Where do DFMs sit in the ESG equation?

Gemma Woodward is accustomed to compiling funds based on a person's ethical nuances, but a particularly memorable moment was when a Quaker charity called on her expertise. 

"Obviously they have a series of set beliefs, but their concern was about the environment as well," Woodward, Quilter Cheviot director of responsible investment, explains. "It actually ended up that we did a workshop for the six trustees for about two to three hours, going through the different permeations of the policy to make sure they were really comfortable with what they were excluding and including within that."

Woodward says working with clients who have certain ethical preferences can take more effort, but ESG guidelines were incorporated into most of the firm's portfolio compilations.  

Everyone’s ethics are different… for example, they don’t like fur, but they’re not bothered about tobacco, alcohol, pornography or anything else. It’s very much on an individual level

"The sustainable and ethical [funds] absolutely are bespoke. When it comes to ESG, it is embedded into our process - we are thinking about it for every kind of stock we're looking at," she adds. 

When approaching DFMs to match their client's ESG preferences, advisers are often drawn to pre-packaged funds that are managed on a discretionary basis. 

Chartered financial planner and DFM Gibbs Denley director Mark Denley explains his Cambridge-based firm does not run bespoke funds for ESG investors, mainly because of VAT rules. 

"As DFMs we would restrict our discretionary service to our model portfolios," he says. 

"If someone wanted an ethical-style investment then we would point them to our ethical model. If a client wanted something very specific, instead of running the model portfolio on a DFM basis, we would pop it into an advisory capacity and in that way it would still be VAT effective."

HM Revenue & Customs regulations dictate that VAT applies to portfolios managed on a discretionary basis but not to investments run on an advisory basis. 

"It's just a technicality - because we don't ask for permission to do a rebalance, it's not managed on a discretionary basis." 

Denley, whose firm runs three ethical portfolios, notes that advisers and end clients are showing more interest in ethical investing as momentum towards sustainable living grows. 

"I think sustainables have become very vogue because we've all become climate friendly, which is a good thing, and there will certainly be a continued trend towards those ESG areas," he muses. 

On the other hand, True Bearing Chartered financial planner Paul Hoyle sees some resistance to ESG from advisers, while the public shows increasing interest in the area. 

"I think the IFA community as a whole probably holds the key to sustainable investing and it's becoming more prevalent with client investment strategies. There's a bit of resistance to go down this route because it's a bit of devil they know, devil they don't - not that it's a devil, but that tends to be how they see it," he says. 

Customer surveys, Hoyle continues, have shown that 70% of clients want to know more about ESG and so perhaps it should be up to advisers to include it in their fact find. In his view, advisers and DFMs have a responsibility to provide education around ESG and sustainable investing.

"Because most DFMs won't have access directly to clients they need the IFA community - we are an important link in that chain - and the more they want to talk about it the more the IFA community themselves will be educated to bring it into play," he adds. 

"Certainly for the higher net worth clients, DFMs should play a more positive role in promoting it [sustainable investing]." 

The consensus among advisers seems to be that clients need at least £250,000 to invest through a DFM and that does not change for sustainable investors. Morningstar EMEA chief investment officer Dan Kemp, who started his career as an adviser specialising in ESG 25 years ago, agrees DFMs can help advisers engaging clients on ESG.  

"The first thing a DFM does is create time for the adviser, which is the most valuable thing because the more time they can spend with their clients, the better the outcome is likely to be. When somebody says they want to incorporate their values into their investment, the adviser has to spend more time with them helping them understand the options available to them," he says.

"This goes far beyond the normal financial options and the impact of those options on the likely risk and return of the portfolio. They have to find a portfolio that reflects their values rather than just financial considerations."

Kemp believes there is value in managing predetermined portfolios on a discretionary basis for those who want to invest sustainably, as well as specifically tailored models. 

"There are DFMs who build bespoke portfolios that are built to the specific requirements of an individual client - that's potentially more valuable in an ESG context where people will want to overlay their normal risk and return desires with specific environmental and social concerns," he explains. 

"We don't do that, partly because we want to provide portfolio services to everyone, not just the very wealthy who can afford a bespoke service. What we're really doing is creating a range of portfolios which are relevant for clients that want to incorporate broad ESG characteristics into their investment and those portfolios."

Quilter Cheviot's Woodward says a challenge for DFMs tailoring ESG models is that investors can fall into the trap of screening out too many companies in their quest to create ethical portfolios. 

"What can happen quite easily is that people can say ‘actually I don't want to invest in anything' and they can end up with a portfolio where they're literally just investing in banks or something," she says. 

Drilling down to how a client defines their own ethics, she adds, is crucial to piecing together a portfolio aligning with their values. 

"Everyone's ethics are different. What could be thought of as very ethical could actually mean they've only got one concern - for example, they don't like fur, but they're not bothered about tobacco, alcohol, pornography or anything else. So it's very much doing it on an individual level." 

Kemp adds that, because ESG investors have fewer options, it is important to be aware of the ripple effect screening out companies to build an ESG portfolio can create. 

What is more, because of the limitations such exclusions can create, Morningstar was careful in its approach to negative screening to build an ESG portfolio: "We do exclude tobacco, we do exclude controversial weapons, nuclear and thermal coal, but that's the extent of our screening. If we went on and excluded alcohol or animal testing or all tobacco retail as well as manufacturing, gradually you'd get a smaller universe of things you could invest in." 

He says most sustainable fund managers look to align portfolios with the United Nation's sustainable development goals (SDGs), which are aimed at addressing global issues including poverty and climate change. 

But, he adds, the subjective nature of ESG investing and the need for investments to perform meant mandating this approach could be problematic: "It's quite difficult to very clearly define the limits of the SDGs and we want to make sure we're never in a situation where we're trying to force a holding to be aligned. We take a fairly rational approach to a holding and saying ‘is there a way within our long-term valuation approach within the exclusions to align this portfolio more closely with the SDGs?'"

He says trying to build a portfolio based on positive impact investments was also problematic because of the loose definitions around the issue. 

"The data is very difficult to interpret and there's a real question over whether something does generate a positive impact or not. I think people want to make a positive impact, but we have to be very careful about how we define and measure impact," he adds. 

For example, Kemp says, if someone buys shares in a company that is making drugs more accessible to the developing world, but they are buying those shares from somebody else, they are operating on stock markets. 

He adds: "I would query whether by buying the shares I am making an impact because I'm not providing any new capital for that business." 

This article was first published in the February issue of Professional Adviser's sister title Multi-Asset Review. To make sure you receive your own copy of the next issue, please do register your interest here

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