Sustainable Investing and Compliance Risks Sustainable Investing and Compliance Risks

Attracted by the increasing demand for sustainable investment products, financial advisors are expanding their product offerings. However, before advising clients they must avoid common tripwires around training, product screening and reporting in order to avoid compliance risks.

According to the Swiss Sustainable Investment Market Study 2020, the volume of sustainable investments has grown tenfold between 2014 and 2018, from CHF 71 billion to CHF 717 billion. In 2019, the volume reached CHF 1.1 trillion. The majority of these assets are attributable to institutional clients, however, the growth in the retail investor segment has picked up considerably (last year sustainable investments attributable to retail clients has grown by 185%).

Not surprisingly, an increasing number of financial institutions are looking to offer sustainable investment to their clients. However, as financial institutions are currently reviewing their investment advice and portfolio management processes in the context of their implementation of the Financial Services Act (FinSA), consideration should also be given to the peculiarities of sustainable investments. Indeed, the Swiss Banking Association has published a guideline in June this year to provide guidance to financial institutions who are looking to advise clients on sustainable investments in compliance with their regulatory obligations.

When integrating ESG into a firm’s advisory process, it is essential to follow a holistic and cross-functional approach in order to avoid greenwashing or mis-selling. In practice, financial institutions are likely to experience challenges in the following four key areas.

The Swiss Collective Investment Schemes Act (CISA) as well as the requirements governing the prospectus of financial instruments pursuant to FinSA contain certain safeguards to avoid the misappropriation of certain investment characteristics by investment funds or other financial instruments. Although this may also include the “sustainability performance” of financial instruments, the current regulatory framework is too generic in most cases to allow for a meaningful classification. As a result, it is usually up to the financial institution that distributes such products to come up with a “scoring methodology”. A clear methodology should link the expressed client preferences with the ESG features of the products or strategies. It is essential to strike the right balance between capturing client preferences in terms that are too broad (may not be actionable) or too narrow (may require constant change in the advisory process if product universe is altered).

In practice, a number of firms provide “ESG scores” of their products to clients, using relatively simple indicators (letters, numbers of stars or traffic lights etc.). While a single aggregated score may suffice from a regulatory perspective, most likely it will not meet client expectations who will want to see the sustainability performance broken down into further sub-categories relevant to them. Also, aggregated ratings will put more reliance on client advisors and their ability to steer the client to the right product.

Training must be function-specific with relevant and understandable content while considering the financial service provider’s particularities (responsibilities, product shelf or suitability and advisory procedures). Most importantly, training content must be based on the institution’s ESG classification system and the related product criteria and client preferences. Their meaning and interrelation must be clear to all advisors in order to avoid miscommunication or poor advice.

Client advisors need to engage with clients in a structured manner in order to assess ESG preferences. This can include values or norms that should be reflected in the investment strategy or exercise of voting rights, specific impacts that should be achieved or implications for risks and returns. As mentioned above, without a robust scoring methodology it may be challenging to explain to clients in tangible terms what the advantages and disadvantages of an ESG strategy is in comparison to an equivalent “traditional” strategy.

Importantly, ESG preferences should not lead to contradictions regarding the client’s knowledge and experience, financial situation and investment objectives. As such, while ESG preferences should be part of the suitability assessment, it should be an ancillary factor.

The ex-post reporting should provide information on how the client’s investment objectives (incl. ESG preferences) have been met, thus reflecting the institution’s overall classification system. Depending on the origin of the products (third party or in-house), this information may not be available. Besides the classification system itself, the institution must also ensure access to ESG data to be able to produce the reporting. In practice, this can be a more complex undertaking and accessing data can cause considerable costs.

Also, varying levels of service (e.g. transaction-based advice vs. portfolio management services) require different depths of disclosure.

Greenwashing and mis-selling are pervasive risks when advising on sustainable investment products. With the introduction of the FinSA suitability requirements, these can easily lead to suitability breaches. In order to address such risks, financial institutions will need a methodology according to which their products can be screened and reported on. The methodology will also form the basis for the training of the client advisors.