Best Practice Sustainable Suitability
When giving instructions, is it better to focus on a general direction, or map out a precise series of steps? Does it make a difference if the directions are for a lost tourist looking for the Louvre, a military unit looking for an enemy target, or a financial adviser looking to provide suitable advice to a client?
The answer, of course, is that it depends.
In situations with many routes to the desired destination, you probably want a general steer, especially where there’s a chance of being ambushed by a plan-busting punch in the face. If you’re trying to repair a broken toaster or defuse a bomb, you probably want more prescription.
Suitability regulations need to provide enough guidance to be effective without becoming over-prescriptive. This can be a difficult balance to find.
The more space you leave for interpretation, the more you invite unintended consequences to rush in and fill it.
Set a rule that a solution ‘must account for a client’s willingness to take investment risk’ and Risk Tolerance will be considered. But how that Risk Tolerance is assessed may not be. The same goes for ‘considering’ Risk Capacity with a sentence nodding towards a client’s age or cash flow. Or Knowledge and Experience with a form designed to close off a compliance file rather than open up a client’s relevant investing history.
What about a client’s sustainability preferences?
Accounting for sustainability preferences under the new MiFID regulations
Proposed amendments to the MiFID regulations state that such preferences will need to be “taken into account”.
The draft regulations state that what must be taken into account are:
- What proportion of their portfolio an investor wants invested in sustainable investments.
- What weight to give to environmentally focused investments within that sustainable proportion.
- Which potentially adverse effects companies may be having on the world should be reported on (e.g. arms, tobacco, etc.).
This is welcome… in a way.
At Oxford Risk, we’ve long argued that sustainability preferences are a key part of understanding financial personality – and therefore integral to a comprehensive suitability process. Especially now that ESG is in the headlines, and more ESG products are on the shelf. We’ve strong evidence that merely asking clients about ESG increases their engagement with investing as a whole, which is undoubtedly the sort of good thing that a suitability process aims to achieve.
However, how do you avoid an investor stating simply: ‘Yes, I’d like some ESG’, and ending up with a token-gesture allocation to a fund that changed its name to include ‘sustainable’ a couple of weeks before? That would tick the box, but it would be a stretch to call it suitable. It would meet the letter of the law, but it would be insulting the spirit of it.
And, as we wrote here, it is the spirit that should be primary, because meeting the spirit of the regulations will always meet the laws, but the reverse is not always true.
Open to interpretation needn't mean open to confusion
All over Europe, we’ve spoken to the people that must interpret and implement this guidance. The only things on which they can agree is that they can’t agree on how to interpret it, but they have to implement it by 2nd August regardless.
Some element of being open to interpretation is necessary. But this is no excuse for encouraging confusion.
Among other shortcomings, the proposed regulations encourage:
- Capturing investor preferences for complex ESG minutiae they couldn't possibly have real preferences for – which encourages box ticking and undermines the spirit of the regulations.
- Expecting investors to assign a ‘sustainable’ percentage out of the blue – which is inherently unreliable: it reveals more about their general perceptions of investing, their mood, and the last thing they read, rather than their true preferences.
- Relying on jargon – which is more likely to make investors turn off than tune in.
- Seeing preferences as more fixed than they are – which over-emphasises the initial assessment relative to the monitoring and updating of preferences (and available solutions to best meet them) over time.
Making interpretations intentional
Regardless of the inevitable imperfections in interpretation, there are some sensible ways to tick the required boxes:
- Assess preferences properly – You’ve got an ESG ‘test’, but how has that test been tested? Without a rigorous validation process, behavioural assessments notoriously end up eliciting different preferences than intended. There is a behavioural best practice for asking questions that allow us to uncover what clients really care about in a clear and stable way.
- Build sustainability preferences into a comprehensive suitability methodology, don’t bolt them on at the end – Sustainability preferences are part of a wider financial personality. Sustainable investments are part of a wider portfolio of investments. They are inevitably intertwined with questions of risk, and other goals, both social and financial.
- Recognise and account for the moving parts of financial preferences – When establishing what ESG preferences investors genuinely have is, we also need to be aware of which of these are stable and measurable, so we don’t end up treating preferences as fixed that are nothing of the sort.
- Identify and integrate trustworthy ESG assessment criteria – Any suitability assessment is pointless if it’s not possible to robustly match its output to the universe of investible solutions.
These are all features of our comprehensive Oxford Risk ESG Suitability tools, which were launched in 2019, and continue to evolve based on our market-leading behavioural research. We’ve been researching and reporting on sustainability preferences for over half a decade. Our tools were created and refined by seven studies involving thousands of investors over four continents.
Our methodology provides a solid scientific grounding to the questions of: how much sustainable investing is suitable? And of this, how much should be weighted towards specifically environmental causes?
Trusting the answers to these questions requires assessment tools with more pedigree than some questions rustled together in a rush to beat a regulatory deadline.
A fully transparent outline of our methodology is available on request.
Beyond good intentions
If incorporating sustainability preferences is worth doing – and it surely is! – it’s worth doing right. Prioritising matching ticks to boxes over investors to suitable solutions will turn the best of intentions into the worst of outcomes. Click here to download our new guide, ESG: The Compelling & The Complaint for more information around the European regulation and how you can best meet it.
