful surrogate for evaluating how deeply ESG factors are embedded in a company or fund manager’s approach, as it outranks many of the other factors advisors could consider.

In addition, performance remains an important factor in advisors’ evaluation process. For instance, when considering a fund manager’s brand, nearly half (45%) of advisors say fund performance is critically important. The next most common answer is third-party ratings, which are deemed critically important by just 14% of advisors. Third-party ESG ratings, by contrast, are deemed critically important by just 10% of advisors—although 57% say they are at least somewhat important.

There is a larger focus on ESG due diligence when adding ESG managers, compared to adding managers with a focus on diversity and inclusion.

Many firms are planning to increase the number of ESG criteria they use in the manager due diligence process. For instance, 50% of advisors say a fund manager’s formal ESG/SRI policy is already part of their firm’s due diligence process or will be in the next one to two years. Responses are similar for other factors, including whether a manager has a dedicated ESG/SRI team in place or whether ESG/ SRI has been incorporated into portfolio and performance reviews. In fact, only about a third of firms do not plan to consider these kinds of criteria in their due diligence.

Advisors are much less likely to evaluate a manager’s focus on diversity and inclusion, with just over a quarter (29%) considering this factor when selecting a strategy. In fact, nearly half (48%) of advisors say there’s no value in asset managers weighing in publicly on diversity, equality, inclusion and community issues at all, while just 11% say this behavior has high value. The difference between the due diligence levels on these two themes may reflect the fact that ESG/SRI has been around a lot longer as a strategy than has diversity and inclusion. Advisors also say diversity and inclusion is
slightly less important to younger clients than ESG.

Download the full report, ESG and Diversity & Inclusion Strategies: A Look Ahead.

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