3 reasons ESG is still crucial to wealth management

April 10, 2024 8:00 AM

With millennial and Gen Z clients coming of age and gaining more wealth, experts say ESG investing will grow more important.

Historically, financial advisors have not been huge fans of ESG. But as the economy evolves and a new generation of investors takes the reins, wealth managers may want to give the category a second look.

In a profession that values prudence and caution, a volatile product like ESG funds (standing for "environmental, social and governance") are a tough sell. In 2021, ESG ETFs enjoyed their highest-ever inflows — and then, in 2023, they suffered their worst-ever outflows.

Such ups and downs are not appealing to a group whose motto is "Stay the course." In 2023, 61% of financial advisors said they were unlikely to recommend ESG products to clients, according to Arizent's "Predictions 2024" study. Only 14% said they were very likely to suggest them.

"I do not recommend ESG to clients," said Jenny Logan, founder of Chisholm Financial Planning & Investments in Watertown, New York. "It's always easy to do what is popular or new when it does not have a downside, but the track records are unproven."

But that's not how everyone sees it. Even as ESG suffers a political backlash and historic outflows, many experts believe it has a secure place in the future of investing — one that is only likely to grow.

Their main argument is that evaluating a company's environmental and societal impacts is not just idealism; it's a form of due diligence. If a car company ignores climate change, for example, that company is likely to miss opportunities as its competitors invest in electric vehicles — and that's important information for an investor.

"Some ESG metrics, the true ones, are actually related to firm risk," said Sam Adams, CEO of Vert Asset Management, an ESG fund manager in Sausalito, California. "So ESG will grow, it will continue to thrive and become a bigger part of the investment landscape, because it is additional information. And all investors, whether sustainability-minded or not, want additional information on risk."

That information will be especially important to millennial and Gen Z investors, who tend to be more "sustainability-minded" than their elders — and who stand to inherit trillions of dollars in wealth. For these and other reasons, wealth managers may want to rethink how they look at ESG. Here's why:

The crusade is failing

In recent years, ESG has suffered a withering political backlash. Florida Governor Ron DeSantis has crusaded against the use of "woke political ideology" in investing. Texas' board of education has banned BlackRock and other ESG-friendly firms from managing its pension funds. And most recently, West Virginia's state treasurer barred Citigroup and HSBC from providing banking services to the state, allegedly because they "boycott" the fossil fuel industry.

And yet the damage from this backlash has been surprisingly small. At the end of 2023 — ESG's annus horribilis — the research firm Cerulli Associates polled institutional investors on their attitudes toward the products. Only 4% said they would no longer invest in ESG funds, and just 3% said they would stop using ESG criteria to evaluate investments.

"Despite challenges created, the anti-ESG movement has not dissuaded any asset managers polled by Cerulli from moving forward with responsible investing," Cerulli wrote. "No participants surveyed plan to stop incorporating ESG considerations into investment decisions or expect to stop offering ESG/sustainable investment products."

Similarly, many financial advisors say the anti-ESG crusade had little impact on their views of the products.

"ESG has been through the political ringer, but it also seems that it has continued to mature," said David Tenerelli, a certified financial planner at Strategic Financial Planning in Plano, Texas. "Over time, it may even become table stakes to use ESG data in investment decisions in the U.S., as it is in Europe and elsewhere."

Young investors want it

After the year ESG has had, one might expect demand for the funds to be plummeting — but one would be wrong. According to a recent study by Morgan Stanley, 84% of U.S. investors were still interested in sustainable investing. In fact, the study found, demand seemed to be rising.

"U.S. investors also appear more interested in making investments in sustainable themes in the next year compared with Europe and Japan, suggesting there may be more opportunity for growth in the U.S. market," Morgan Stanley wrote.

Importantly, enthusiasm for ESG was even higher among young investors — 96% of millennials and 85% of Generation Z expressed interest in the products. And as these Americans approach their peak earning years — the oldest millennials are now 43, while the oldest Gen Zers are 27 — they're becoming an important client base for wealth managers to cultivate.

"Younger investors tend to be more inclined to seek values alignment in their portfolios," Tenerelli said. "There seems to be a collective sense among younger investors that investing is, by definition, a future-oriented process … and therefore investing in alignment with a future that they want to live in is more desirable."

The great wealth transfer is coming

That brings us to the third reason, which, in a nutshell, is the "great wealth transfer."

The same investors who show such commitment to ESG are the same ones who stand to benefit from that historic transfer. By 2045, Cerulli has estimated, millennial and Gen Z Americans will inherit $72.6 trillion from their baby boomer and Silent Generation predecessors.

That's a lot of wealth to manage. And with between 85% and 96% of those heirs interested in sustainable investing, a good deal of that money is likely to go into ESG funds. Financial advisors with knowledge of the category will have an edge with these young — and wealthy — clients.

In spite of years of political attacks, ESG still enjoys strong demand and is likely to see that demand increase in the future. The only thing that's been tarnished, some say, is the name — but that could change.

"The future of ESG looks bright," said Allan Moskowitz, principal of Transformative Wealth Management in El Cerrito, California. "However, it probably won't be called ESG for long."