Sustainability and its implications for risk and for the suitability of investment portfolios is now centre stage for all parties across financial services.

Environmental, social and governance factors potentially having a negative effect on the value of investments are all in the spotlight. For example, the instances of workforce standards in a company’s supply chain or business ethics are increasingly making headlines and as a result, pose material risk. There appears to be no hiding place.

Financial markets are further perturbed by transition risks tied to change in global sentiment, politics or labour policy, all of which can trigger a reassessment of an asset’s value. In the future, there are additional liability risks potentially, still to be quantified, as people impacted by climate or social change pursue compensation.

All the while, the speed of change increases as governments and investors accelerate plans to transition economies and companies toward more sustainable practices.

Rising tide, rising demand

Larry Fink’s letter to investors in January this year laid bare BlackRock’s commitment to supporting net zero greenhouse gas emissions, across its portfolio by 2050, founded on their opinion that there is now a fundamental reallocation of capital towards sustainable assets. Meantime, in 2020, we saw household names like Barclays unveil a net zero target for businesses it lends to, while similar pledges too have been made by HSBC and JP Morgan Chase, adding weight to the movement.

Against this backdrop, advice firms are increasingly talking about sustainability, its risks and opportunities, with their clients. A survey we carried out last year, revealed that 55% of advisers, more than half, discussed sustainability with clients during reviews and 83%, more than four in five, wanted more information on the sustainability of investment solutions.

Measuring ESG risk – What’s the problem?

That said, how is the industry currently measuring sustainability risk and opportunity; explaining it; and accounting for it in client portfolios and final recommendations? The short answer is there is no accepted or uniform answer yet. Why? Below are three key reasons:

  1. Lack of consistent, objective disclosure of a company’s activities in relation to ESG risks alongside the practice of ‘greenwashing’ – implying sustainable credentials for funds when the reality is different
  2. Externalities – the wider cost paid by the environment or society from a company’s activities are not simple to understand or measure
  3. Longer term, the scale, incidence and impact of potential risks are uncertain and difficult to factor in. Five years ago, then Bank of England Governor Mark Carney called this the ‘tragedy of the horizon’ as investors discounted very long-term risks

At the heart of these three issues is measurement and the need for consistent, objective assessment here. Regulators around the world are driving this agenda. From next month [10 March], EU Regulation on sustainability-related disclosures in financial services [Disclosure Regulation or SFDR] must be implemented.

UK managers distributing in the EU are already preparing for this. The UK regulator has commented they are ‘working closely with the Government and other regulators on how to implement the EU’s proposals in the UK’. Already this year, new regulations in line with the Task Force on Climate Related Disclosure, a global initiative mandated by the G20’s Financial Stability Board, demand stricter disclosures from listed companies in the UK.

As better data becomes available as a result, so fund analysis around the risks and opportunities here will improve.

Going beyond manager questionnaires and self-descriptions is important in order to create more universal models founded on publicly available information, accurately capturing historic patterns and allowing for forward-looking risk assessment without an absolute reliance on opinion. In this way, we will match the way those models take a view on risk.

ESG research available to you today

At Dynamic Planner, we have long considered a wide range of risk factors of each individual holding, when assessing the overall risk of investments. In that light, our own approach here has been to incorporate similar, whole of market ESG data from MSCI, a world leader in gathering sustainability information from public sources.

We this year made this research available to advice firms, to inform objective conversations with clients and enable them to compare investments fairly like for like. Over time, we are interested in understanding what does or does not pose risk for investments, in particular against its risk profile peer group, as we do today with liquidity and credit risk, for example.

Without doubt, we are only part way along the ESG assessment journey. From an adviser’s standpoint, the key is to adopt tools and data available today and to not let ‘perfect’ be the enemy of ‘good’ in terms of having a meaningful discussion with a client. As measurement of sustainability improves, the market will become more accurate in its risk assessments.

Read more about sustainable investing research, available today in Dynamic Planner.

At the Dynamic Planner Annual Conference at the end of January, reviewing clients’ portfolios to ensure ongoing suitability was high on the agenda. In a poll of delegates, 42% said they spent half a day or more preparing for a client’s annual investment review.

It’s probably true to say that most firms were still assessing the implications of MIFID II at that point. However, these new regulations, introduced at the beginning of January, bring in additional requirements regarding the breadth and frequency of the review. As such, the suitability review must consider, among other things:

Of even greater concern was the quality of the output to the client and how well, or otherwise, it helped the firm demonstrate the value they bring. 87% of respondents answered ‘Adequate’ or ‘Could do better’ in answer to the question; ‘How do your reports make you look in your clients’ eyes?

Finally, we asked whether firms used the same definition of risk throughout the investment review process. While the majority did, 29% said they did not.

So why is the annual review so challenging and what can you do to ensure you meet MIFID II’s requirements?

The following table shows the steps a review process needs to go through in order to ensure a portfolio remains suitable and the potential sources of error. Down the side are the list of sources or providers of information from which data or analysis has to be gathered.

    1. Client investment experience and attitude to risk, including their attitude towards risk-reward trade-offs
    2. Client capacity to take risk. Assessing the losses a client can withstand including changes in their financial situation. Best undertaken through cashflow with risk definitions aligned with the ATR
    3. Risk, return & correlation assumptions. These provide a consistent framework for the risk-reward trade-offs from investor to an investment
    4. Asset allocation, including asset class definitions. Here the risk the client is willing and able to take is translated into an asset allocation strategy which stands a high probability of delivering an acceptable range of returns for a given level of risk
    5. Classification of investments into asset classes. Information on individual holdings and their value needs to be gathered from the client’s portfolio, perhaps from a back office and/or across multiple platforms and translated into the right asset classes
    6. Investment risk profiling. Assessing the likely forward-looking risk that the portfolio represents against the client risk profile and asset allocation strategy. Assessing whether the investment is targeted at the risk profile and likely to stay suitable
    7. Investment performance rating versus risk benchmark. Whether the investment is delivering good risk-adjusted returns and likely to continue to do so

You can see that unless a consistent definition of risk is used throughout the investment process there is a high likelihood that suitability can get lost in translation.

Dynamic Planner has a 12-year track record of ensuring investment suitability using a consistent definition of risk throughout the review process that many thousands of firms now rely on. We gather data from back offices and the leading platforms and deep dive analysis on more than 1,200 multi-asset funds and portfolios in a joined-up process that’s simple and easy-to-use.

Our newly designed suite of reports helps you demonstrate the value you and your firm’s proposition are adding.

Please download our white paper on MIFID II or get in touch if you would like to know more.