Financial advisers, Mifid II changes your…

Mifid II is a broad directive that covers investor protection, rights transparency, internal and external controls, market structure and, soon, sustainability.

The regulation has been in force for several years, which means that financial companies have had to adapt their advisory and asset management activities to demonstrate their commitment to investor protection and maximum transparency, as established in the directive.

But changes to the regulations mean that from August 2 this year, sustainability considerations will take center stage.

Investment firms must consider sustainability risks in all decision-making procedures and, when providing financial advice, must obtain sustainability preferences from their clients as part of the matching process.

While these new changes may place new obligations on financial professionals and the due diligence process, the changes fortunately align well with the growing demand from clients for sustainable investment.

People are becoming more aware of sustainability issues and are using their purchasing power to support businesses that have a positive impact on the environment.

Where to start? ESG motivations and approaches

Customers are usually already familiar with sustainability practices, as there is significant overlap with decisions they may already be making in their daily lives.

Therefore, the integration of sustainability in the investment process should not be complicated.

A good place to start is to look at the different motivations and approaches to sustainable investing, as outlined in Morningstar’s Sustainable Investing Framework.

If it was not already obvious, sustainable investment can be implemented and managed by applying exclusions, limiting ESG risk, looking for ESG opportunities, practicing shareholder engagement, targeting sustainability issues and evaluating the impact .

The application of exclusions, for example, refers to the exclusion of actions or sectors that harm society or the environment. Common sector exclusions include tobacco, alcohol, gaming, adult entertainment, small arms and controversial weapons such as cluster munitions.

ESG risk mitigation, on the other hand, refers to the use of ESG information, usually in the form of ESG ratings, to assess material ESG risks as part of the overall risk assessment.

Many funds now offer a combination of all these investment styles. What is important to remember is to find the investments that best suit the clients’ preferences, respecting their investment and savings objectives and their risk limits.

This brings us to the next point: what questions should you ask your customers to better understand their sustainability preferences?

In order to provide appropriate investment advice and counsel, the following questions—although not exhaustive—can help frame some of the conversations you may have with clients.

Do they want to emphasize the “E”?

This usually refers to climate change or resource efficiency.

Your client can have an impact by excluding sectors or activities that have the most harmful effects on the planet, including companies involved in coal and oil mining or aviation, for example.

Do they want to reduce their carbon footprint?

While it is possible to view carbon emissions data and compare it with appropriate benchmarks or other investments, you can also use the Morningstar Carbon Risk Score to determine the level of carbon risk held in a portfolio.

This risk typically arises when a company is overly dependent on fossil fuels, whether for its transportation, operations or supply chain. A good example would be the plastic industry. It can also happen when a company is involved in the extraction, sale and distribution of fossil fuels.

Are you concerned about ESG risk?

There are many examples of how poor environmental and social practices can create risk in investments, but poor governance can also have negative financial repercussions.

Poor governance can lead to corruption, over-committed boards, overpaid executives, underqualified staff promoted too high, and a general lack of diversity.

Each of these issues can lead to costly litigation, government sanctions, fines, or poor performance.

The overall ESG risk of a client’s portfolio can be assessed using Morningstar’s ESG Risk Score, while best-in-class investments across all Morningstar fund categories can be identified using the Morningstar Sustainability Rating.

Morningstar can help

The upcoming changes to MiFID II mean that advisers will be challenged in how they collect and disseminate sustainability data to their clients. In addition, one investor’s ESG goals and objectives may differ completely from another’s. Trying to meet all these (possibly conflicting) ambitions highlights the need for diversification of products and advice.

Morningstar is available to advisors with a full suite of sustainability solutions, research and assessments to meet these new demands.

To learn more about the changes to MiFID II and how to prepare, you can download our free guide: Understanding Your Client’s Sustainability Preferences.

© Morningstar, 2022 – The information contained herein is for educational purposes and provided for informational purposes only. It is not intended and should not be considered an invitation or encouragement to buy or sell the securities listed. Each comment is the opinion of its author and should not be considered as a personalized recommendation. The information in this document should not be the only source for making an investment decision. Be sure to contact a financial advisor or financial professional before making any investment decisions.

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