Three questions every ESG multi-asset investor needs to ask (part 3): ongoing suitability

Having risen to prominence following 2012’s Retail Distribution Review (RDR), risk-targeted funds have become a fixture in the financial adviser’s toolbox. By targeting a specific level of risk, advisers can ensure suitability for their retail clients, and by monitoring how risk tolerance changes over time they can achieve ongoing suitability.

Having examined how diversification and portfolio charges affect ESG (environment, social and governance) investors in previous blogs, let’s now turn to the issue of marrying sustainability with ongoing suitability.

Measuring performance dispersion

Ongoing suitability is mandated by RDR and is no less relevant when servicing ESG investors. However, in the UK the offering of risk-targeted funds with an ESG focus remains limited, and the lack of an explicit volatility target could potentially lead to wider dispersion of investment outcomes for those with ESG requirements.  

To quantify this risk, we revisit the three distinct peer groups we introduced in our second blog:

1. Risk-targeted: funds targeting risk profile 5 as per Dynamic Planner. Funds with an ESG mandate can fall into this peer group if they are risk-targeted, but as noted above the number of these funds is currently limited
2. Passive: funds with a risk rating of 5 and a passive approach as designated by Dynamic Planner
3. ESG: funds with a risk rating of 5 and designated ESG/Sustainable/Ethical by Dynamic Planner

We will again focus on funds with a risk profile 5 on the Dynamic Planner scale as it represents the intermediate level of risk, which is the most popular among UK retail investors.

While the multi-asset ESG peer group is still relatively new, this is not necessarily a limitation as the past few years offer a wide range of distinct market regimes for our analysis of the dispersion in client outcomes:

• 2019: markets characterised by US/China tensions against the backdrop of a multi-year late cycle
• 2020: markets dominated by COVID-19 news and huge fiscal stimulus across the developed world
• 2021: a broad-based recovery as markets welcomed the vaccination roll-out and a gradual re-opening
• 2022: dominated by inflation worries, volatility in commodity prices and recession fears

So how did our peer groups fare in such volatile times, and was risk targeting helpful in narrowing the range of performance?

Looking at the difference between the worst and the best performers across peer groups, the gap is smallest for peers targeting a specific risk profile for every calendar year since 2019 as well as the first half of 2022.

That gap then widens for multi-asset strategies that predominantly invest in index funds; it is largest for funds with an ESG/sustainable/ethical approach (as designated by the Dynamic Planner). Looking at the aggregate impact over three full calendar years to the end of 2021, the range in performance is as wide as 12.5% for risk-targeted peers, 17.2% for passive peers and 25.9% for ESG peers.    

That could suggest that relying solely on the current risk rating might result in a relatively wider dispersion of future outcomes among ESG investors, given the wide range of approaches adopted by ESG multi-asset strategies. By contrast, risk-targeted funds – including those with ESG mandates – could result in a relatively narrower dispersion of future outcomes.

Greater dispersion could also be associated with a higher probability of drift for ESG funds across risk profiles. That’s why risk-targeting might be particularly helpful for retail investors interested in ESG multi-asset solutions, as it could give advisers peace of mind that the funds will remain within their prescribed risk profiles over time.

Finding the right balance

Reflecting clients’ sustainability preferences shouldn’t come at the expense of ongoing suitability. The same tools that have helped advisers over the years since the RDR remain equally relevant in today’s world of ESG.

Multi-asset ESG investing is about balance. Here, the balance is about securing material ESG benefits while not losing sight of other key portfolio considerations such as diversification, costs and risk stability. Otherwise, choosing an ESG solution could leave investors more vulnerable to changes in market conditions or result in materially different long-term outcomes. This, in turn, could impact future investor preferences, drive asset flows and undermine confidence in ESG strategies .

For the good of the investor and the good of the planet, we’d better get this balance right.  

Key risk: The value of any investment and any income taken from it is not guaranteed and can go down as well as up, and investors may get back less than the amount originally invested.