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Why divestment must be the ultimate ESG sanction
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Cast your mind back, if you will, to the halcyon days of 2015. Back then, national scandals involved slightly deflated footballs. Game of Thrones was still on TV – and still good. And a good old Greek debt crisis passed for a major financial concern. But it wasn’t all good. We should not forget that the year started with a meltdown that threatened to divide families and friends forever. I am referring, of course, to ‘the dress.’ If you don’t remember the dress, here’s a quick recap: The internet went crazy over a photo of a dress that some people saw as black and blue, while others perceived it as gold and white. Long story short, it was all to do with how different peoples’ eyes process light. And so to ESG, very much ‘the dress’ of the investment world. Everyone is obsessed with it, but no one can agree what it looks like. And this lack of consensus on ESG definitions can make it difficult to establish the lay of the land – something we try to address in this special report. In chapter one, we look at ‘greenwashing’ and ask how widespread the practice is. In chapter two, we dig into some of the preposterously large numbers attributed to the size of the ESG market and examine how they were arrived at. And in chapter three, we examine the proxy voting records of some of the largest asset managers and discuss why these firms don’t seem to practice what they preach on ESG. Or do they? We also catch up with two investors making strides in the space and humbly offer our own (tongue-in-cheek) solutions to ESG’s definition problems.
Taking Responsible Investment from Talk to Action
Screening for quality: the value of sustainable earnings
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making a model
the devil's dictionary of esg
THINKING OUTSIDE THE BOX
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esg investing asian style
a tipping point for esg
a stake in sustainability
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Bailey Mccann Everything that achieves a certain level of success, at some point, faces a backlash. Sometimes this is justified. Sometimes it is not. And so, as ESG investing shifts in status from asset management’s crusty cousin to its new favorite child, it has inevitably attracted criticism. The most common accusation is that asset managers are not really committed to or, in fact, running ESG funds and are instead practicing what is known as greenwashing. A PATH TO POPULARITY Before we get into the issue of greenwashing, it is worth taking a step back and looking at just how popular ESG investing has become, or at least is predicted to become. A recent report from the Deloitte Center for Financial Services predicts that client demand will drive ESG-mandated assets to comprise half of all professionally managed investments in the US by 2025, growing from $12tn of assets in 2018 to $34.5tn in just seven years. The same report suggests that in order to meet the spike in client demand, as many as 200 new funds could come to market in the US in the next three years. ESG assets in Europe, the largest ESG investing market, already top $14tn and continue to grow. According to a report by Morningstar, the number of US-based funds and ETFs that can be classified as ESG, impact or sustainable, grew to 303 at the end of 2019, up from 270 the year before. Meanwhile, the number of conventional funds that claim to consider ESG factors grew nearly sevenfold last year, from 81 in 2018 to 564. In terms of flows, those 303 funds and ETFs took in $21.4bn, taking assets under management to $137.3bn. While the flows may not be a huge number when compared with the wider market, they are a fourfold increase on 2018. LABELS AND FABLES But is it all as it seems? Are all these various funds bona fide ESG strategies or are some using the moniker for marketing purposes and not delivering on their labels? Indeed, there are notable examples of apparent greenwashing. In November 2019, a Wall Street Journal article reported that eight of the 10 largest sustainable funds in the US had some exposure to oil and gas companies. The report highlighted how Vanguard’s FTSE Social Index fund was designed to avoid companies with ‘significant controversies regarding environmental pollution or severe damage to ecosystems’ but held Occidental Petroleum, which settled a lawsuit in 2015 over contamination of the Amazon rainforest. The firm updated its index and blamed its benchmark provider FTSE Russell for the stock’s inclusion, but the headline was written, and the story was likely to reinforce the perception, held by some, that the industry was putting labels ahead of values in the pursuit of assets. Greenwashing exists on the corporate side too, with companies making efforts to secure good ratings from increasingly influential ratings agencies, despite not seeming to meet many people’s understanding of what ESG means. James Rich, senior portfolio manager of the sustainable fixed income strategy at Aegon Asset Management, said: ‘Ten years ago, when ESG was still a very small market, you’d see managers sign on to the UN Principles for Responsible Investment (PRI), and that was a solid guide. ‘Now, there is $86tn represented by UN PRI signatories, and you go into meetings with some of these firms and they ask me what the standards mean. So you have to assume there’s a pretty significant amount of box-checking going on with some of this stuff.’ It is an issue that appears to be on the Securities and Exchange Commission’s (SEC) radar too. In March, the regulator took the first steps toward updating its nearly 20-year-old rules on how funds are named and, as part of this, asked if ESG funds should have 80% of assets invested in ESG securities, as is the case for regular bond and equity funds. According to Bloomberg, there are 331 funds with the phrase ‘ESG’ in the name, 208 with ‘SRI,’ 162 with ‘sustainable’ and 68 with ‘green.’
Clearly, there is an increasing number of funds using these words and phrases in their names and an increasing amount of money going into such strategies. No doubt, some are more worthy recipients than others, but does this mean the phenomenon of greenwashing is widespread? Hervé Duteil, chief sustainability officer at BNP Paribas Americas, said that while greenwashing is an undercurrent within the ESG investing world, it is, on balance, ‘still a relatively small slice of the market and, in many cases, comes with blowback. If firms are found to be engaged in greenwashing, it’s a reputational hit and often a financial one.’ In that way, ESG, like other parts of the finance industry, is relying on a measure of self-regulation, banking on reputational and financial risks to keep people honest. BEHIND THE SCREENS If asset managers are not going out of their way to lie about funds being ESG, why, then, is there a perception that they are, and why is there a number of so-called ESG funds that invest in companies that do not appear all that ESG-friendly? The answer lies in a problem at the heart of ESG investing: the term means different things to different investors and managers. And some managers may be limited in how they approach the issue due to the structure of their fund. Large index providers, for example, will have to wrestle with the idea of whether non-ESG friendly companies such as fossil fuel providers can be deleted from the index without breaking it.
In recent years, fossil fuel companies have started to make greener claims extolling the sustainability of bridge fuels and updated infrastructure. That’s enough for some indexers and fund managers to keep fossil fuel companies in their offerings. But it may also mean that, when investors look at these ESG funds, they’re going to see a list of companies that they weren’t expecting. Fund buyers and managers Citywire spoke to for this article mentioned that, to deal with this, the largest index providers and fund managers have opted to say that they’re embedding ESG considerations into their processes, while stopping short of outlining exactly what that means. In this way, it’s hard to prove that they’re greenwashing, but it’s equally as hard to define what exactly their ESG processes are.
Not everyone finds this argument credible. ‘Why not delete these companies from the index?’ Wim Van Hyfte, global head of ESG investments and research at Candriam Investors Group, asked. ‘Pressure is important if we want to see real change.’ Index provider MSCI has responded by opting for a ‘best-in-class’ methodology, which is designed to exclude the worst offenders while rewarding companies that are at least trying to be ESG friendly. Meanwhile, active managers can lay claims to be working to improve corporate behavior. Fund managers that are willing to be activists in their proxy votes and investment ratings have also been effective at making changes in company policies as well, but it remains to be seen if there is ultimately a cap to this. If a company knows it won’t be deleted from an index, then it may be less inclined to respond comprehensively to pressure for improvements on ESG. That’s exacerbated when the largest investors vote with management and against ESG on proxy provisions (see chapter three). For fund buyers and advisors getting their heads around how to deal with these issues, much of it will come down to personal choice. The three pillars included in the acronym – environmental, social and governance – are broad topics that allow for a lot of customization within portfolios, and investment managers have responded to the potential for customization perhaps more than anything else. ESG remains one of the few parts of the market where managers can still differentiate on portfolio construction — and they’re running with it. Investors want that customization as well because many are still working through what their portfolio values actually are from a fiduciary and philosophical standpoint. But that also means investors will have to have a clearly defined set of expectations and be willing to raise them with managers when it comes to holdings.
‘The problem is that if you search just by the label “ESG,” you’re going to get a lot of false positives,’ Martin Jarzebowski, director of responsible investing at Federated Hermes, said. ‘The phrase “ESG” sets a psychological expectation for investors about what’s in a portfolio, but that doesn’t always match the reality.’ DIGGING DEEPER Kiley Miller, associate portfolio manager for impact portfolios at Envestnet, said the firm has created a questionnaire for managers on its platform to make sorting easier. While the firm doesn’t get prescriptive about which managers are better or worse at ESG, the questionnaire touches on portfolio construction, asking how ESG is used in position analysis and how the firm integrates that into its investment process.
‘We’ve found that ESG products that perform the best tend to embed ESG analysis as part of their fundamental analysis process,’ Miller explained. ‘But, that said, not every investor is going to have the same view or the same goals in their portfolios, so funds that negative screen or those that go more activist may work better for them.’ Many of the fundamental metrics for manager selection still apply, even when choosing an ESG strategy. Investors should look at performance and manager quality. But perhaps more importantly, they should understand how managers are getting their ESG data. Aegon’s Rich noted that a lot of ESG investment work on the manager side is happening through outsourced third-party data providers, and investors need to understand the extent to which managers are leveraging it. ‘It’s OK if they’re reading the research,’ Rich said, ‘but if they’re just picking the same buys, sells and holds as the data provider, it would be like a traditional equities manager just copying whatever Goldman’s research said that week. We all read it, it’s good research, but managers shouldn’t be outsourcing their investment decisions.’ Jarzebowski added that outsourced ESG ratings are often backward-looking and could miss the early trend if companies decide to make new commitments or change policies. As a result, investors can miss some of the upside if a manager is relying entirely on outsourced data. A recent example of this is JetBlue, which has spent the past few years steadily investing in what has only recently become a publicly stated carbon neutrality policy. The company chose fuel-efficient planes when it made new orders in recent years, but that was before it came out with a broad and public set of ESG claims. BNP Paribas recently amended JetBlue’s $550m commercial line of credit to include a sustainability-linked financing provision. Duteil said that the deal was directly linked to the investments JetBlue had already made in its carbon neutrality policy.
Frédéric Samama, head of responsible investment at Amundi, a long-time manager in the space, said that ESG can be a way of understanding how dynamic corporate management teams work when it comes to responding to shifts in the market. Are they making the investments upfront? Or are they spending time trying to find workarounds that are going to catch up with them later? Automakers and fossil fuel companies that opted for workarounds have already seen their costs of capital go up and have taken hits on their share prices. This same style of analysis can be applied to ESG managers in terms of how they integrate ESG into portfolio construction. Managers should be able to articulate a clear thesis around what is included in a strategy and what isn’t. If the answer is based on what third-party data providers say, it’s unlikely that a manager truly understands ESG investing. MAKE IT, DON’T FAKE IT The next one to three years are likely to be big for ESG. The EU is working to standardize its market through minimum standards and a clear-cut taxonomy that defines what ESG is. That’s likely to shine a brighter light on issues such as greenwashing, as early efforts to standardize in the EU have already excluded some companies and investment products that were labeled as ESG. And while the US isn’t planning a market-wide standard, massive investor inflows have gotten stakeholders talking. Managers Citywire spoke to for this story reported that the SEC has started to include ESG-focused questions on its investment look-throughs. ‘I think we’re going to get to a place where you aren’t talking about ESG as a separate issue. It’s a fundamental issue,’ Samama said. ‘There’s a huge opportunity for alpha generation for those that take it seriously.’
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Case for divestment There is a growing voice among asset managers that argues by avoiding unethical companies, we leave ownership and therefore governance to investors uninhibited by ethical considerations, thereby strongly promoting continued investment. Yet in modelling, building and managing portfolios, fund managers make choices every day on stocks they hold and divest from on financial grounds. It seems strange then that divestment on ESG grounds has become so contentious. Our imperative is to deliver long-term out performance by investing in superior companies that have a compelling investment and ESG case. Whilst sustainability is important – and we look for thematic plays that support our key strengths in education, health & wellbeing, social infrastructure and sustainable solutions - we always seek to ensure that these are also strong candidates in terms of business ethics, corporate governance, human rights and environmental management. Choosing not to allocate capital to companies exhibiting poor overall environmental, human rights and business ethics credentials is a perfectly valid risk-adjusted approach to ESG analysis and oversight. In what circumstances then would divestment support an ESG investment strategy? We apply the sanction to companies consistently failing to make progress in improving their performance in key areas such as climate change, or which have particularly poor records in fines, prosecutions, higher than average health & safety accident rates or pollution incidents. These factors reduce a company’s ability to achieve superior long-term performance, thus potentially justifying divestment. For example, we recently divested from Deutsche Bank, which has been implicated in multiple financial scandals. Due to poor internal controls, the company saw ballooning contingent liabilities and has been weighed down by prosecutions. However, our concerns centred around operational integrity, and where culture became severely challenged by the ongoing failure to restore trust. Finally, a severe misconduct crisis, which included LIBOR rigging, mis-selling and money laundering – with serious implications for the long-term prospects of the company – prompted our decision to divest. We also withdrew our investments in British multinational security services company G4S. The company was facing multiple ethical challenges over care and protection, including assault, use of non-approved restraint and more serious torture allegations in South Africa. Operating in a high-risk environment, there was mounting evidence G4S was failing to provide adequate care and custody. Our decision to divest was ultimately prompted by allegations of abuse at the Medway young offender unit.
A multi-layered approach We certainly endorse engagement, but there is the perceived danger among industry observers that the responsible investment industry has turned engagement – and the pursuit of it for its own sake – into an excuse not to take more decisive action when needed. The fossil fuel divestment campaign which emerged in 2010 has also had a growing influence, backed by studies suggesting client portfolios may incur significant ‘stranded asset risk’, given the world needs to transition to a low-carbon economy, by keeping unexploited fossil fuel assets in the ground. This has built a powerful case on moral and financial grounds for avoiding or indeed divesting from fossil fuels in order to align portfolios more closely to the Paris Agreement target – keeping the increase in global temperatures to below 2OC and limiting the increase to 1.5OC. EdenTree’s Amity Funds have taken an increasingly focused approach to being ‘carbon aware’ by avoiding thermal coal, oil & gas exploration and production and some high emitting industries and companies that are unlikely to transition. At EdenTree we invest for the long-term. We do not take the decision to divest lightly and always look constructively to engage with a company first, often over long periods of time. However, these efforts are not always rewarded and from that we may sometimes conclude that divestment is warranted. Since 2012, we have proactively divested from 10 stocks and fixed interest instruments specifically on ethical or ESG grounds. These range from systemic business ethics failures (corruption, money laundering etc.) to product quality and safety issues, incompatibility with our climate change stance, to pressing human rights and safeguarding concerns. We believe the balance between good stock selection and constructive engagement, but with the ultimate sanction of divestment, provides a robust process of risk assessment for clients. It also provides the reassurance that we have clearly established values with divestment red lines. Timely divestment can also protect client capital from growing legal and regulatory headwinds. Many of the stocks we divested from on ethical and ESG grounds still face systemic challenges including fraud related litigation and product safety. Some financial institutions are still recovering from headwinds sustained during the financial crisis a decade ago. Understanding these sometimes long-term impacts via our robust ESG due diligence process and acting on them, has, we believe, protected clients from reputational impacts and capital loss. For example, Samsung Electronics has been mired in controversy regarding corruption and poor employee engagement for some time, and we had strong concerns over cobalt sourcing and the integrity of human rights within the supply chain. Governance remained a real problem, coupled with a culture of impunity given rising safety challenges. After engaging with Samsung following the arrest and conviction of senior management for corruption, the company’s lack of reassurance left us no choice but to divest.At a time when financial services are suffering from high levels of mistrust, investment managers are under pressure to demonstrate active principles alongside wider ESG credentials. We believe divestment, deployed wisely, sits comfortably within a balanced strategy of focused engagement and research. Withdrawing client capital or taking profit from disreputable businesses provides ultimate reassurance of the overall process, and one we know is supported by clients who seek strong values-led action from their managers.
The S&P 500® Index represents the large-cap segment of the U.S. equity markets and consists of approximately 500 leading companies in leading industries of the U.S. economy. Standard & Poor’s, S&P, and S&P 500® are trademarks/service marks of MSCI and Standard & Poor’s. The views expressed are those of the author and Brown Advisory as of the date referenced and are subject to change at any time based on market or other conditions. These views are not intended to be and should not be relied upon as investment advice and are not intended to be a forecast of future events or a guarantee of future results. Past performance is not a guarantee of future performance and you may not get back the amount invested. The information provided in this material is not intended to be and should not be considered to be a recommendation or suggestion to engage in or refrain from a particular course of action or to make or hold a particular investment or pursue a particular investment strategy, including whether or not to buy, sell, or hold any of the securities mentioned. It should not be assumed that investments in such securities have been or will be profitable. To the extent specific securities are mentioned, they have been selected by the author on an objective basis to illustrate views expressed in the commentary and do not represent all of the securities purchased, sold or recommended for advisory clients. The information contained herein has been prepared from sources believed reliable but is not guaranteed by us as to its timeliness or accuracy, and is not a complete summary or statement of all available data. This piece is intended solely for our clients and prospective clients, is for informational purposes only, and is not individually tailored for or directed to any particular client or prospective client.
Neville White, Head of Responsible Investment Policy and Research at EdenTree Investment Management
In today’s market there is an opportunity for companies and issuers to make a material difference in addressing looming sustainability concerns, such as climate change, public health and food security. Indeed, investors should not ignore the potential opportunity to make a difference by investing thoughtfully within the large public equity and fixed income markets. Investing with a long-term perspective in companies and issuers that are driving significant projects has the potential to materially affect environmental and social outcomes across the globe. Solving for sustainability challenges within these asset classes is a worthy ambition, for problems of this scale will not be met with funding from governments and charitable dollars alone. Interest in and appetite for sustainable investing solutions have grown sharply over the past decade. According to Morningstar, net flows into sustainable open-end and exchange-traded funds neared a record $21 billion in 2019, up nearly four times from 2018’s annual record for net flows. At Brown Advisory, our approach to sustainable investing is straightforward and very much focused on our clients. We seek to identify problems that our clients face and then work to solve those problems. We have thoughtfully developed sustainability research expertise for over a decade in order to make better investment decisions and to deliver attractive, risk-adjusted investment returns for our clients. Over time, we have found that our clients grapple with four important challenges when it comes to sustainable investing. First and foremost, clients want to avoid trade-offs between returns and values. We do not think investors need to give up performance by embracing sustainable investing, and this forms a key pillar in our philosophy. Additionally, clients want to find a credible partner in an increasingly crowded space; they wish to make sense out of the imperfect and confusing array of available environmental, social and governance (ESG) data; and finally, they seek solutions tailored to their specific needs in an ‘off-the-shelf’ universe. By addressing these four challenges, we have helped clients achieve and exceed their goals. Our proprietary ESG research frameworks drive investment strategies that put investment performance first while also making a positive global impact. The integration of ESG research in our overall investment process is helping us better manage downside risk and more thoughtfully engage management teams on material ESG topics. OUR ESG RESEARCH APPROACH—HOW WE DO IT AND WHY Our ESG research team collaborates with portfolio managers and fundamental analysts by performing deep, bottom-up due diligence on a company’s or issuer’s ESG risks and opportunities that inform investment decisions. Our process provides portfolio managers with a broader and deeper set of information useful to discern whether to buy, sell or hold an investment.
Source: Brown Advisory
In this article, we discuss our approach to sustainable investing across both equity and fixed income asset classes, offering tangible examples of how the marriage of fundamental and sustainable research is producing benchmark-beating returns as well as positive environmental and social outcomes.
SUSTAINABLE BUSINESS ADVANTAGES In our Large-Cap Sustainable Growth portfolio, we invest in companies that we deem to be fundamentally strong and that are strategically focused on using sustainability strategies to bolster performance. We believe that some of the most attractive business models are those with sustainable drivers at their core. Since the strategy’s inception, we have focused on companies with what we call Sustainable Business Advantages (SBAs); the SBA concept helps us clarify how a focus on sustainability-related initiatives helps to drive a company’s revenue growth, cost reduction or enhanced franchise value. SBA is fully integrated into our fundamental due diligence as we allocate capital to our most compelling, risk-adjusted opportunities. INTEGRATING FUNDAMENTAL AND ESG RESEARCH Our investment philosophy places equal emphasis on the fundamental, sustainability and valuation picture for any company we consider for the portfolio. We only invest when we are confident on all three criteria. Central to our approach is our search for companies with Sustainable Business Advantages (SBAs) that can drive tangible, long-term business results.
SEEKING HEALTHY RETURNS The health care sector offers an excellent case study of how our SBA framework helps us pursue compelling sustainable investing opportunities. We believe the importance of the health care sector to both society and the global economy is undeniable. Global health care spending is likely to exceed $10 trillion per year by 2022, according to Deloitte’s 2019 Global Health Care Outlook. Unsurprisingly, health care has also grown to become the second-largest sector in public equity markets, representing 14% of the market cap of the S&P 500® Index as of December 31, 2019. With skyrocketing drug prices, concerns about data privacy and potential policy changes, the sector is experiencing acute pressures. However, we believe many health care companies are making meaningful strides in key areas. Biotechnology advancements are helping to treat and potentially cure previously incurable diseases, and drug innovation is helping the fight against a variety of global contagions. Companies working toward these developments, we believe, can make for compelling investment opportunities. While drug companies have massive growth potential, they also require favorable regulatory outcomes to succeed, so we focus on companies that are capable, in our view, of achieving measurable and reliable results—in other words, businesses that have some control over their own destiny. In health care, these companies often include devices, services, tools or technologies that generate consistent results for customers, such as shorter hospital stays for patients, reduced medical waste, higher success rates for medical procedures or other tangible and somewhat predicable outcomes. COMPANY SPOTLIGHT: ILLUMINA Illumina is an example of a health care company that meets our investment criteria. The enterprise offers a wide range of tools for large-scale analysis of genetic variation and function, helping to advance disease research, drug development and molecular diagnostic testing. Its genomic testing reduces misdiagnoses of rare and inherited diseases, enables the delivery of time-sensitive treatments to patients sooner, and can even help doctors choose among therapies to find the most effective option with the fewest side effects. The company has a dominant position, possessing an estimated 70% market share in the next-generation DNA sequencing instruments market. Additionally, an estimated 90% of all sequencing to date has been generated on Illumina technology. We believe that regardless of the outcome of the debate on drug pricing, the company is strongly positioned, as its tools should constantly be in demand from health care firms looking to improve their research. INCOME AND IMPACT At Brown Advisory, we believe that sustainable investing principles are especially well-suited for fixed income investing. From a performance standpoint, understanding downside risk is a primary goal of both ESG research and traditional credit research. From an impact standpoint, bond issuers often offer investors a high degree of clarity regarding use of proceeds, so those investors can essentially lend money to an issuer and see with reasonable transparency where that money is going. We have found that our approach to sustainable investing can enhance our returns by steering us to responsible and forward-thinking issuers. In our security selection process, we integrate ESG research, fundamental credit research and careful examination of how bonds’ proceeds will be used. This allows our clients to simultaneously pursue their long-term investment goals and their goals for driving meaningful changes in society. INTEGRATING FUNDAMENTAL AND ESG RESEARCH Our investment process places equal emphasis on fundamental research and ESG research.
Through this approach, we find a variety of opportunities to generate impact across traditional fixed income sectors. The municipal bond market offers a healthy mix of bonds that fund education, health care, clean energy, water, community development and other initiatives. Corporate bonds are being used more and more often to fund clean energy and green building projects, and the mortgage market is, in our view, an excellent source of bonds that support affordable housing. A deeper dive into the municipal and securitized sectors will highlight our approach and implementation of this philosophy across our sustainable fixed income portfolios.
MUNICIPAL DEBT AND THE FRONT LINES OF CLIMATE CHANGE Municipal bonds are issued, at least in theory, to produce a public benefit, so the asset class offers inherent appeal to impact-minded investors. In particular, we believe that municipal bonds will play a large role in combating climate change, as they will provide the financing required to build out infrastructure needed to combat the impacts of a warming planet. We are highly focused on the climate-related risks associated with any municipal bond investment. We are pleased to see that cities and states—as well as the agencies that assess their creditworthiness—are also focused on these risks. The market as a whole is pushing for more rigorous climate risk disclosure, and issuers are funding a wide variety of high-impact projects aimed at climate mitigation and adaptation. THE CLIMATE-ALIGNED MUNICIPAL BOND UNIVERSE Research from the Climate Bonds Initiative in 2018 identified a $264 billion climate-aligned municipal bond universe.
Labeled green bonds offer one avenue of exposure, but we look well beyond the green label to a more expansive universe of bonds across many sectors. We believe that investing in this space requires a commitment to proprietary ESG research, enabling us to vet an issuer’s sustainability merits and ensure its proceeds are used to generate real impact.
CREDIT SPOTLIGHT: DENVER WATER Denver Water is a recent example of a credit driving meaningful positive impact within the climate bond arena. The utility services a population of approximately 1.4 million residents. It relies heavily on runoff from the Rocky Mountains for its water supply, making it especially vulnerable to drought caused by climate-driven precipitation changes. The Joint Front Range Climate Change Vulnerability Study estimates that a warming of 5°F in the region could decrease water supply by 20% and increase water use by 7%, even if precipitation patterns do not change. As a result, Denver Water is engaged in a variety of long-term initiatives, including reservoir expansion projects, water recycling projects and conservation efforts. SPOTLIGHT ON SECURITIZED ESG INVESTMENTS Securitized bonds is not a sector that readily comes to mind when investors think of sustainable investing. However, the sector—which includes government (MBS) and commercial (CMBS) mortgage-backed securities as well as asset-backed securities (ABS)—offers impact-oriented investors a number of compelling opportunities. We believe that our investments in this space are generating impact in a wide variety of thematic areas: from affordable housing and community development to green building and energy efficiency. Affordable Multifamily Housing – We are invested in both government-guaranteed and nonguaranteed multifamily housing projects that support housing with rents that are affordable for the majority of low-income to middle-income households in a geographic area. Community Development Financial Institution ABS – We continuously look for opportunities to provide underserved communities with access to affordable credit, including through certified Community Development Financial Institutions. Targeted Single-Family MBS – We invest in securities backed by mortgages held by low- and moderate-income families, supporting affordable homeownership for millions of Americans. Green MBS and CMBS – Primarily through Fannie Mae green bonds, we help to finance property-level improvements that reduce energy and water use. Equipment & Automotive ABS – We are invested in a number of ABS backed by leases for equipment that is sustainably made and that helps borrowers be more sustainable, while also extending the useful life of the equipment. Single-Asset Mortgage Loans – These securities are backed by a variety of commercial real estate holdings, ranging from energy-efficient cold-storage warehouses to life sciences office buildings, driving positive impact in areas such as affordable health care, environmental sustainability and neighborhood revitalization. CONCLUSION There is no shortage of sustainability-related issues on investors’ minds, and we recognize that this can result in different approaches to sustainable investing. At Brown Advisory, we are committed to providing equity and fixed income solutions to meet our clients’ evolving ESG needs and to reinvesting in our sustainability offering for decades to come. BROWN ADVISORY SUSTAINABLE OFFERINGS
Source: Climate Bonds Initiative.
Mark D. Sloss ‘If, by the end of 2017, already one in every four professionally managed dollars in the US was identified as sustainably, responsibly and/or impactfully invested, who has all those assets? Because we don’t.’ This is a question that has, in some variety, been put to just about every champion of sustainable investing at internal meetings. Other versions of this same question have included asking, based on the one-in-four number, why dedicated ESG shops are not bigger? Or why the adoption rate by financial advisors is still so low? In short, where is the money? Let’s start with that one-in-four number, or $12tn in ESG assets. It is from the bi-annual trends report prepared by the Forum for Sustainable and Responsible Investment (US SIF), which, in its 2018 issue, says that a quarter of professionally managed dollars would be identified as sustainably, responsibly and/or impactfully invested. The total figure is very inclusive, pulling together managed assets incorporating ESG for retail and institutional investors, as well as money managers filing shareholder resolutions, and then correcting for overlapping assets. The slope of the curve is dramatic, achieving the proverbial ‘hockey stick’ moment around 2012 when the totals leapt from less than $4tn to where we are now. The overwhelming majority of that growth resides in assets that incorporate ESG.
The Sustainable Funds US Landscape report, published in February by Morningstar’s director of sustainability research, Jon Hale, looks at the mutual fund and ETF marketplace. It shows a four-times increase in flows toward what he defines as ‘ESG consideration’ funds (as opposed to sustainable funds) from 2018 to 2019, and a relative explosion in the number of such funds, from 81 to 564 in the span of a year. WHAT’S IN A NUMBER? Why, then, the pushback? Why is advisor uptake still a challenge, and where are the firms that measure ESG in billions and trillions? Are these assets and flows overcounted or underappreciated?
Anna Snider, Bank of America’s head of CIO due diligence, is a vocal champion of ESG and a standard-bearer within her firm for a deeply disciplined and research-driven approach to vetting (and counting) ESG strategies. Her firm identifies roughly $25bn in ESG assets against a total asset base of around $3tn for the entire bank, which clearly tells a different story than one in four dollars for ESG. Snider believes that sizing the market is about defining the market. What one person may call ESG another may not. She highlighted the concept of ESG integration as being particularly problematic. Integration could mean that no investment decision is made by a manager without thorough and intentional consideration of material ESG factors, or it could mean that ESG data is included as part of a broad research framework but without any consistent expectation that that data will drive portfolio construction. She said it was also difficult to measure intentionality to distinguish between ESG and other motivations for blocking certain securities, industries or sectors, such as conflicts of interest.
KEEPING COUNT At the industry level, there are some serious challenges to tabulating ESG-aligned assets that have little to do with the degree of intentionality and are more structural to how we think about the financial supply chain. A multi-fund model manager may report ESG assets based on what is invested in their models, while a wealth manager that utilizes those models may also report those assets, and then the constituent mutual funds and ETFs similarly report. So already the same dollars could be reported three times. But it would not stop there. Those mutual funds are managed by asset management firms also reporting their ESG assets. It would be impossible to trace the provenance of every reported dollar committed to ESG to make sure it was only counted once, so simplifying assumptions have to be made to adjust for the risk of an overcount.
Steve Schueth, most recently founder of Thrize Partners, served for 11 years as the chair of the board of US SIF, and was instrumental in the launch of the aforementioned trends report. Explaining how the report was constructed, he said: ‘We debated and included screened assets as well as advocacy (related to the Interfaith Center on Corporate Responsibility, for instance) where they were actively working on global change or championing resolutions, but the assets would not have been screened.’ He said the report was not just interested in good investing: ‘It was about changing the world.’ In his time building the report, he said, the nature and scope of assets it counted had evolved. According to Schueth, the first iteration was ‘socially responsible investment (SRI) 1.0,’ which came, not from Wall Street, but from the grassroots. It was rooted in the belief ‘that if we avoided bad companies, we were going to end up with better portfolios.’ After that came ESG, which he describes as ‘SRI 2.0,’ bringing market-based disciplines and frameworks such as the Sustainability Accounting Standards Board and stepping beyond the values-driven intentionality of 1.0 to include material investment rationale. This broader definition meant a bigger circle was drawn and more assets were counted.
He described the moment we are now in as SRI 3.0, which brings the intentionality of 1.0 together with the materiality and alpha discipline of 2.0, seen through the lens of the UN Sustainable Development Goals (SDG). In order to get to a more substantive count of assets, Schueth suggested using SDG alignment as a new threshold for inclusion. How to define and categorize ESG assets is not a new challenge for this market. It is one fund buyers and advisors face on a daily basis.
Brett Wayman, vice president of impact investing at Envestnet, explained his approach. Envestnet’s 30-person research team starts by identifying strategies using data and research from the likes of Morningstar and Veris Wealth Partners. The team categorically does not accept mere self-identification by managers. Wayman called this ‘a strict no-no.’ He added that the firm also eschews high scores from ESG ratings that look at portfolios but do not look at the underlying investment processes. ‘We are moving away from coincidental scoring and toward intentional scoring,’ he said, as means to distinguish between accidental and deliberate outcomes. Wayman said that the firm tracked the growth of ESG assets by looking at ‘same-store growth’ and has found assets growing ‘at astounding rates.’ He pointed to the rising tide of product launches as evidence that there is substance to the magnitude and rate of change in ESG adoption. DEFINING ERA Wayman’s point about the value of self-identification is critical and intersects with Hale’s partitioning of ‘ESG consideration’ as distinct from truly sustainable funds. It may also explain the drama in the headline numbers. Without an industry or regulatory framework for defining what ESG is and is not, there is the risk of overreporting. Until quite recently, it was deemed unfashionable to be identified as an SRI investor. In the age of Greta Thunberg, the attitudes of asset owners have dramatically shifted, and the downside risk of being perceived as ESG-adjacent is minimal.
Across all of the perspectives from Snider, Schueth and Wayman, a recurring point emerges. In varying ways, they all agree that ESG has evolved to a point where it is time to refine definitions, set thresholds, and create new bins for classifying and counting strategies and assets. Wayman described SDG versus ESG as being like squares versus rectangles – all squares (SDG) are rectangular (ESG) but not all rectangles are square. In Schueth’s framework, the boundaries may be set by how SRI 3.0 is ultimately defined. It is apparent that the industry is ready for wealth and asset managers, academics, NGOs, trade organizations and regulators to acknowledge the dramatic increase in adoption and sharpen the pencil to better characterize what has become a massive and growing part of the investment market.
Samantha Stephens Mirova Responsible Investment Analyst
This material is provided for informational purposes only and should not be construed as investment advice. There can be no assurance that developments will transpire as forecasted. Actual results may vary. The views and opinions expressed may change based on market and other conditions. Investing involves risk, including the risk of loss. Sustainable investing focuses on investments in companies that relate to certain sustainable development themes and demonstrate adherence to environmental, social and governance (ESG) practices; therefore the universe of investments may be limited and investors may not be able to take advantage of the same opportunities or market trends as investors that do not use such criteria. This could have a negative impact on an investor’s overall performance depending on whether such investments are in or out of favor. Mirova is operated in the US through Mirova US LLC. 2953968.1.1
Faced with environmental and social challenges at an unprecedented scale, ensuring the long-term viability of natural resources, livelihoods, and governments will require society, and investment managers, to do more than just repackage old ideas. At Mirova, we believe we must make and carry out deliberate, thoughtful choices that reflect a new, more sustainable economic model. We are identifying significant opportunities associated with long-term sustainability. Yet markets often underappreciate the growth potential inherent in ongoing demographic, technological, environmental, and governance transitions. A growing middle class in Asia, diminishing populations in developed countries, and increasing global demand for quality affordable healthcare indicate economic tailwinds for companies looking to provide solutions to these challenges. In addition, growing international consensus around the need for more aggressive efforts to fight climate change suggests positive long-term prospects for companies working to reduce the carbon intensity of the global economy. By examining the interconnected environmental, social, governance, and economic systems that will help define the future, Mirova’s research and investment processes are designed to leverage the transformation towards a more sustainable economy and create financial outperformance and positive impact. Three areas in which Mirova takes action across all of its portfolios to make a difference are explained here. MATERIALITY ON FINANCIALS & SUSTAINABLE DEVELOPMENT Within responsible investing, materiality can take two forms: financial materiality – how intangible ESG factors can affect a company’s value – and materiality on the Sustainable Development Goals (SDGs) – how relevant a company’s activities are to contributing or obstructing the 17 Sustainable Development Goals defined by the UN. Mirova believes both are important. We ask ourselves not only what ESG issues could do to our portfolios, but also what our portfolios can do for society and the environment. We seek to maximize our information inputs by looking at non-financial ESG factors as an integral part of fundamental analysis, adjusting our valuations and allocations accordingly. Our Responsible Investment Research Team comprises 10 specialists, 8 of whom are dedicated to specific sectors. The team focuses exclusively on analyzing companies’ ESG performance in the context of their sector, regulatory environment, local and global trends, and more. Considering non-financial data in our fundamental analysis allows us to identify opportunities related to the long-term sustainability and economic transitions affecting the world, and to avoid reputational, regulatory, and climate risks. RISKS AND OPPORTUNITIES IN TODAY’S GEOLOGICAL AGE (ANTHROPOCENE) Should we fail to limit temperature rise to 2° C or less, climate change will wreak global havoc and lead to vast costs, undoing centuries of advances brought about by free markets and free society. To mitigate the costs and impacts of climate change, we have no choice but to reduce emissions. As it pertains to investing, Mirova is convinced that a comprehensive carbon footprinting method – considering lifecycle (both direct process emissions and indirect emissions through the supply chain and products) and avoided emissions – is the most efficient way to build portfolios that work to reduce climate risks. In fact, without considering emissions savings, lifecycle data indicates a cosmetics company and a wind turbine manufacturer emit the same amount of carbon dioxide per unit invested. This obscures the high climate benefit of the wind turbine manufacturer relative to the cosmetics company. Mirova uses a method co-developed through a partnership with Carbone4, climate strategy specialists. Carbone4 calculates the lifecycle emissions arising from a company’s products and activities as well as the emissions saved relative to a pertinent baseline. This offers more complete data, company by company, and paints a comprehensive picture of the role each plays in the transition to a low-carbon economy. Over the last two years, we have improved the climate impact of our consolidated equity portfolios from a “business-as-usual” scenario to one that spells a far healthier, and arguably less risky, future for the planet, and one that is in line with international greenhouse gas emission objectives. We have also used our carbon footprinting approach to develop a Mirova Carbon Neutral Strategy, which seeks to reduce induced emissions by a factor of 5.5 relative to the market index – representing cuts recommended by international objectives. It then balances induced and avoided emissions for overall carbon neutrality. CULTIVATING GENDER DIVERSITY IN LEADERSHIP Increased gender diversity, especially in senior management, can have positive financial impacts and create social good. Given its strong correlation with improved financial performance, all Mirova’s equity strategies are now using the below criteria to supplement fundamental analysis in the investment process. In addition, last year we launched Mirova Women in Leadership Equity Strategy for our European clients. Measuring a company’s commitment to empowering women criteria: • High (>30%) percentage of women in the executive committee • One or more women in C-suite level positions (CEO, CFO, etc.) • Balance (<15% difference) between the share of women in executive management and the share of women in the company’s overall workforce • Qualitative factors: gender pay gap transparency, measures to improve work-life balance, commitments of senior role models to gender diversity, and leadership training for “high-potential” women Overall, the use of non-financial information to seek out an information advantage is at the heart of Mirova’s value proposition: combining financial outperformance and positive environmental and social impact.
Nicole Piper As ESG investing grows in popularity, fund managers’ votes in corporate elections have come under the spotlight. Proxy votes on ESG-related topics, such as gender pay equality, environmental stewardship and human rights, can be seen as indicators of how committed a given asset management firm is to ESG. A recent paper by Morningstar examines the proxy voting record of the largest asset managers in the US to show how often they backed ESG-related shareholder resolutions. In its analysis, Morningstar excluded funds with ESG mandates because most firms have a separate proxy voting strategy for these products. The remaining funds offered by the 50 firms examined control 88% of US-domiciled fund assets, or $16.9tn. Support for ESG-related proxy votes has increased, according to the report. Across the 50 firms, average support for ESG resolutions was 46% in 2019, compared with 27% in 2015. As can be seen over the page, Morningstar found that DWS, Allianz Global Investors, Blackstone, TIAA and AQR led in supporting ESG-related shareholder proposals. DWS voted in support of resolutions in 87% of the 998 elections it faced between 2015 and 2019. However, some unexpected names fell at the bottom of the pile. Federated, Wellington, Amundi, Vanguard and BlackRock are among the 10 least-supportive firms. BLACKROCK STEPS UP BlackRock’s presence on the list of laggards may raise eyebrows given that the firm and its CEO Larry Fink have been vocal on the issues of sustainability and climate change. In January, Fink wrote to clients to say the firm would make climate change central to its investment considerations. He also set out measures to back this up, doubling BlackRock’s sustainable ETF offering to 150 products and exiting positions in thermal coal producers in active funds. He said the firm was joining the Climate Action 100+ initiative on climate change and that BlackRock would align its approach to how it votes by proxies. Yet its historical proxy record shows BlackRock only voted in favor of 3% of 1,033 ESG shareholder resolutions from 2015 to 2019.
According to the report, BlackRock’s stewardship team directs proxy voting across non-ESG funds and all ETFs, including iShares products, while ESG funds vote separately. A spokesperson for BlackRock gave the following statement: ‘As noted in our recent letter to our clients, we have engaged with companies on sustainability-related questions for several years. Given the groundwork we already laid and the growing investment risks surrounding sustainability, we will be increasingly disposed to vote against management when companies have not made sufficient progress.’ While the mismatch between public pronouncements and previous proxy votes makes for a neat headline, the Morningstar report notes: ‘BlackRock’s recent commitment to using proxy voting to advance TCFD [Task Force on Climate-related Financial Disclosures]- and SASB [Sustainability Accounting Standards Board]-aligned financial disclosures and to an unprecedented standard of proxy voting transparency will very likely create new energy in the “stewardship ecosystem.” ‘Votes by BlackRock in support of sustainability measures would amplify the impact of others’ votes and potentially cause more resolutions to pass. Other large asset managers who, in the past, have routinely sided with management may realize that the time has come to take a more active approach to proxy voting.’
LARGE FIRMS LAG Larger asset managers have historically backed company management on such votes. According to the Morningstar report, five of the 10 largest fund families – Vanguard, BlackRock, American Funds, T. Rowe Price and Dimensional Fund Advisors – voted against more than 88% of ESG-related shareholder resolutions. ‘As a group, the largest of the asset managers are the least likely to support ESG shareholder-sponsored ballot initiatives,’ the report says. Those that responded to Citywire all gave variations of the same answer: they engage on these issues directly with management rather than via proxy votes. For example, a Vanguard spokesperson said: ‘Our stewardship team diligently studies the merits of each shareholder proposal we receive and supports those that would improve long-term shareholder value. While proxy voting is an important component of Vanguard’s stewardship efforts, it is only one part of a broader investment stewardship program. ‘Our investment stewardship team engages on a number of ESG-related issues through both our company engagements and advocacy efforts with industry organizations and initiatives. Last year alone, Vanguard participated in 868 meetings with portfolio companies, advocating on the importance of disclosing material risks and strategies, including transparency on ESG issues, that could have an impact on a company’s long-term value. We do not believe in telling company leaders how to run their businesses, but rather focus on ensuring they consider, and disclose, the risks associated with their businesses.’ It was a similar story at T. Rowe Price. ‘While T. Rowe Price consistently supports effective, well-targeted proposals that reflect our concerns as investors, we believe it is debatable whether many shareholder resolutions represent a meaningful solution to various ESG-related challenges. ‘In almost every instance, shareholder proposals are non-binding votes that are opposed by the company’s management and board. Our experience after many years of assessing ESG issues as part of our investment process is that one-on-one engagement with companies produces better outcomes than shareholder resolutions,’ a spokesperson for the firm said. A spokesperson for DFA, which came in last position on the report, voting in favor of just 1% of 1,004 ESG shareholder proposals brought forth during the period, said: ‘Many of these proposals relate to requests for additional disclosure. In these cases, we often engage with management to understand what information is already publicly available and the potential costs to the company (which are ultimately borne by shareholders) to provide the requested information… We balance these costs with potential benefits of disclosure.’ PROXY’S PLACE In short, the argument goes that proxy voting does not reflect these firms’ commitment to ESG. However, Anna Snider, Bank of America’s head of CIO due diligence, said looking at proxy votes can be insightful, especially for funds that are not explicitly ESG-focused. ‘I think it is a really valid and good way for asset managers and their strategies that are not running an ESG strategy to put their toe into the water around how they’re starting to think about integrating ESG into their investment process,’ she said. ‘They’re voting proxies anyway and looking at the issues through an ESG lens, even though they may not be using ESG to necessarily select the companies in which they’re investing.’ John Tennaro, a senior investment analyst with CIBC Private Wealth Management, said it was important to consider proxy votes on a case-by-case basis. ‘I would want to know more about what the resolutions actually are, because that ESG bucket, unfortunately, has become quite large,’ he said. ‘With that being said, it [managers’ proxy voting record] is important,’ he added. ‘We wouldn’t necessarily make a decision off of [it], but it’s certainly one that we ask about… because it’s just more insight into the [manager’s] thinking.’ Both Snider and Tennaro recognized complicating factors in assessing managers’ commitment to ESG based on proxy voting records. ‘[Being] supportive is a hard thing to measure quantitatively,’ Snider said. ‘I think that you’re seeing this huge acceleration of products that are thinking about different ways to integrate ESG, regardless of whether they call themselves an ESG strategy. So I think you’ll see such data growing exponentially, with proxy voting and engagement obviously being one way that [asset managers] might be able to better integrate ESG concepts into the overall way they manage money.’
Kevin Walkush Portfolio Manager, Growth Investment Team Jensen Investment Management
Kevin Walkush, portfolio manager at Jensen Investment Management, on what it takes for companies to be included in the Jensen Quality Universe – and why Apple only recently made the grade
Disclosures: The information contained herein is intended to serve as an illustration of Jensen’s investment process and of the incorporation of environmental, social and governance risk analysis in the investment process for the Jensen Quality Growth Strategy. Nothing contained herein is intended to be a recommendation or offer to buy or sell any security or designed or intended to serve as a basis for making any decision. The specific security identified and described herein does not represent all of the securities purchased and sold for Strategy and it should not be assumed that investment in any securities in the Strategy were or will be profitable. The information contained herein represents management’s current expectation of how the Jensen Quality Growth Strategy will continue to be operated in the near term; however, management’s plans and policies in this respect may change in the future. In particular, (i) policies and approaches to portfolio monitoring, risk management, and asset allocation may change in the future without notice and (ii) economic, market and other conditions could cause the Strategy and accounts invested in the Strategy to deviate from stated investment objectives, guidelines, and conclusions stated herein. Jensen Investment Management, Inc. is an investment adviser registered under the Investment Advisers Act of 1940. Registration with the SEC does not imply any level of skill or training. Although taken from reliable sources, Jensen cannot guarantee the accuracy of the information received from third parties.
With economic uncertainty an intrinsic feature of equity investing, so-called quality companies – those with strong fundamentals, sustainable earnings and attractive valuations – are gaining ground as a way to offer returns at lower risk. Indeed, the Jensen Quality Growth Strategy universe includes only those businesses that have produced a return on shareholder equity of 15% or greater in each of the past 10 years, as determined by the investment team. ‘We search for quality companies by targeting exceptional businesses combined with endurance,’ says portfolio manager Kevin Walkush, who joined Jensen in 2007. ‘Qualifying businesses possess durable competitive advantages, compelling growth opportunities, strong financials and an effective management team and board. An ability to maintain these characteristics over time generally results in robust and sustainable free cashflow well in excess of a company’s operating needs. ‘This enables such companies to reinvest at a minimum to maintain and ideally enhance competitive advantages, thereby perpetuating a business’s ability to sustainably generate significant shareholder value that ultimately gets recognized via share price appreciation.’ SELECTION DISCIPLINE Jensen operates as a collective team, which is a key differentiator. The investment team syncs up a robust investment process with bottom-up portfolio construction that considers a company’s fundamentals, valuation and security-specific risk. Such is their quality discipline that Apple only met the criteria four years ago, despite its prior decade-long status as a strong growth and momentum stock. Key to Apple’s inclusion as a Jensen Quality Growth company, was its shift from a momentum business to a sustainable, quality business. In the case of Apple, looking at its growth profile through the lens of the innovation S-curve helps to frame this distinction. ‘Our goal is to participate when the curve starts to flatten out and therefore the company is in a position to provide stability and sustainability,’ says Walkush. ‘This delivers what we think is the appropriate balance of risk and return on behalf of our clients.’ Ahead of taking the position in Apple, the investment team identified many durable competitive advantages, including brand strength and high switching costs. ‘Once you are in their ecosystem, it is hard to leave,’ he says. What’s more, Apple enjoys strong barriers to entry and economies of scale, especially on the services side, where the sale of additional services doesn’t cost a lot to implement. He continues: ‘From a growth point of view, what we’re really attracted to is their services business. It’s a high margin and high growth business, which the team believes can offset the slowing growth of the lower margin iPhone business. By expanding their services, the Jensen team believes Apple has enhanced its switching costs as further adoption of more services makes it more difficult for a customer to break away from the iOS ecosystem.’ INVESTING RESPONSIBLY At Jensen, the integration of environmental, social and governance (ESG) factors is, and always has been, an inherent part of the fundamental research process. ‘We strive to evaluate all relevant financial and non-financial factors that may affect a business and, ultimately, investment results,’ Walkush says. ‘Our investment team seeks to identify companies that understand and thoughtfully manage all of the inherent business risks, including ESG. ‘We do believe that overlooking relevant ESG issues – as with any material business issue – can increase the risk of negative investment outcomes. However, we do not view it as a binary tool used to separate good investments from bad. We continue to review new research on the potential impact of ESG factors within our long-standing research approach.’ STRONG ENGAGEMENT Jensen scores and ranks every company in their quality universe by applying weighted ESG criteria. The team does not use the scores to make portfolio construction decisions, but rather to inform them of potential ESG-related risks and opportunities to the portfolio. It is the responsibility of the analyst to understand the underlying drivers for a given company’s ESG score and vet any ESG risks identified by the metrics. Today, Walkush says, the entirety of Apple’s operations is powered by renewable energy. Additionally, the company has strong sustainability goals, is reducing its environmental impact and is also focusing on its supply chain. ‘What’s impressive is that they’re driving the goal to be 100% renewable down to their vendor base,’ he says. ‘They are focused on conserving materials and recycling, as well as having a strong commitment to consumer protection and data privacy.’ Ultimately, he adds, engaging with company management has always been an important element of the Jensen process. It enables the Jensen investment team to better understand the fundamentals of a business, as well as assess the quality of a company’s management team. ‘We are not activist investors,’ says Walkush. ‘However, we do expect Jensen quality companies to function with strong governance structures and management teams that exhibit effective stewardship of shareholder capital. We expect the leadership teams from our quality companies to appropriately value ESG issues as they would any relevant business issues. ‘Moreover, we need to have confidence that they will manage them in a way that mitigates business risk and enhances long-term shareholder value.’
Amelia Garland When Jeff Gitterman launched his eponymous firm, Gitterman Wealth Management, over 25 years ago, he was your usual committed wealth manager focused on delivering the best returns and services to his clients. But everything changed a few years back after he came face to face with the true impact climate change was having on our planet. It was following this moment of clarity that Gitterman decided to dedicate himself to incorporating ESG principles into his portfolios. His New York-based firm has now become a leader within the RIA community’s sustainable and impact investment movement, with Gitterman even helping produce a documentary on the topic. Here, he discusses some of the key roadblocks facing the adoption of ESG principles among RIAs and why current ESG data gathering is flawed. Q: HOW DID YOU COME AROUND TO EMBRACING ESG PRINCIPLES AT YOUR FIRM? We have direct clients, and we manage about $1bn in assets. A lot of that money is from college professors, who are generally prone to accepting the theories around climate change and want to be more sustainable.
In 2015, we helped produce a documentary called Planetary, which was released on Earth Day and featured interviews with environmentalists such as Bill McKibben, Paul Hawken and a group of astronauts. The movie really changed my thinking around sustainability and the risks that we face globally. Then over the next two years, I spent a lot of time doing due diligence around the sustainability theme, and in 2017, I started going to my clients to tell them that we were now offering ESG and more sustainable portfolios. From then on, I started converting my whole practice and, over the following 12 to 18 months, moved around $100m of the firm’s total assets into ESG strategies. Today, we have about $200m-plus in ESG strategies.
Q: WHAT IS YOUR VIEW OF THE GROWING INTEREST IN SUSTAINABLE INVESTMENT? Surveys show that clients want to talk about this topic with their advisors, but they also show that advisors are not yet prepared to have that conversation. Around 80% of clients polled want to talk about their investing values with their advisors, but only 6% of advisors are actively having those conversations. So there’s this big mismatch right now. That’s why you’re seeing a lot of demand from clients, but not a lot of money moving. You’re seeing it in passive funds from firms like BlackRock and Vanguard, as they can move a lot of money very quickly. But that kind of dwarfs what’s actually happening in the advisor community. Advisors are doing a lot to educate themselves on sustainable investment right now and that’s the space where we’ve been trying to help them. But, truthfully, you’re not seeing a lot of asset movement yet. Q: MANY ASSET MANAGERS IN EUROPE ARE NOW INCORPORATING ESG CRITERIA INTO THEIR RISK MODELS. WHICH FUND HOUSES DO YOU THINK ARE LEADING THE CHARGE IN THE US? Wellington Management has set up partnerships with the Woods Hole Research Center and the McKinsey Global Institute to look at climate risk modeling and incorporate that into their portfolios. Neuberger Berman made a big announcement last year about hiring three climate scientists to help them with a review to better understand how their investments will be affected by climate change. Alliance Bernstein has also been warning about how climate change is a big risk for municipal bonds. And then you have European firms like Schroders, Hermes and Allianz, which are leading the way on bringing these physical risks into their portfolio analysis and modeling. So we’re seeing it happen behind the scenes; the advisors just aren’t aware of it. Goldman Sachs also went all-in with a $750m investment over the next 10 years on researching climate change. But at the same time, they said they’ll lean toward doing what’s right for their firm over the climate, if that is the ultimate decision. But you have to balance that. People are going to find out more and more about how to be a sustainable business. You have to care about these issues. And what we’re seeing from the larger asset managers is that they’re all acknowledging it and are all trying to get to market with solutions.
Q: WHAT ARE YOUR VIEWS ON THE ACTIVE VERSUS PASSIVE APPROACH TO ESG INVESTING? When you do pure passive investing using ESG criteria, the problem is you’re using the top-line score from a data provider, which doesn’t give you a good look at all the available data. On top of that, the data isn’t updated often enough. This data is really vibrant and it’s changing regularly. There is new data available every day. It would be like if I told you that you’re going to travel from New York to an address in Florida and you’re going to make that 12 times over the next year without being able to change or update your GPS. You’d be like, why would I do that? I want to know about traffic, about road closures, about detours. I want all that current information, so why would I freeze the data for a year? We really only work with companies who put together the top-line scores using multiple data providers, because there’s still not that much overlap among data providers. The companies we work with are using at least two to three data providers – some are using six – to pull in all the data and create their own maps, and they are acknowledging and assessing the risks that way. That is our preferred way of doing things. We do think active management has a leg up now and climate change risk is going to be a constantly evolving theme. We have spent the past 10,000 years as a human race with a stable climate and now we’re moving into a world where the climate is not so stable anymore. The last example I would give is Pacific Gas and Electric (PG&E). If you are a passive fund, you would have seen that PG&E had a great top-line score because they were converting the highest number of people to alternative energy faster than any other utility company, due to California’s large size and tighter regulation. But they were self-reporting that their risk of fire due to the severe droughts in Northern California was off the chart. If you looked at a map of utility companies, PG&E was so far off the risk map compared with the rest of them. And because of that, active managers avoided PG&E. But passive funds owned them and, for me, that is a great example. I said to somebody the other day that if PG&E is the canary in the coal mine and Australia is the coal mine, then the whole coal mine is on fire. We are beyond the point of the canary dying.
Alex Steger The rise in popularity of ESG is not just an opportunity for fund managers, research teams have also responded to client demand by adding products to buy lists and building model portfolios. One of the earliest movers was the Raymond James Asset Management Services (AMS) team, which first launched a set of ESG models in April 2018. The portfolios, of which there are four in risk profiles ranging from Conservative Balanced to Growth Equity, attracted $60m in their first three months. Today, two years after their launch, they have around $350m in assets under management. Work first began on the models in the fourth quarter of 2016 but was put on hold as the manager research team leading the charge could not, initially, find enough ESG managers to fill the portfolios they had planned. ‘[ESG] wasn’t quite at the fever pitch it is now in terms of the attention it was getting, and certainly there were far fewer products,’ Jeremy Brothers, a senior analyst on the AMS team, said. ‘There were some [funds] coming to market, particularly ETFs, but we took a look at the landscape and took a lot of meetings, and at that point we actually recommended that we pass and delay launch because we just weren’t comfortable with the options available to us.’ ‘For every line item we are going to allocate to, we need a backup and that was the real issue,’ he added.
BACK TO BASICS However, the firm quickly revisited the plans and began working on models that would have a lower minimum investment – $5,000 to be precise – and portfolios that had five or so managers covering major asset classes, rather than more sub-asset classes, categories and managers as had originally been planned. This can be seen in the team’s current Freedom ESG Balanced with Growth model, which – as of the fourth quarter of 2019 – allocated to five headline asset classes: US large cap, US mid-cap, non-US developed markets, and investment grade intermediate maturity fixed income, plus cash.
Again, the manager lineup is not disclosed, but these models typically allocate to around 12 different funds. In short, certain categories just did not have the strength and breadth of ESG managers the team was looking for, thus they are not allocated to these portfolios. These include emerging markets equity and debt, international small cap and high yield. Brothers acknowledged that asset allocation differences based on the availability of managers had meant that the ESG portfolios diverged in factor exposures compared to non-ESG models. ‘There are some leanings within the ESG opportunity set and our ESG models relative to the rest of the platform that do look a little more growthy,’ he said. ‘We do, at the holdings level, have some factor biases that aren’t as aggressively expressed as in some other similar products. ‘Our performance is pretty solid but it’s a pretty high-quality portfolio. Not owning some of those smaller spaces really helped out. We are happy with performance but the whole space is pretty growth-oriented, so there has been a tailwind on our backs.’ The Freedom ESG Balanced with Growth model returned 22.19% in 2019, according to the same factsheet on the firm’s website, compared to the Freedom Hybrid Balanced with Growth model, which was up 20.93% over the same period, both on a net-of-fees basis.
BEATING BETAS While the ESG portfolios have fewer categories and funds in them, the team wanted them to use the same framework and have the same performance targets as the non-ESG models. ‘We wanted ESG strategies that were still trying to beat traditional betas,’ Brothers said. ‘We are expecting our international equity allocations to beat the MSCI EAFE, and our large-cap allocation to outperform the S&P 500. We didn’t want to create a separate policy and, frankly, create capital market assumptions for some of the more thematic approaches to ESG.’
Finding benchmark-beating funds is one thing, finding ones that had bona fide ESG credentials is another. Brothers said the best way to do this was to get out and meet as many managers as possible. He said one key way in which he assessed managers’ commitment to ESG was by the level of resources they had dedicated to assessing the ESG credentials of every holding in the funds. He said this could be through analysts embedding ESG in their process as well as firms having separate ESG teams that engaged with companies and voted on shareholder resolutions. ‘We have a bias towards active managers within this space. For ESG investors, how [portfolio managers] are voting their proxies, how they’re engaging with companies, that is part of the value add we’re really expecting our managers to bring,’ he said. ‘We didn’t hire our first ESG manager because he was ESG, we hired him because he was a really good manager that happened to use ESG analysis as part of his process. That was a real game-changer for us.’ The firm is aware of ESG ratings services, but Brothers expressed some reservations over the disparity in scores between different providers. He said that although they can help flag an issue within a fund – for example, a particular holding being hit by a controversy – and so can inform questions for managers, he did not expect managers to be ruled by these ratings. He argued that, in some cases, companies and funds which hold them, may have a low score based on current ESG credentials, but that this could miss the progress being made toward improvement. An example of this could be oil and gas firms that are exploring clean energy solutions.
TAPPING TALENT As ESG strategies increase in popularity and win greater flows from investors, the Raymond James team is keen to see asset managers continue to invest in their ESG teams and capabilities. Brothers said the scarcest resource within the space was experienced and knowledgeable managers. ‘Frankly, there’s not a huge pool of people, particularly here in the US, that have been doing it for a long time,’ he said. ‘The primary constraint for growth in this space is from human capital. We have spoken to teams that have had recruiters out for over a year, trying to find the right person to bring in and it’s a long process.’
The team could not disclose the exact lineup and allocation to every manager or fund in the portfolio. However, a fact sheet on the Raymond James website highlights five managers, with each one seeming to fit in each of the asset classes set out above. These are: • Vanguard FTSE Social Index • Brown Advisory Sustainable Growth • Parnassus Mid Cap • Domini Impact International Equity • TIAA-CREF Social Choice Bond By contrast, the wider AMS team’s non-ESG version of the portfolio, the Freedom Hybrid Balanced with Growth model, which was also 78% equities and 22% bonds, according to its Q4 factsheet, allocates to eight asset classes. These are US large cap, US mid-cap, US small cap, non-US developed market equity, non-US emerging market equity, investment grade short maturity fixed income, investment grade intermediate maturity fixed income, and cash.