Climate change; racial and gender diversity; stakeholder capitalism—several years ago, investment advisors might have been surprised to hear these terms come up in conversations with clients. Today, they’re discussed as frequently as risk and return. Though it’s been around for decades, interest in sustainable investing has exploded over the past five years. Investors have grown increasingly comfortable with the evidence that integrating environmental, social and governance (ESG) factors into the investment process doesn’t require sacrificing investment performance. In fact, many in the investment industry would argue that ESG analysis can enhance risk-adjusted returns.
Aligning Family Values
But where to start? Building a diversified, sustainable investment portfolio can seem daunting. Eager to deploy capital, investors risk getting pulled in different directions as they try to maximize their impact, keep their portfolios aligned with their values and achieve their investment objectives. The challenge is often compounded for owners of family businesses, whose wealth is often concentrated in a single asset. Diversification may be prudent, but few owners are eager to loosen the connection to the source of their family’s success.
Equipped with the right tools, advisors are in an excellent position to help families strike the right balance among these often-conflicting objectives. Investment advisors are already familiar with the process of developing an investment policy statement (IPS) to guide the pursuit of investment returns, while respecting constraints like risk tolerance and liquidity needs. We believe a similar process is needed when helping clients clarify and operationalize their sustainability objectives. Drafting a sustainability strategy statement to sit alongside the IPS helps ensure the portfolio reflects the family’s values and can facilitate a much deeper engagement with the advisor.
Here are prompts advisors can use to help families articulate their sustainable investing goals. We’ll also offer guidance on how to transform those goals into practical investment guidelines that can steer portfolio implementation.
The Social Conversation
The desire to incorporate sustainable investing can come from younger generations within the family, but it can also come from senior generations or a combination of both. Your family business clients should evaluate the opportunities and take stock of their resources.They must identify the social and environmental issues that are important to the family and consider the resources they have available to address them. While investment capital may be the primary tool at their disposal, their personal networks, expertise and time are also resources they can use to help achieve their sustainability objectives.
Engaging with all generations who are interested in sustainable investing, by asking the following questions, can lead to clarity around the mission and help identify the social, environmental, or values-based issues your clients would like their portfolios to address:
1) Why is your client motivated to address these issues or express these values?
2) What are the most compelling opportunities to create change or advance progress?
3) Do you or the client have a view on the role private capital should play in addressing the client’s targeted challenges?
4) Does your client have expertise, contacts or other resources that may be helpful in particular areas?
5) How might the client’s investment activity complement their philanthropic activity?
Statement of Purpose
Once you’ve guided the conversation around those questions, you can move towards creating a statement of purpose (SOP) for your clients. The SOP should succinctly capture your clients’ long-term alignment and impact objectives. It also offers the opportunity to clarify the balance that should be maintained between the pursuit of social and financial returns. Questions to consider when drafting the SOP include:
- Ask the client to think five or 10 years ahead. What characteristics should the portfolio have? What would they like to be able to say they’ve accomplished with their capital? What does portfolio success look like?
- How much of the portfolio should be activated in pursuit of impact and alignment objectives?
- Should specific outcomes be prioritized? For example, in building a portfolio with family values in mind, is the focus to support women or minority-led companies or climate action?
Guiding Principles and Beliefs
The family’s principles and beliefs provide the “rules of the road” for portfolio implementation. Here are a few key areas to consider:
- Impact-first investing. What types of trade-offs are the family willing and unwilling to make to further its goals? Is there a role for “concessionary capital” in the portfolio?
- Negative screens. Are there sectors or companies the family wants to avoid? Are there particular business activities, such as predatory lending, that should be kept out of the portfolio? How comfortable would the family be if their portfolio underperformed the benchmark because of a negative screen?
- ESG benefits. What benefits does the family hope to realize from including ESG investments in its portfolio: values alignment, investment performance or a combination of both?
- These determinations influence the kinds of investment strategies that will fit into the portfolio. For example, if the family is primarily concerned with values alignment, a best-in-class ESG strategy that delivers a specific ESG profile may be appropriate. Alternatively, if the family is most eager to reap the performance benefits of ESG, it might consider investing in an ESG-momentum strategy that targets companies with poor ESG performance but that have the potential to improve.
- Emerging managers. Small, upstart investment managers feature prominently in the sustainable investing market, and they often offer the only means of gaining exposure to specific impact themes. Supporting these managers helps grow the talent pool and can be lucrative, but emerging managers also come with risks. Family businesses should consider how much of their capital they’re willing to place with emerging managers and how central they are to the achievement of their impact objectives.
Measurable Objectives
If the SOP is the portfolio’s final destination, the portfolio objectives are the map that will get you there. Establishing near-term objectives that are both actionable and measurable helps set the portfolio on a path towards success. While it may be tempting to set specific investment targets, allow for flexibility. Objectives that commit to learning more about particular issues or simply sourcing opportunities from a particular market may be the most appropriate, especially if your clients are just beginning to explore sustainable investing.
- Guiding questions to help your clients establish portfolio objectives include:
- What’s achievable in the next six-to-12 months versus two-to-three years?
- Where is more learning needed before action can be taken?
- Which sustainability strategies offer the greatest potential to achieve your client’s mission?
- What metrics can your clients track to measure progress?
Among the more common objectives sustainable investors consider is to set a target allocation to sustainable investments. That may be appropriate for some investors, but it’s not the only allocation strategy available. We find that investors generally build sustainable investment portfolios in one of three ways:
- Opportunistic. Gradually replace “traditional” investment managers, one-by-one, with “sustainable” ones. The opportunistic approach can be taken with or without a particular allocation target in mind.
- Carve-out. Set aside a pool of capital dedicated to sustainable investments.
- Full transition. Some investors are prepared to shift their entire portfolio into sustainable investments and will declare a 100% allocation target from the start.
Key Planning Considerations
Some investors find their sustainability planning efforts evolve over time. That’s why it’s important for your clients to stay flexible and think strategically about the positioning of their portfolio before they get started. Focus on developing a plan that can grow with your client’s family as perspective changes over time. Consider emphasizing process rather than outcome to maximize flexibility.