The traditional approach to ESG (environment, social, and corporate governance) is product-based — it’s about building and selling funds. This approach is ultimately mistaken, because it assumes that fund flows will violate the iron law of wealth management: clients very rarely switch products or providers.1 As things stand, the hype around ESG will always outstrip actual allocation, and values investing will remain niche. The status quo fosters high-priced specialty solutions, and it confuses and cannibalizes asset managers’ existing lineup. However, ESG proposed as a feature can catalyze full uptake.
This is the third in a series of posts. In Part 1, I described the death of funds and the emergent post-fund paradigm, enabled by DCIs (Dynamic Custom Indexing). Part 2 highlights the opportunities financial advisors face with this shift.
We’ve all heard the impressive statistics citing record interest in SRI (socially responsible investing). For example, a Morgan Stanley study showed that 75% of individual investors and 86% of millennials are interested in sustainable investing2. There’s a true business opportunity here. But it’s also just “interest,” and studies are typically structured to generate media-worthy numbers.
Most clients (with the exception of many from the next gen) will not proactively ask their advisors for such products. After all, that’s why they’re paying their advisors: to figure things out for them. Meanwhile, advisors don’t want to change their storyline or re-paper clients.
And what about those massive US SIF3 numbers we all read about on SRI allocation? According to its 2018 report, $12 trillion in professionally managed US assets are now classified as socially responsible. Over 1:4 professionally managed dollars have an ethical mandate.
Perhaps a dirty little secret of the SRI industry is that this is mostly relabeling of existing products. Industry insiders whisper that most of this growth comes from large institutional mandates that already had common restrictions on investments, such as provisions on tobacco, landmines, or Sudan.4 And now their managers are proudly declaring these to be part of their ESG solutions.
The “iron law of wealth management,” as I refer to it, is that end clients almost never switch products or providers. The industry enjoys ~90% client retention rates. Clients are generally not highly engaged, knowledgeable, or motivated. They’d rather get back to Game of Thrones. Even the undeniable “active-to-passive” shift may largely be due to older investors dying, and their heirs switching products only at the moment of intergenerational wealth transfer. People won’t even switch products to save themselves from paying higher fees, let alone help the environment! This client stickiness is a great benefit to incumbents, but it stifles innovation.
Because wealth managers know there is limited demand, but genuine interest, they add an ESG product to their lineup, and they price it highly. That of course makes sense for any niche product, like artichokes, or sports cars. It also means that it stays a specialty product.
These launches also confuse communications and cannibalize an investment manager’s existing product set. Is the provider now saying that their other funds are not ethical? And if part of the new storyline is that SRI doesn’t hurt performance, what is the logic to keep selling “unethical” conventional funds? “Now you can destroy the planet for the exact same returns!” is not a great tagline. So which side are you really on, mister? The marketing is messy, to say the least.
The end result is that everyone is rolling out ESG products (often with disproportionately large PR campaigns), but usually half-heartedly and at premium prices. In 2018, 16 ESG ETFs were launched, and AUM invested in ESG ETFs posted 63% year-on-year growth. But ESG ETFs as a category accounted for just under $8 billion in assets, a tiny fraction of the $3.5 trillion invested in ETFs overall.5
Most importantly — ESG is still offered as product, and clients rarely switch products, as we discussed. This is a good recipe for keeping impact investing — like artichokes — as a plaything for the rich for another couple decades.
On the bright side, all this marketing is educating customers and setting the stage for future opportunity. Clients aren’t shifting all their assets; but they’re increasingly conscious and interested, as the data shows.
So what is the true, near-term business opportunity? How can ESG spread from niche to mainstream without waiting for an entire intergenerational wealth transfer?
It’s best to experience the answer directly. Next time you are speaking to a group of individuals with investable assets, try out this exercise:
I do a lot of public speaking, and I ask these questions every chance I get — from an auditorium full of Scandinavians to a room full of skeptical pinstriped money managers. No matter how perfect your target market, you only get a few hands for Question A. You get a few more for Question B. However, for Question C… every hand in the room goes up… every time.
People don’t want to mess with their finances. But if you make it easy, if you give them a free lunch — a button that overlays their personal values without requiring them to break up with their advisor, re-examine their asset allocation, tax reporting, personal loans, and IRA — then who wouldn’t press the damn thing?
(Full transparency: OpenInvest is in the business of building and giving out those buttons. Our APIs allow platforms and advisors to overlay client values onto their existing tactical allocation mix. Advisors preserve their benchmarks and can engage clients purely on the values conversation.)
We won’t get technical here, but creating these “buttons” is accomplished through post-fund equities management, or Dynamic Custom Indexing (DCIs.) DCIs replicate funds, buy the underlying securities, and “stream” those strategies directly up to advisor workstations.6 I have written extensively elsewhere about the post-fund future, and what it means for advisors.
The important thing is respecting the iron law. Don’t compete with other people’s products, or worse yet, your own! Don’t have some confusing conversation about performance vs ethics. Let the clients opine only on the things they know and care about — the environment, social issues, politics. Talk to them about values like you’d talk about sports. Then overlay that on your best financial thinking– that’s the part they hired you for.
DCIs have the following impact benefits, in summary:
- Customization. Clients can mix and match all the things they care about, seamlessly overlaying them on their existing strategies
- Dynamism. A new woman is elected to a board, new data is available for gender pay gaps in European mid-caps, the client wants to divest Facebook, etc. This data flows dynamically through all relevant exposures, which instantly break apart, and then reconstitute to keep the clients tracking their benchmarks.
- Full Transparency. Clients can see what they own and why they own it.
- Real-Time Impact Reporting. Clients can also see what difference their portfolio choices made for the world – e.g. how many cigarettes they avoided financing, etc.
- Direct Shareholder Engagement. Clients and advisors get alerts when there’s a shareholder resolution relevant to the causes they care about. They receive a summary on their iPhone, and can swipe through their queue of ballots, directly engaging in board-level decision making.
We all want to mainstream values investing. Surely it would be a better world if we supported great leaders and businesses with our cash, and if we didn’t blindly let bad actors spend on things that hurt us, our community, the market, or future generations. But we can’t just keep cheerleading the SRI space along. The world can’t wait. We need a technology step change to disrupt the product-based asset management paradigm, which fundamentally blocks ESG integration at scale.
That technology revolution has arrived. It is already eating away at the funds-based model. DCIs fully unlock ESG — both directly, through values customization, and also indirectly. DCIs create vertical integration and demand for clean data down the value chain, resulting in new levels of transparency and control for advisors and investors. In turn, this opens up an ecosystem of engaging ESG apps and features that can sit on top of existing investment products.
As these technologies are rolled out with major investment product providers, the limitations of funds will become increasingly apparent. Integrating your personal values into your finances will become “table stakes.” And ESG will mainstream as a long-awaited feature, rather than a niche product.
Chief Strategy Officer & Co-Founder
- Hortaçsu, Ali, and Chad Syverson, 2004, “Product differentiation, search costs, and competition in the mutual fund industry: A case study of S&P 500 index funds,” The Quarterly Journal of Economics 119 (2): 403-56.
- Morgan Stanley Institute for Sustainable Investing, 2017, Sustainable Signals: New Data from the Individual Investor
- The Forum for Sustainable and Responsible Investment
- The 2018 Global Sustainable Investment Review has identified $19.8 trillion of the total global $30.7 trillion in sustainable investing assets as using negative/exclusionary screening. It is possible that some or all of these assets also use other sustainable investing strategies in addition to negative/exclusionary screening.
- Lara Crigger, ETF.com, December 20 2018, The Year In ESG ETFs
- The DCI solution is significantly different from another common feature-based approach: asset managers who state: “we integrate ESG into everything we do behind the scenes.” That’s a great approach for manager who’d rather die than be caught doing “ESG.” For example, I was chatting with someone from SASB (Sustainability Accounting Standards Board), and they’re getting great uptake from the likes of oil funds, who need to assess environmental risks, but don’t want to talk about it. If you do want to talk about it, then my sense is that this approach is market limiting for three reasons:
- Everyone has their own values. Unlike financial research, there’s no common denominator. Values investing is and always will be subjective. Clients will often get upset when they look under the hood, no matter how “perfect” your ESG data is.
- If it’s “behind the scenes,” you’re doing the work without realizing much of the benefit.
- Since you’re offering a black box, many clients will be skeptical that you’re greenwashing. And in fact they are right to be skeptical, as the market is subject to adverse selection. Adverse selection is also known as “the lemons problem,” put forward by economist George Akerlof in a 1970 paper. When customers can’t distinguish between good and bad quality used cars, they will price all used cars similarly. Sellers, who know if they hold a good or bad quality car, will only sell when they hold a lemon, and sellers of good quality cars will choose not to sell. Thus the good quality cars end up exiting the market, leaving you with just lemons.