Why do investors need both core and thematic ESG funds?

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Advisors may be worried they don’t have all the answers when it comes to environmental, social, and governance (ESG) investing. But the key to explaining ESG to clients is to understand the fund and its intention.

“It’s not about understanding all of these companies within the fund,” says Deborah Debas, Responsible Investment Specialist with Desjardins Group. “It’s about understanding what the fund wants to do and what financial role it plays within a portfolio.”

The first step is to find out whether it’s a core or thematic fund. What’s the difference?

A core ESG fund is representative of the economy where it invests, explains Debas. For instance, it could be a U.S. equity fund or an emerging market fund. “These funds are diversified in all different sectors, they help you optimize returns over time, and they’ll have an ESG overlay, which is ESG integration that will orient security valuation and selection.”

She adds the intention of a core ESG fund is to identify companies of all sectors that are best equipped to manage ESG risks, and that work at making their operations more sustainable. For example, the company could be reducing its own waste, or source materials that are deforestation-free.

“We are also active shareholders and we aim to influence companies to improve their disclosure and practices,” she says. “All sectors need to improve their ESG practices. If we were to invest only in the solution, we’d only influence a small portion of the market.”

Meanwhile, many thematic funds are globally diversified but are focused on specific sectors. “The intention is to have a higher concentration of companies developing solutions to ESG issues, such as energy efficiency or precision agriculture solutions. They are seizing opportunities tied to the evolution towards a more sustainable economy,” she says.

As much as clients are usually very excited about thematic funds, it’s important to have both core and thematic funds in portfolios. “We’re protecting ourselves from risks through diversification with core ESG funds, and we’re working toward the solution with thematic funds.”

“We’re protecting ourselves from risks through diversification with core ESG funds, and we’re working toward the solution with thematic funds.”

Debas uses a metaphor to further explain the importance. Let’s say you’re selling a car and there are several buyers who are interested, she explains. You may stress different features to different types of buyers. For instance, for a family with three young children, you may point out that the back has room for three car seats. For an older couple, you may stress the security features. Still, each of these potential buyers would be leaving with the same car.

Advisors may be faced with high-conviction investors who want 100% thematic funds, but Debas cautions against that. “Advisors know it’s not recommended from a risk management perspective because the trade-offs in terms of diversification would be too heavy, and it would likely be unsuitable for most investors.”

Part of an advisor’s role is also to educate clients and manage their expectations.

“Clients want the feature and, in that case, it’s the thematic fund. But they still need the four wheels, brakes, and engine, which is the core. And that’s why both core and thematic funds are important. They’re all part of a well-diversified portfolio.”

Also, when analyzing companies to be included in a core or thematic fund, it’s important to know that there is no such thing as a solely ESG company or non-ESG company.

“It’s never black or white,” she adds. “It’s 50 shades of green. It’s about understanding that no company is perfect. All companies have somewhat of an impact on the environment and communities. The key is to invest in those companies that are positioned to try and minimize the negative impact, and work on improving the positive impact.”

Learn more about how to systemize your RI approach with Desjardins’ webcast series.

Deborah Debas Responsible Investment Specialist with Desjardins Group

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