Sustainable Investing Opinion Briefs: July 2019

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Opinion Briefs Coverage
Opinions cover the following topics in descending date order: Possible disruption of ETFs by ESG, hedge funds ESG survey, exploring the question of what ESG investing really means, a critique of socially responsible investing and a rebuke of same, investing in thematic water-related funds, the US House Financial Services Committee July 10 hearing on ESG, the identical nature of ESG-themed funds, shorting companies based on their ESG profiles and Moody’s Investors examines the ESG risks banks face and explains how they are captured in the credit rating agency’s credit analysis.

July 25, 2019 – In an article entitled “Voices: Disruptive ETFs Face an ESG disruption themselves,” by Nir Kaissar of Bloomberg News, the author makes the case that ETFs have been “one of the most disruptive forces in investing in recent years.” But the ETF industry, according to the author based on discussions at the IMN Global Indexing and ETFs conference, “may soon face a disruption of its own.” Kaissar notes that even as individual investors have so far turned mostly to ETFs and mutual funds for ESG investing, enthusiasm for ETFs has been limited. Of the roughly $4 trillion invested in ETFs, only about $13 billion is in social investing-related funds. And even that is about to change as a new “generation of online financial advisers buys stocks directly rather than through funds, allowing investors to customize their portfolios. And for social investors, the ability to decide which companies are worthy of their investment dollars is the whole point.” Size of investment portfolios in addition to restricted access to data, cost, time and expertise are deterrents to an approach pursuant to which individual investors would build their own ESG portfolios. However, this is being overcome by a new breed of online advisers. Upstart firms such as Open Invest Co. and Ethic Inc. are removing those barriers and allowing investors to customize their portfolios around their social investing priorities. We agree that the creation of customized portfolios may overcome the one size fits all approach offered by mutual funds and ETFs and this will appeal to some investors with the requisite level of assets under management. At the same time, customized portfolios consisting of individual securities are not a panacea as these will depend on a set of ESG criteria and related qualifications that, in turn, will reflect the judgments of third party evaluation and scoring firms, such as MSCI or Sustainalytics, to name just two. Such judgements may or may not align with the sustainability sensibilities of investors. It’s probably too soon to write-off sustainable ETFs that still have more room to align themselves with the interests of investors, especially by improving their reporting and disclosure practices.

July 25, 2019 – A recent survey of hedge fund managers by BarclayHedge reported in Chief Investment Officer (“Most Hedge Funds Don’t Consider ESG Factors When Stockpicking”) finds that 41% actually do take ESG factors into account when making investment decisions. Sol Waksman of BarclyHedge feels that part of the reason for this is that hedge fund managers are not yet comfortable with the link between ESG factors and performance. He states that ESG factors acceptance by hedge managers “needs time to develop as an (sic) investment trend.” He suggests that an initial emphasis on governance as a focal point, as opposed to all ESG components, may be a better route to gaining hedge managers’ acceptance. This is because some hedge managers have past experience assessing governance as an element of company investment quality. The stance of 59% of hedge fund managers with respect to ESG factors is puzzling. It seems to us that portfolio managers, whether they be dealing with hedging strategies or benchmarked mandates, get paid to analyze and recognize risks as well as opportunities linked to ESG factors. They should willingly embrace the analysis of ESG risks/opportunities in decision making whenever these are relevant and material.

July 19, 2019 – After examining the holdings of funds with ESG in the title, Joe Rennison of the FT asks “What does ESG investing actually mean?” The author examined the holdings of several funds, such as the BlackRock iShares JPMorgan ESG $ EM Bond UCITS ETF, Vanguard ESG ETF and FlexShares Stoxx US ESG Impact Index Fund, and found that these funds held about $8 million of the BlackRock fund’s $300m in assets is in the debt of Saudi Aramco, the world’s largest oil producer, and in bonds issued by Saudi Arabia, when the website for the BlackRock ETF says it “excludes issuers involved in controversial sectors.” Or in the case of Vanguard, the ESG ETF held stocks of companies involved in the fossil-fuel industry, such as crude refiner Marathon Petroleum and oil services company Schlumberger, while the Flexshares Fund disclosed a $1.3m holding in Exxon Mobil. The author rightly argues that “fund managers must do a better job of articulating exactly what qualifies for inclusion — and why.” Rennison goes on to say that “the world of ESG is still a new one; further teething problems should be expected. But an industry based on the best of intentions needs to be careful. If fund managers pushing ESG products are going to earn the trust of investors, they need to ensure that they are above reproach in the way they sell them.” We couldn’t agree more and this is why we believe that sustainable investment funds in general and ESG funds, in particular, should extend their reporting and disclosure practices. In addition to materials and reports that cover the organization’s sustainable investing approach in general, investment managers should offer investors individual fund specific explanations that provide insights into investment considerations involving stock purchases, sales and retention decisions, particularly affecting controversial companies, performance attribution implications, if any, and outcomes or impacts that may be linked to the fund’s sustainable investment strategies. Such disclosures would inform investors and assist them to more fully understand the investment management firm’s strategy and linkage between fund objectives, financial results and social and environmental outcomes.

July 17, 2019 – In an opinion piece entitled “Critics of ESG funds are wrong — sustainable investing delivers competitive returns” authored by Lisa Woll, the CEO of US SIF and published in MarketWatch, the author rebukes a critique of sustainable investing published by Alicia Munnell, also published on MarketWatch. According to Woll, Munnell, who is the Director of the Center for Retirement Research at Boston College, offered “a highly skewed analysis with conclusions that simply aren’t justified by the facts.” Munnell reflects on the fact that “since 2015, ESG investing has become very popular” and discloses that she has always been opposed to socially responsible investing or investing with the aim of making a political statement in the public pensions environment. The reasons for this are that the approach does not perform as well as the S&P 500, it has no impact on targeted companies (here Munnell is focusing on exclusions or divestiture), public plans are ill-equipped to integrate another criterion in their investment decision making and divestiture advocates will not be the ones who will bear the burden of lower returns. Woll, whose organization is the source for the widely disseminated statistic showing that $12 trillion in U.S.-domiciled assets are sourced to ESG portfolios, up 38% since 2016, argues that various metastudies from organizations ranging from Barclays, the University of Hamburg, Morgan Stanley, MSCI, Nuveen/TIAA and UBS indicate that sustainable investors do not have to pay more to avoid companies with poor ESG practices. For example, Morgan Stanley’s review of sustainable mutual funds in existence for seven or more years found that “sustainable equity mutual funds had equal or higher median returns and equal or lower volatility than traditional funds for 64% of the periods examined.”

We would argue that both commentators could benefit from adopting a greater level of precision when addressing ESG. First, the opinions perpetuate an increasingly common misunderstanding by conflating ESG integration for the purpose of properly evaluating investment risks with social or ethical investing practices. Even as the elements of what constitute E, S and G are still being debated, the idea of ESG integration, in line with the CFA Institute’s definition, is to take into consideration, in a systematic and consistent manner, any relevant and material environmental, social and governance risks or opportunities. The consideration of ESG issues in investment analysis is intended to complement and not substitute for traditional fundamental analysis that might otherwise ignore or overlook such risks or opportunities. On the other hand, ethical or social investing relies primarily on screening out or excluding companies from investment portfolios for a variety of reasons, including ethical, religious, social as well as other strongly held beliefs, such as environmental concerns or involvement on the part of companies in specific business activities. These may include companies involved in the production or manufacturing of tobacco, firearms, alcohol, or even fossil fuel companies, to mention a few. Second, in the light of the above definition of ESG integration, an increasing number of companies are ready to acknowledge that their assets under management are subject to such strategies. This, in our view, is skewing the assets under management figures and growth statistics. Third, to the extent that such strategies are fundamentally different than their approach previously, it is much too early to conclude that it is having a positive or negative performance impact.

July 14, 2019 – While relevant and possibly even central to many environmental considerations, investments by funds in water-related companies introduce a range of risks and other analytical questions not always present for other sectors. This is according to a New York Times article by Tim Gray (“A Scarcity Adds to Water’s Appeal”). He notes that while water is considered a commodity by some, “it can’t be bought and sold directly” and consequently, “it’s not a tradable good.” Funds may focus on water infrastructure, individual company’s efforts to manage “water handling” and related risks, and especially water delivery technology, as they often do. These investments however, carry with them a unique range of regulatory, political, and social justice exposures that may not be present for other environmental factors. We agree, but would add that the question of benchmarking a thematic fund with “water investments” requires added attention. In our opinion, the article’s fund performance discussion could have better informed investors as to the sector’s risks and opportunities by providing performance comparisons to both narrow and broad based securities market indices such as the S&P 500 for domestic-oriented portfolios or MSCI All Country World Index (ACWI) Index for portfolios that may invest in US and non-US stocks, both developed and developing countries.
July 11, 2019 – The US House Financial Services Committee held a hearing on July 10 to debate the merits of five draft bills that would require public companies to disclose information on several environmental, social and governance, or ESG, topics including climate change risk, political expenditures and human rights risk. Hosted by the Subcommittee on Investor Protection, Entrepreneurship and Capital Markets, the hearing included witnesses representing CalPERS, Global Reporting Initiative (GRI), Ceres, Decatur Capital Management, an investment management firm, and Patomak Global Partners, a consulting firm for which former SEC Commissioner Paul Atkins serves as CEO.

The committee memorandum prepared by the majority staff prior to the hearing stated that “investors have increasingly been demanding more and better disclosure of ESG information from public companies.” The target for improving this disclosure has been the SEC, which received an October 2018 petition from a coalition of investment managers, public pension funds and non-profit organizations requesting that the agency develop a robust ESG disclosure framework. Representative Juan Vargas (D-CA) noted in his remarks that this petition was the impetus for his draft legislation, ESG Disclosure Simplification Act of 2019, one of the bills considered at the hearing.

Several committee members on both sides of the aisle noted that, as interest in ESG disclosure rises, some public companies have responded by voluntarily adding these types of issues to their reporting efforts. However, debate ensued when considering that the draft bills would mandate this type of disclosure for all public companies. Issues raised during the question and answer period included: (1) Whether mandated disclosure is necessary given current voluntary disclosure practices, (2) The potential increased regulatory burden of these disclosures, which could negatively impact U.S. IPO markets, and (3) whether ESG issues qualify as material information for investors.

This committee is not the first to discuss ESG issues in a hearing this year, as the Senate Committee on Banking, Housing and Urban Affairs held a hearing in April 2019 on the application of ESG principles in investing. Regulators also are considering these topics, with the Commodity Futures Trading Commission (CFTC) holding a Market Risk Advisory Committee meeting last month that focused on climate-related financial risks. On the SEC side, Commissioner Hester M. Peirce voiced her opinion on ESG efforts in a June speech, stating that they are a “scarlet letter phenomenon,” in which corporations are publicly shamed.

We agree that additional disclosures of relevant and material risks are desirable, and a number of voluntary efforts are underway to secure such information from companies in a consistent and systematic manner. One example is the initiative of the Task Force on Climate-related Financial Disclosures (TCFD). At the same time, institutional investors are engaging with companies to secure additional disclosures and companies are responding. We would give priority to voluntary disclosures on the part of companies and other entities such as sovereigns, states, local governments and municipal entities, to name just a few, and evaluate the quality and progress of such disclosures before the introduction of legislatively mandated disclosures. Also, it’s one thing to mandate disclosures around physical environmental risks, but quite another to legislate disclosures around social and governance risks.

July 9, 2019 – Investors selecting among ESG-themed funds are sometimes confronted with “very similar or nearly identical” portfolio structures. According to an article (“Why ESG Investing May Become Problematic with Overlaps and Redundancy”) by Jon Ogg in 24/7 Wall St. He suggests that a big part of the problem lies with many funds relying upon a single benchmark, the MSCI USA ESG Select Index. In addition, a “broad definition and range for what ‘ESG’ really means” may be part of the problem. We recognize that there is currently a somewhat limited choice of ESG indices that, in turn, also restricts the definitions and scoring of ESG factors based on the methodology of the underlying ESG scoring firm, although this is expected to change somewhat over time as other index providers step in. For example, S&P Dow Jones recently launched the S&P 500 ESG Index. In the meantime, improved disclosures on the part of the management firms (see July 25 ETFs opinion above) would help investors better understand what ESG means.

July 2, 2019 – The possibility of companies being underpriced with “no single tipping point” due to risks from climate change is highlighted in an article in the Financial Times. The article entitled “Climate Change: the bigger short” suggests that as climate-related risk “precipitates price drops” shorting opportunities arise along the length of an industry’s supply chain from its origin with hydrocarbon suppliers. On the plus side, such “underperformance reflects alpha elsewhere.” The article concludes that “ESG-screening tools … help investors assess companies for both propensities.” We agree with this view, but warn that the widespread application of ESG risk integration as a component of the investment process, especially among retail products, is anything but complete. Even in those cases where processes are in place, their thoroughness is sometimes inconsistent. That said, the opportunity is there asking to be embraced.

July 1, 2019 – Moody’s Investors reports that environmental, social and governance (ESG) risks “are becoming increasingly important for bank regulators, investors and stakeholders in general. This report examines the ESG risks banks face, and explains how they are captured in our credit analysis. ESG risk factors such as investment in environmentally harmful industries, misconduct issues, and governance failings can affect bank credit strength. ESG risks are becoming more significant. ESG risks cover a range of factors related to the sustainability and social impact of banks’ activities and investments. Although some ESG risks such as governance are established drivers of bank creditworthiness, they are becoming more significant for banks due to changes in regulations, government policy, social attitudes, and market developments. In several cases, these have been prompted by climate change. Banks are exposed to ESG risks directly, as well as indirectly through their loans and investments. Sustainable finance is influencing banks’ behavior. Policymakers, consumers and investors expect banks to play a key role in funding the development of a sustainable economy. The rise of sustainable finance opens up new lending opportunities for banks, but also exposes them to increased risk of asset stranding, regulatory penalties, capital constraints, and reputational damage. Regulatory incentives to promote sustainable finance can give rise to credit risk, as they can distort risk measurement. ESG risks are captured in our bank credit analysis. ESG risks shape our view of a bank’s credit strength as they affect our assessment of its asset quality, capital strength, profitability, liquidity and funding. For example, climate change may undermine the repayment capacity of borrowers in carbon-intensive or weather-dependent sectors, reducing both asset quality and profitability. Our bank credit analysis includes a qualitative adjustment for corporate behavior that directly measures governance risk. ESG risk exposure varies by region. Physical exposure to environmental risk is greater for banks in developing countries, which tend to be more agriculture-dependent. Risks arising from the shift to a low-carbon economy are higher in Europe, where climate change has been a matter of public concern for some time, but are also growing fast in some emerging economies highly exposed to carbon-intensive industries. The risk of misconduct litigation is greater in developed countries, which typically have stricter consumer protection laws. Governance is a key driver of credit quality, and is relevant for all banks.” Difficult as it may be to identify and quantify direct and especially indirect ESG risks, we applaud Moody’s for its efforts to systematically and consistently address this topic in a more transparent manner across various sectors, including banking.

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