Technology
Tech Traps: Four ESG Investing Traps Awaiting the Unwary

Daryl Roxburgh is President and Global Head of BITA Risk. The BITA Wealth application provides suitability profiling, portfolio and model ESG and risk management, and compliance monitoring for wealth managers. Here, he outlines four key areas of danger that firms should be aware of as they attempt to embed ESG factors into their investment processes.
Two comments from clients come to mind when I think about our
approach to creating a solution for ESG investing
- undoubtedly one of the biggest trends of our
time. The first is, “Your system turns the Investment Policy
Statement from a dead filed paper into a living document at the
centre of the investment process.” The second is, “You give
my client advisors freedom within a framework.”
As will be made clear, implementing mass customisation in ESG and
impact investing is not easy. But it was the logical evolution of
our applications, as well as being the right thing to do for the
planet, clients and the wealth sector’s own interests. Staying
relevant is crucial as the biggest intergenerational wealth
transfer in history gets underway.
We interviewed clients and reviewed academic and industry
literature, investment houses and activists on both sides of the
Atlantic during our research and development into ESG investing.
Here are some of the biggest traps we found to be lying in wait
for wealth managers.
Trap 1: Taxonomy – not coming to a common understanding
of what ESG means
ESG is specifically directed at Environmental, Social and
Governance factors that measure how a company is run and performs
its business. It is one form of sustainable investing, which also
includes SRI (Socially Responsible Investing), product exclusion,
impact and active investing. Often people will group these forms
under one label with which they are familiar, such as
“impact”.
There can be tens or hundreds of these factors, but usually
significance is given to a smaller number of aggregate factors.
So, to avoid trap one, make sure all parties understand what
should be included in terms of preferences and controls.
Trap 2: Client preferences – allowing mandates to be
either vague or over proscriptive
For decades clients have expressed preferences with respect to
product involvement – the so called “sin stocks”. ESG extends the
capability to measure a company’s attributes far beyond its
industry sector. The danger is that each client will have their
own ESG preferences and given free rein may be overly
proscriptive about what can be included in a portfolio.
Equally, they could be quite vague. Clients’ preferences may
range from “I want a greener portfolio than the benchmark”,
through to them having a view on multiple product exclusions, ESG
and impact factors.
My advice would be to define which preferences your firm can
accommodate in an ESG Management Policy, together with how these
are captured and delivered through your investment process.
So, to avoid trap two, and to make the ESG investment process
scalable and consistent, clients’ preferences should be treated
as structured data within a framework, with clear documentation
for the client on what these mean and how they will be applied.
In addition, the impact on the investable universe of the client
preferences should be made clear to the client.
Trap 3: Data – poor understanding and transparency over
what is being measured
There are many ESG data vendors. Original data capture is
generally manual and then distilled into quantitative scores.
Secondary data is the aggregation of this original data either to
a product score, or across original data vendors to achieve a
consensus view.
A firm needs to ask itself what it is trying to achieve with the
data: an asset’s absolute score, sector relative score or score
trend, or all three?
Next, decide how granular the data should be. Is it enough to say
that the asset has a better ESG score than the benchmark? Or, do
you need to know the ways in which it is better?
Here, the trap is that the asset can have an OK score overall,
but with some really poor underlying scores. You must unpick how
the poor scores relate to the client’s preferences. It is key to
understand the asset’s ESG factors at least at the same level as
client preferences. Scores can be aggregated, but the method
should be transparent. Points really relevant to client
preferences may be there in the detail, but hidden by
aggregation, so avoid this trap by looking at the data in
depth.
To avoid data traps, a firm should understand the data
collection, aggregation and analysis as part of its investment
due diligence process, so that it can explain and justify its
views on assets to clients.
Trap 4: Analysis and portfolio construction – only
carrying out superficial analysis
One client I spoke to said, “It’s like ordering a green salad,
and it arrives with red peppers and chillies in it” (fine for
some; unpalatable for others). Understanding the detail is key to
avoiding issues. Portfolio managers must have visibility and
clarity over the ESG attributes of each asset; how they
contribute to the overall portfolio scores; and where any
conflict with client preferences lie.
Of course, this becomes harder with composite assets such as
mutual funds and unit trusts. Look-through gives the best answer
as it will reveal the underlying detail, but then statistical
significance needs to be considered. If the portfolio has 10 per
cent in a fund with 100 holdings, the smallest will be at most
0.1 per cent of the portfolio. If such a holding conflicts with
the client’s preferences, is it significant?
Typically, a firm’s ESG Management Policy would set out for the
client how this is approached. The alternative is to use a
published score for a fund, being conscious of potential
underlying conflict. If the client is not willing to accept
conflicts such as these, then it has to be questioned whether
they should invest through composite assets.
To avoid the superficial analysis trap, use the data available
and a good portfolio construction tool which incorporates that
data to understand exposures. Always making the firm’s policy on
significance clear to the client is also key to avoiding
issues.
Doing good, well: your policy, your process, your
systems
This brings me right back to the two client comments at the
beginning of this piece. These covered making the client’s
preferences a living document as part of the ongoing investment
process, and setting a pragmatic framework for investment.
Combining the client’s ESG preferences as part of the suitability
and investment management solution and monitoring the results,
meets the objective of constantly delivering the investor’s
needs. It is therefore difficult to envisage this as not being
part of most wealth managers’ offerings looking ahead.
To do this well, an FI should have a clear ESG Management Policy
setting out how ESG will be applied to client portfolio
management, which preferences can be accommodated, how ESG data
will be gathered and how exceptions to the process will be
managed. This is key to setting the boundaries of preferences
within a framework and collecting structured data which will
together support mass customisation and ensure clients’ needs can
be met.
Our mission has always been to help establish a common
understanding between the client and their advisor of what
portfolio risk means, as the foundation to a long-term
relationship. We aim to achieve the same in the more complex area
of sustainable investing.
This forms part of this publication’s latest research report,
“Technology Traps Wealth Managers Must Avoid”. Download your free
copy by completing the form below.