Afford Anything - Ethical Investing 101, with Dr. Jon Hale, Head of Sustainability Research for Morningstar

Episode Date: April 8, 2020

#250: Should we invest in sustainable funds? If we choose sustainable funds, will our investment returns suffer? Will our expense ratios be sky-high? What drawbacks might we face? How do we know that these funds are actually ethical? And what choices are out there for people who want to invest ethically or sustainably? We invited Dr. Jon Hale to our show today to answer these questions. Dr. Jon Hale is a chartered financial analyst and the global head of sustainability research for Morningstar. He directs Morningstar’s research on sustainable investing, which launched with the Morningstar Sustainability Rating for Funds in 2016. For more information, visit the show notes at https://affordanything.com/episode250 Learn more about your ad choices. Visit podcastchoices.com/adchoices

You can afford anything, but not everything. Every choice that you make has a trade-off against something else. Saying yes to one thing implicitly means, saying no to an alternative. And that is true for any limited resource that you're trying to manage, whether it's your money, your time, your attention, your energy, or your focus. So what matters most to you? And how do you make daily life decisions in accordance? Answering these two questions is a lifetime practice, and that is what this podcast is here to explore.

My name is Paula Pan. I'm the host of the Afford Anything podcast. And today, Dr. John Hale joins us to talk about sustainable investing. Dr. Hale is a chartered financial analyst and the global head of sustainability research for Morningstar. In his role, he directs Morningstar's research on sustainable investing, which began with the launch of the Morningstar Sustainability Rating. for funds in 2016. This interview was inspired by a question that we received from one of the members of our community, a woman by the name of Lily. She called in with a question about sustainable investing, and we originally intended

to answer Lily's question in the same way that we answer almost all of the questions that we receive, which are during the Ask Paula episodes. But as I was in the process of answering Lily's question, I realized that that question deserved more than a 10-minute response. It deserved its own episode. So let's listen to Lily's question right now. And after that, we'll bring on John Hale from Morningstar to talk about the landscape of ESG funds and sustainable investing. Hey, Paula. My name is Lily. And I love your show. I've been listening for a few months. I'm super inspired by you, both being a woman in real estate and your personal growth emphasis. It's super inspiring. Thank you. And my question is about ethical

investing. When I asked the retirement person at my first nursing job 13 years ago about socially responsible investing saw options, he told me that there was one, but he advised strongly against it because he said it wouldn't do well. And I wasn't willing to compromise my values, so I chose it, and it did do fine. A few years back, I called Charles Schwab asking for a socially responsible fund, and their advisors were mostly stumped. The first one said they didn't really exist and that they were just labeled that way, but there was no regulation on them, so you couldn't be sure what you were getting. And I finally got someone who was able to help me learn how to search for a fund that did do well and was labeled socially responsible, and I could see what was in there.

And I got that fund, and I'm happy with it. And later on, I got a Betterman account because they offered an SRI version, and I didn't see that elsewhere. and I'm also happy with that account. So I'm wondering a few things. Why do I never hear anything about ethical investing in the fire movement and how do we get there? Is there a third-party reviewer of these funds? And are these funds labeled well or are they essentially a scam? Thank you.

Lily, that's a fantastic question. To answer that, here is Morningstar's Global Head of Sustainability Research. And by the way, just as a note, we recorded this interview before the pandemic. I feel like that needs to be a disclaimer on almost all content that was created pre-coronavirus or pre-when it became a really big thing in the – pre the month of March. So as you listen to this conversation about investing, if this conversation about investing sounds like it was recorded before the stock market crash and before the pandemic struck, that's because it was. So with that, here is John Hill. Hi, John. Hi, Paula.

How are you? I'm great. Thank you. Pleasure to be here today. John, I wanted to talk to you about socially responsible investing. And I wanted to kick it off, actually, by asking you to make sense of some of the alphabet soup around this topic, because we've got so many acrony, there's SRI, there's ESG funds, there's CSR.

And so let's start before we get into a deeper conversation about. about socially responsible funds. Let's start by first laying the groundwork, defining some of the acronyms. Can you talk about socially responsible investing, SRI? What is that? What does that mean? Well, socially responsible investing is really a term that refers to a particular type of investing in which investors want to add an element or a dimension of social responsibility to the investing process. You could contrast that today with a term or another group of initials. It's not even really an acronym since you can't pronounce ESG other than to say ESG. But today we refer more often, it seems like, to ESG, which stands for

environmental, social, and corporate governance issues. And these are the kinds of considerations that, I guess you could say, that socially responsible investing actually tries to incorporate into an investment process. So you'll hear ESG and SRI in some ways. used relatively interchangeably these days. To me, it's, I wouldn't worry about the specifics as much as thinking they mean more or less the same thing. Also, we hear even more of sort of umbrella term sustainable investing sometimes used for SRI or ESG. And then CSR, corporate social responsibility. How is that defined? Well, you know, CSR, it's interesting. Corporate social responsibility refers really to companies and how.

they address this concept of social responsibility, which is really about how they relate to their stakeholders in the world around them over and above their pursuit of profits. And clearly what we find is that some corporations are better at this than others. You know, many companies today put out CSR reports, although a lot of times they're now called sustainability reports, that, you know, try to highlight all the good things they've done for their stakeholders and communities. But the whole process of sustainable investing using ESG analysis really goes beyond just what a company says it does to much more, you know, detailed analysis of how a company is doing on the most financially material ESG issues that it faces in its industry, how well it's performing

relative to its peers and so on. I want to ask you about that detailed analysis in a minute, but before we get there, can you, in terms of laying the groundwork, can you outline some of the different types of sustainable or socially responsible funds that are out there? Like, what's the current landscape? Yeah, sure. So a timely question, because I've just written a report called the Sustainable Funds' U.S. Landscape Report. And in that report, what I pose is that you can think of kind of a taxonomy of sustainable funds. And by funds, I mean open-in mutual funds as well as exchange-traded funds. I think of them in sort of three

parts, and then there's a fourth type that's sort of like a sustainable fund, but maybe not quite. And so I think of sustainable funds as being what I call ESG focused funds. And so these are funds that they may pursue from a sort of investment strategy standpoint. They may pursue a growth strategy, a value strategy. They could be passive funds or actively managed funds. But the common element that they have is that they put front and center, this analysis of ESG factors when they make investment decisions. So that means when they're selecting securities, as well as when they are constructing

the overall portfolio, they're considering how well the companies in a portfolio are handling the various ESG risks and opportunities that they face. In addition to that, some of these funds may also use broad-based exclusions. That's something that's a little more. a traditional SRI type of activity, but you still might have an ESG fund that excludes, say, tobacco stocks or gun stocks or controversial military weapons, manufacturers, things like that. On top of also using this ESG analysis on a routine basis, another thing that I think is very pertinent and that people should really know about and consider when they're thinking about

investing this way is that most ESG focused funds also actively engage with the companies they own. They're shareholders. That means they have a voice in company management. And so they will engage with companies around various ESG types of issues that they might think the company needs to improve on. And they may even take it so far as to sponsor a shareholder resolution that could be voted on at a company's annual general meeting that puts the question in front of all shareholders. And this is a way, and we can talk about this in a little bit more detail, but this is a way that sustainable investing, I think, is very impactful beyond just the financial returns element of it. So ESG focus funds. In addition to that, we have what I call impact and thematic funds. And so these are funds that

in addition to their kind of underlying ESG focus, they may be focused also on a broader theme. So there are gender diversity funds that really focus their analysis on making sure that all the companies in a portfolio have good, strong diversity policies. They have women in executive suite and women on the boards. You know, there are also quite a number of fossil fuel-free funds out there. So there are different themes, sustainability themes, I guess I would say, that fall into this category, as well as funds that just are interested in demonstrating to their investors that here is our assessment of the overall impact of the companies in this portfolio. And so they'll do things like try to measure the overall carbon emissions of the companies in this portfolio, as opposed to, say, a standard market-based portfolio. and other impact metrics along those lines. The third type of sustainable fund out there is what I call a sustainable sector fund,

and those would be funds that are a little more focused around kind of a quasi-sector. There's no like officially defined sustainable sector, like an energy sector, utilities, etc. But these are funds that really focus on, I would say, companies that are creating products or services that will hasten the transition to adjust sustainable, low carbon economy. And so you can think of renewable energy in that regard. You can think of environmental services, companies, and those involved in things like enhancing energy efficiency and so on. So ESG focus, impact thematic and sustainable sector funds.

The other type of fund or the other type of thing that you might want to consider out there, is what I call ESG consideration funds. When I talk about the sustainable funds, it's a relatively small portion of the overall universe of funds and ETFs out there. Now, I think we probably have too many funds in the overall universe. There's 7 or 8,000 available to U.S. investors, only about 300 sustainable funds. But one of the things that I've noticed in the last couple of years is that a lot of conventional funds out there are adopting ESG as a, literally as a consideration in their investment process.

So they're saying, gee, you know, we're starting to see that a lot of companies' financial fortunes could have to do with how well they are managing their ESG risks. And so we also need to start thinking about that. It may not be the central focus of our decision making, but it's an element of our decision making. And so just last year, more than 500 pre-existing conventional mutual funds in the United States added language in their prospectus saying that, yes, we now do consider ESG factors in our investment process. So to me, that's one step better than most conventional funds that just don't really mention it at all and presumably aren't all that concerned about it to this next step of ESG consideration

fund. So if you have mutual funds that you're already invested in that are not sustainable funds with ESG focus or impact focus or a sector focus, you may have a fund that has at least added this idea of, yes, we consider ESG factors now in our investment process. What level of churn is there inside of these funds? Well, I mean, it would vary. I think in general that sustainable funds have, probably lower turnover than funds overall because, you know, a lot of the focus is really on long-term investing. I mean, it's one of the things that sustainable investors want to see companies do. So, you know, we're in this era, Paula, of, you know, short-termism, you know,

where investors or CEOs of companies will claim that, well, our investors are forcing us to focus on short-term quarter-by-quarter earnings growth. And gosh, we would like to have a broader, longer-term perspective that focuses more on all of our stakeholders and not just on this short-term profit maximization, but, you know, our darn shareholders are kind of forcing us into this short-term perspective. Well, sustainable investors are doing just the opposite. They're saying to companies, no, we would like for you to manage towards long-term sustainable stakeholder value. We want you to take all your stakeholders into consideration as you manage the company. We want to focus on long-term.

We want this to be literally a long-term sustainable investment for our fund. And so I think the real interesting impact that we're seeing, and I think we'll see from more and more sustainable investors, is that. that a company will start to see in its investor base more investors that have this kind of long-term perspective and it will allow them to take a broader view on how they manage the company. And I think over the long run, that'll make for more successful, more sustainable companies, both in terms of their sustainable impact on society and the environment, but also more sustainable earnings and profits to shareholders over the long run.

And so because of that general perspective, I think you would see with sustainable funds as a group, possibly lower turnover than mutual funds overall. As you were describing the various types of funds, one thing that struck me is that there are some funds, as you mentioned, that exclude behaviors that they dislike, such as funds that exclude tobacco, for example. And there are other funds that focus on including companies with behaviors that they like, such as companies that pursue the development of renewable energy. How does that shake out in terms of the landscape? Is one more prevalent than the other? Is the trend going more in one direction or the other? So the trend is going towards this sort of comprehensive ESG analysis of every part of the portfolio. So what that might mean for a typical, you know, ESG focus fund is that if you're looking at a company that's creating important sustainable products and services that are really going to enhance the transition to a low-carbon, more sustainable economy, then those types of companies will be favored in an ESG-focused portfolio or then especially in an impact-focused portfolio.

but at the same time, there may be a sort of, I don't know, a core part of those portfolios where the analysis is really more about, you know, companies that you need to have in the portfolio because you want to have a broad-based diversified portfolio. So they could be companies that we think of in everyday terms, whether they're Microsoft or an Apple or, you know, a pharmaceutical company or something like that. And in those cases, the evaluation is really around who, within these industries, what companies are doing the best at managing their ESG risks. You know, they may not be companies that have particular sustainable products, but, you know,

how are they managing these various ESG issues? So that's a big part of it. And then in addition to that, you may have funds with a few exclusions. So, you know, overall, it's moved away from exclusion-based towards what I would call ESG integration and impact. The very first time I made an investment in a mutual fund was in the 1990s, and it was in a socially responsible fund. But the definition of that fund was basically that it had a set of exclusions. I know tobacco was one of them, a set of product exclusions. And then beyond that, it was more or less like any other fund. So that's quite different today.

You've mentioned the phrase managing ESG risk a few times. What exactly is ESG risk? risk? The way this is looked at in investment terms today is increasingly in terms of ESG risk, although I would say you could think of it in terms of ESG risk on the one hand and then sort of sustainable impact on the other as sort of two dimensions here. But ESG risk, here's kind of the story of ESG risk. When I described the fund that I invested in the 1990s, the idea there was to invest in companies that are doing well on. on this just general, around the general concept of social responsibility, of corporate social responsibility, but we didn't really have the means to evaluate companies very well, except in

terms of like, oh, if we knew a company is primarily producing cigarettes, we, no, that's not a company we want to invest in. But what about all those other companies out there? We didn't really have a lot of systematic data to back up any kind of analysis of a company. You know, we'd have some impressions of maybe a company as a polluter or something like that, but nothing really to go on. And so what we've seen is the development of what I would call ESG research and analysis, and literally starting from just a couple of small companies that started doing this in the 1990s to the point where over the last 10 years, we have extremely sophisticated and robust measures of how companies are doing industry by industry in terms.

of addressing their ESG risks on the one hand and perhaps opportunities on the other. So to give you some examples of ESG risk, you can almost think of any industry as having kind of a unique mix of potential ESG risks that companies have to deal with. And the reason they have to deal with it is not just feel good stuff. It's that they might actually have material financial implications for you if you're not dealing with them adequately. And so probably the most obvious example would be in the fossil fuel industry. Obviously, in any kind of energy company that deals with fossil fuels, the main ESG-related risk comes with carbon emissions.

And how well is this company able to manage carbon emissions? Because at some point, they're going to be regulated and they're going to be costly. already at this point today, they are becoming costly in terms of customers turning away from using some of these products and services. So that is a big ESG risk for, you know, an oil and gas company, but also things like pollution, how well a company handles, you know, its oil fields and extraction and what's its impact on the environment. That's another issue there. Worker safety is an issue for them. So these are ESG issues that are relevant to, say, an oil and gas company. You turn attention, say, to a retail apparel company.

The key ESG risk there tends to be for the larger companies especially. How well are they overseeing their supply chain? What are worker conditions there? Their child labor, slave labor conditions there. How are they overseeing it? How are they monitoring this kind of activity? That's a big ESG issue in the approach. apparel industry. You turn to internet companies and social media companies. Clearly, customer

privacy and data security is of paramount importance there, but also issues like human capital. How are you managing your human capital? There's a lot of industries out there today that require top-notch, well-trained, well-educated individuals to work for them. And what we're increasingly hearing today is that those folks want to work for companies that are doing good. And so if a company's sort of overall is not interested in or focused on generally speaking broad corporate social responsibility issues and in particular the actual material ESG issues that it faces, then you could have a problem on your human capital front because people may not want to work for you. You may not be as attractive in an environment where you're like at keen competition to to attract the best and the

brightest. That can be a big deal. So ESG risks, in this context, it's risks to the future prospects of the company as it relates to ESG related topics. Yeah, and you can think of it as material risk. So every sort of corporate responsibility issue that might be out there is not necessarily material from a financial standpoint to a company or might not potentially be material. So when we talk about the ESG risk footprint for each industry out there, we're talking about issues that we think are going to be or potentially could be, if not managed appropriately, material to that company's actual financial well-being. But the other thing I would just add, because among customers today and

And among workers, employees, there are companies face these growing expectations for, you know, responsible behavior. Then there are some issues that might not appear to be material on the surface that actually are because of these growing expectations. So to give an example, there are quite a lot of companies out there for whom, say, carbon emissions are not necessarily that material to their financial fortunes. Like, you know, a company, for instance, like I work for a Morning Star, I mean, our carbon emissions as a company are not that great.

So it's not like if we had to all of a sudden pay more for carbon, it wouldn't be a big material issue necessarily. But what if our employees say, you know what? Why aren't we buying renewable energy? That's something we should be doing, just as a way to be responsive. And if that's something that helps people come to work here and think, wow, this is a great place to work and I want to work here longer because of that and be more productive, then it does have a material impact.

So there's a lot of ways sort of direct and indirect that ESG issues are our material today. And the big difference between an investment process that incorporates ESG versus one that doesn't, even if it's just doing it on a kind of low level or a light touch is that a lot of these ESG issues, they aren't necessarily discernible through traditional financial analysis. So in order to get some kind of a feel for how ESG might be affecting the stock price of a company, you need today, I think it's just kind of becoming a required thing for all investors to at least consider ESG. risk when they look at a company. How do fund managers conduct ESG analysis?

Well, there's a variety of ways, but I'd say that generally speaking, it starts off with collecting the data, the ESG data on companies. And luckily today we have, there's an entire sub-industry out there of ESG data providers. Morningstar owns 45% of one called Sustainable. analytics. There's another big one out there called MSCI ESG research. But in addition to that, there's like about a dozen others that are collecting this kind of information about companies. And so the data are readily available now in ways that they just absolutely weren't even 10 years ago on

virtually all publicly traded companies, increasingly even on private equities. And so you start with that. You start with some basic ratings and basic schemes that help you understand. what the material issues are in a given industry. There's a group out there called SASB, a Sustainable Accounting Standards Board. You can go to SASB-S-B-O-G.org, and they have what they call a materiality matrix where you can see industry by industry,

what SASB has considered to be the most material ESG issues facing any given industry. So it's actually quite interesting if you want to really, you know, kind of nerd out on this stuff. But, you know, So a typical fund manager will start with that. And at that point, it kind of varies. Some fund managers will say, okay, use this to narrow my universe.

I want to make sure that I have, say, I'm leaving out the ESG laggards from my universe. And after that, I'm just going to pick stocks the way I would otherwise choose them. Some are a little more focused, have a little tighter focus on saying, like, I want to draw from the best core. or the best half of sustainability or ESG performers, industry by industry. Then they go about a standard investment process. If they're value managers, they want to see an undervalued company or stock. If they're growth managers, they want to see what the prospects for longer term growth are. A third way of doing it is focusing really on sustainability opportunities.

So looking for companies for whom their competitive advantage is somehow tied up with sustainability concerns or consideration. So there's a variety of ways that ESG is incorporated into an investment process, whether it's just a traditional fund that's using ESG kind of as a just one among many or even whether it's an ESG focused fund that's really using it as a centerpiece of every single investment decision. We'll come back to this episode after this word from our sponsors. The holidays are right around the corner and if you're hosting, you're going to need to get prepared, maybe you need bedding, sheets, linens, maybe you need servware and cookware, and of course, holiday decor, all the stuff to make your home a great place to host during the holidays,

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Save up the 50% November 13th to 20th. Conditions apply, details online. Now, you mentioned that there are some ESG-focused funds that are issue-specific. So, for example, fossil fuel-free funds or funds that specifically make a priority about gender within the company and making sure that there's a good number of women who are executives or on the board. Assuming, though, that in the context of ESG-focused funds that are not issue-specific, how do fund managers think about? What's the framework for processing a company that might score very highly on certain issues, like, like carbon emissions, but then perhaps they'd score less highly on other issues like women in the C-suite or vice versa. Right. So it depends. If you haven't identified one of those types of themes as being, you know, a primary

consideration, then you're looking at the overall picture on each and every company that you're considering there. Now, in some cases, we're also seeing, when you look at at the portfolio level, the portfolio construction level. Some ESG focus managers want to say, okay, I'm going to invest in every single sector of the economy, just like a broadly diversified fund, you know, a broadly diversified, say, index fund would. But within each one of those sectors and industries, I'm going with the best in class. And that best in class is based not just on increasingly, based for most managers, based not just on all possible ESG issues, but on the material issues.

So, you know, say now diversity, I think diversity is an issue that broadly speaking applies across the board. So it would be a material issue, I think, to be considered no matter what sector you're focused on. But when you're deciding what energy or utility companies to put in your portfolio, carbon emissions would become a bigger deal for those than it would be for, say, your technology exposure. So issues kind of rise and fall based on their materiality relative to a particular industry.

So that's a big difference. So these more thematic funds, though, do tend to kind of apply whatever the sort of issue focus or thematic focus is across the board. And so, you know, a fossil fuel free, although or a low carb, let's say there are funds out there that sort of say we're a low carbon themed fund, which means that across the board we're looking for not only the lowest carbon companies in these areas where it's really important to them material, but we're also looking, you know, in retail and other places for companies that are also buying renewable energy and really taking a stand in that direction. You know, that's happening

a lot in the retail industry, the targets of the world, the Walmart, they're buying renewable energy. And they, their energy consumption is a pretty big deal for them, but it's not as crucial to their financials as that is for heavier industry-type sectors and energy and utilities. There are certain industries in which the industry as a whole contains some degree of controversy. How are those industries handled in this landscape? So there's really two elements to that. One is, again, kind of going back to my best in-class concept where you're looking at pharmaceutical companies and you say, well, how well, you know, and product to government.

governance is really that big material ESG issue. It kind of covers things like, is the product safe? Is the product marketed appropriately? Is it accessible to the populations that need it at a reasonable price? So, yeah, those are the key issues with a lot of pharmaceuticals. So a typical ESG focused fund would say, well, you know, I'm kind of on a relative basis. I'm going to pick the best in class here. I'm not going to pick the ones that are the laggards.

And there is a range of performance on these issues. So that's number one. Number two, the pharmaceutical companies that are in my portfolio, I'm going to monitor for these things. And that's where we get back to engagement and why engagement is so important. If there's an issue that a pharma has that's in my portfolio as a shareholder, I can call them up and say, you need to improve your performance on this. And we need to talk about it. We need to sit down and talk about it.

And I really can't emphasize enough how important and potentially impactful engagements are with companies. Because it now used to be the case that this was considered a real pain, you know, a company is like, I got these SRI shareholders. A lot of times they were like these institutional faith-based shareholders, literally nuns, you know, from Catholic investors, investing on behalf of a hospital or a church or parish somewhere. it's kind of a pain like, ah, what do they want? What do they want us to do? This is all very inconvenient. Well, today, it's really changed. And so more and more companies want to know what their sustainable investor base is concerned about because it helps them understand more generally speaking what their

stakeholders are going to be concerned about, what kind of behaviors they're engaging in that could have reputational impact to the company. So engagements are important. They often involve not just one fund, but a coalition of investors. And they also come with at least an implicit threat that if the company doesn't want to address this issue, then we'll propose a shareholder resolution and we'll put it to the shareholders on a vote at the annual general meeting. Companies typically, historically, have not liked to see that because it's like you're waving a flag, you know, a red flag in front of every single investor out there saying, look at what this company's doing in this area. Do you agree or disagree with us that they should,

you know, address it? And so this has become something that's a very important impact of sustainable investing. And it's something that I think individual investors who even who have just modest amounts of money to invest ought to consider this as a way of sort of adding the dollars that they have to invest to this broader movement, really, of investors that I think are helping companies become more sustainable. Let's talk more about shareholder engagement. Are there any examples of big wins that have happened recently or major changes that companies or industries have made?

Well, one thing that we've just put out another report with a colleague of mine called the ESG proxy voting trends. And what we're finding is that investors in proxy voting, on voting on shareholder resolutions related to ESG issues. Over the past five years, the average support of the 50 largest fund families out there has risen to 46% from 27%. So typical large fund family last year voted in favor of 46% of the ESG resolutions that were out there. That's a big increase over just five years. The resolutions typically are about things like,

asking companies to release to shareholders or prepare for shareholders a climate risk assessment. What is the risk to this company of climate change? And a couple of years ago at the Exxon mobile shareholder meeting, more than 50% of shareholders, a majority of shareholders voted in favor of a resolution asking Exxon to do that. The same thing happened at Occidental Petroleum. So just to put that in context, typically over the years, you know, going back, shareholder resolutions, I think first appeared just a few of them on these kinds of issues as early as the 1970s. But they're fairly few and far between. And typically, their support level would only be, you know, maybe 5 percent or 10 percent of shareholders.

So to see shareholder resolutions today getting majority votes is quite something. You know, it's a big sea change. So the ExxonMobil and Oxygenal Petroleum, what happened in last year's proxy season was that there were another flurry of shareholder resolutions proposed at companies asking them to prepare climate risk reports. And almost all of them were withdrawn by shareholders after engaging with companies that said, hey, can we sit down and talk about this? And here's our timeline. Yes, we will release a climate risk report. would you consider in exchange for us committing to you to do that, withdrawing your resolution? And so typically in this process, that's what's happened. So we've seen because of investor pressure,

a lot of companies now focusing on this idea that, okay, this is something that's important to our investors. And frankly, we're realizing it's important to us as well to make sure we understand the growing risks of climate change to our business. That's a big thing. We're also seeing more and more support for companies to do a better job divulging their expenditures on lobbying and campaign contributions. And that also is connected with climate change because we have a lot of companies out there now saying, oh, we're on board with the idea of climate change. We agree something needs to be done about it, but they turn around and help sponsor trade organizations in Washington that are opposed to climate change and, you know, and addressing the issue.

in a very effective way. And so there's disconnect there, and we're calling that to your attention. And so we've seen companies recently resigning some of their memberships of trade organizations that have been climate deniers. So there's that, I mean, the diversity issue is one that's very much alive with engagement efforts. Any company out there that doesn't have women on its board or at least 10% women on the board and has a commitment to getting that up to 30 percent, increasingly are seeing their directors being voted against at the annual general meeting.

And so shareholder engagement, I think, has become more and more effective. It's a much bigger deal than it used to be. I guess I would just reiterate, though, that it's not all adversarial. We're seeing a lot more companies appreciating coming to the table and being able to become more aware of sustainability issues. A lot of times, it's also kind of connected with people inside a company who also want to see that company do better on these issues. So virtually every company has a chief sustainability officer now.

And so they're especially interested in the exact same kinds of issues. And so it's this kind of virtuous circle between all your stakeholders now, that your customers, a lot of times even your business partners and your workers and your investors all want to see and encourage a company to improve its sustainability profile. If a person listening to this wanted to become a more engaged shareholder, how would they begin? Do they show up to the annual general meeting? What steps can they take? It's a great question. So it's possible for anyone who has owned at least $2,000 worth of stock in a company for one year.

to propose a shareholder resolution. So it's not just a fund or a fund or a big investor that can do it, but a small investor can do it. Now, that's had a lot of impact. In fact, many of the resolutions that have garnered significant support from shareholders have been proposed by individual investors. I happen to know one. And it's kind of unfortunate because I can't divulge all of the details of this particular

engagement, but I know directly of an investor, small investor, $2,000 in a major company recently who simply asked them in the proposal to produce what she called an ESG report. So similar to sustainable, but she said, I'd like for you to produce an ESG report for investors that addresses the ESG risks that you face in your industry. The company called her up and said, we're not sure what you mean by that. So she said, okay, look at the SASB, go to SAS. SB.org and talk to them about it and figure it out from that. They said, okay, they called her back and said, if you will withdraw the resolution, we will start working on it. And just recently,

they've released their ESG, first ESG report. So individual investors can have an impact. Now, the reason I kind of said, interesting question for now, and here's how I'd answer it right now, is that the SEC, unfortunately, is currently considering a rule that would make it hard. for individual shareholders to do this. In fact, they want to ratchet up the amount of stock that you need to own in a company for one year to $20,000 from $2,000. And then it would slide down to $2,000 if you held the company for five years, and you could still propose a resolution then.

So the SEC has not viewed the whole shareholder engagement progress that has been made, all that favorably so far. And they're considering ways to kind of shut up. that down, but it's created quite a lot of opposition among many investors, and it remains to be seen whether they'll follow through on the rule that they've proposed. We'll return to the show in just a moment. Let's talk about the types of fees that are typically associated with these funds. If a person wanted to buy an ESG-focused fund, what typical expense ratio or range of expense

ratios might they see? So here's what I would say about that. they may have to pay a little more. The reasons are fairly complex. I mean, first of all, if you think about passive funds, and there are passive ESG funds out there, many of them, in fact, and really the way they work vis-a-vis a standard sort of market-cap-based index fund is that they say, okay, well, we're going to keep the overall market-based sector weightings about the same as you would see from a standard passive fund.

but we're going to focus on ESG leaders in every industry. So, you know, that's typically the way, what an ESG passive ESG fund would look like. Well, a passive market cap-based weighted fund out there today costs almost literally nothing. So, yes, any ESG index fund is going to be a little more expensive than that. However, there are those types of funds, ESG, passive market-weighted index funds available for about nine basis points now, as low as nine basis points. And you could find a combination of those that would give you an overall equity portfolio covering U.S. stocks and international stocks for price ranging from nine basis points to 20 basis points. So, you know, it's not as cheap as the rock bottom prices of passive index funds today, but it's pretty darn cheap. And it really doesn't affect performance in any real significant way.

In fact, just last year, what I found in my sustainable funds landscape report is that most ESG index funds outperformed the S&P 500. So your performance is good. You are paying a little more. Now, the other thing I would say is that on actively managed funds, you really shouldn't expect to pay more for a sustainable fund than a conventional fund. They're about the same. But I will say this. I know of an advisor I just talked to last week who she had just transformed her entire advisory practice away from conventional funds to using ESG sustainable funds. you know, and it's very interesting because she said, you know, I was a little concerned about it.

I thought, you know, I've got 330 some clients in my practice and, you know, surely there are going to be some that are going to go, no, I don't want to change. I don't want to make this shift. I've never, you know, these are not people that have come in and talk to her about it or anything, but she announced the shift and she said, you know, if you want to opt out, feel free. Not a single client out of 330 clients opted out. But she said in full disclosure, the models that we're going to use for you, using ESG funds, getting away from conventional funds, is going to average about 53 basis points in expenses, and that's up from about 45 basis points for the funds that she used to use. So she said she wasn't necessarily choosing funds based on trying to keep the expenses exactly the same. But that's a, you know, I thought that gives you kind of a sense that, you know, these funds are competitive on fees. It's not like it's a, you know, it's not like the difference in costs between like organic foods at the supermarket versus conventional and stuff like that.

You know, you shouldn't expect to pay a big premium for a sustainable fund. Let's just put it that way. Tell me more about performance. You mentioned that ESG focused funds outperformed the S&P 500 over what duration of time was that? Well, I was just referring to last year, but I've got some interesting stats on how funds, how sustainable funds have performed recently. First of all, one of the things that I think is really interesting about sustainable funds is I think there's a case to be made for them, like in general terms, because they're addressing

these ESG risks in ways that perhaps investors who are not considering ESG are not able to incorporate, rate that in times where we have high volatility, it's possible that these funds should fare pretty well as hold up pretty well. The other side of it is that many of them are not that old, so they weren't around during the financial crisis. So you can't look back into that major fair market and see what their performance is. But year to date through February, ESG funds on the whole had outperformed. And in fact, I looked at core large cap ESG index funds. through the end of February, every single one of them had outperformed the S&P 500 in the international all but one.

So I think it was 11 out of 12 outperformed. And even in emerging markets, there are three ESG index funds. And all three of those outperformed the emerging markets index funds. So they're doing well in difficult markets. Last year, one of the ways I looked at at broadening it out a bit was to look at how all the ESG funds did relative to their Morning Star categories. So, you know, if it's an ESG U.S. large-cap fund, it's put into the category with all the large-cap funds that focus on the U.S. If it's small-cap, same story, international, and so on. The returns of 65% of ESG funds last

year were in their categories top half. So overall, 50% of funds, you know, by definition, make it into the top half. For ESG funds, it was 65%. And the same is true over, more or less, over the last three and five years, in the over three years, 67% of sustainable funds finished in the top half of their category. Even if I narrowed that down a little more and said, how many very top performers versus poor performers, 40% of ESG funds finished in the top quartile of their category over the last three years. So overall, 25% of funds by definition in the top quartile for ESG, it was 40. Only 12% by contrast finished in the bottom quartile. So overall, 25% or in the bottom quartile, only 12% of ESG funds. That's for three years. For five years, the numbers were

64% in the top half, 32% in the top quartile, 13% in the bottom quarter. So overall, they've performed well. I mean, I hesitate to say it's a proof positive of ongoing outperformance from ESG funds, but it certainly helps dispel the myth that a lot of people have, and we could maybe talk about the genesis of that, but the myth that somehow this is a recipe for underperformance, we're just not seeing that in any respect. And why did that myth originate? Did that used to be the case? Or has that always been a myth? To a large extent, I think it's always been a myth. The main reason for it is tobacco, interestingly enough, that back in the day, you know, when I talked about the 1990s and, you know, some of these early days of SRI investing, you know, one of the big exclusions that was made was to avoid companies that were involved with tobacco. And at that time, tobacco stocks outperformed. And they've long been considered a very good defensive kind of stock. People didn't. necessarily, you know, smoke less tobacco during recessions, you know, maybe even, maybe even

smoke more, who knows, and it's a strong dividend paying stock and that sort of thing. So the idea of removing tobacco from a portfolio in this sort of era from, say, the 1990s through maybe the financial crisis was considered like, wow, that's a recipe for underperformance. And in fact, you know, during that time, tobacco stocks, just as a group, outperformed the overall indexes. Interestingly, though, since then, if I'm looking at the 10-year trailing 10-year performance of tobacco stocks as of the end of February, they have underperformed over the last 10 years.

And over the last three years, they've underperformed massively. The MSCI World Index, which is a broad-based index of large-cap stocks, over the last three years has average 7.24%. annualized, tobacco stocks minus 10.38. So they've underperformed massively during the more recent. But back during that previous period, the idea that, wow, you're, you know, by excluding something and you're excluding them for non-financial reasons, right? People that were excluding tobacco or investors excluding tobacco, we're not saying,

oh, I don't think this is a good investment from a financial standpoint. They're like, I don't, you know, ethically want to own tobacco. And so anytime you're doing that, the sort of idea was that, wow, you're limiting your investment universe for non-financial reasons. That's a risk of underperformance. And yes, that's what happened with tobacco in that period of time. But what we can see now, tobacco is underperformed for the last 10 years is really what your risk is tracking error, you know, that you're not going to track the index.

And it could be positive. It could be negative. And so in addition to that, so that's one thing that's kind of. of, I think, helped with that myth and sort of the idea that owner performance is not sort of predetermined in any way through exclusions. The other thing is that we have a lot more sophistication in the way we put together portfolios today. So if you want to exclude tobacco, there are ways to re-optimize a portfolio by replacing the tobacco stocks with non-tobacco stocks that nonetheless might have some of the same financial characteristics as tobacco stocks. So, you know, it's easy to do now

25 years ago, it wasn't as easy to do that. So from all that, and I think from the standpoint of the fact that sustainable investing or SRI investing is, you know, which we called it back then, you know, never really was, there weren't a lot of people that were that interested in it. So it was relatively easy, I think, for investment intermediaries to just kind of give people, you know, give them the wave off and say, well, you don't really want to do that. You can underperform. It's not something you want to do.

If you're so interested in these kinds of things, then why don't you just invest in a standard way and, you know, think about how you give money to charity and things like that to have an impact with your money. Well, thank you for all of that insight. Where can people find you and find out more about this topic if they would like to learn more? Yeah. Well, Paula, we have – I write about sustainable investing on Morningstar.com. usually on a weekly or biweekly basis. I also have a blog called the ESG investor that's available through Medium. And I mentioned a couple of papers that we've just put out that you can find online by just

searching for them and getting and you can download them. One is called Sustainable Funds U.S. Landscape Report, which gives you kind of an overview of all the funds that are out there that you could potentially invest in. And then the other one is called 2019 ESG proxy voting trends. it's a little bit more of a dive into that area, but one that some folks might find interesting. So both of those are available on download from Morningstar.com. Thank you, John. What are some of the key takeaways that we got from this conversation?

First, John says that there are three types of sustainable funds. So let's recap what those are. Number one, are ESG-focused funds. And I'll let him describe what that means. These are funds that they may pursue from a sort of investment strategy standpoint. They may pursue a growth strategy, a value strategy. They could be passive funds or actively managed funds. But the common element that they have is that they put front and center this analysis of ESG factors when they make investment decisions.

An ESG focused fund is a fund in which the fund managers consider how well the companies in a portfolio handle the various ESG risks and opportunities that they face. Now, these funds may also use broad-based exclusions. So, for example, they may exclude tobacco stocks, gunstocks, or controversial weapons manufacturers. Most ESG-focused funds actively engage with the companies that they own and might introduce shareholder resolutions. And so those ESG-focused funds, to recap, are one of the three types of sustainable funds. The second type is impact and thematic funds.

These are funds that in addition to their kind of underlying ESG focus, they may be focused also on a broader theme. These are ESG funds that might focus on a specific theme, such as gender diversity funds, fossil fuel-free funds. So those thematic funds are the second of the three types. of sustainable funds that are out there. And then the third type is a sustainable sector fund. Those would be funds that are a little more focused around kind of a quasi-sector.

There's no like officially defined sustainable sector, like an energy sector, utilities, etc. But these are funds that really focus on, I would say, companies that are creating products or services that will hasten the transition to adjust sustainable, low-carbon economy. These might be funds that, for example, focus on renewable energy companies or focus on environmental services companies involved in things like enhancing energy efficiency. These are examples of sustainable sector funds. And so, to recap, the three types of sustainable funds are ESG funds, impact and thematic funds, and sustainable sector funds.

And while we're recapping, we should also give an honorable mention to ESG consideration funds. This is a fourth category. And these are conventional funds that are adopting ESG as a consideration in their investment process. So they're not ESG funds per se, but they are conventional funds that are keeping an eye on ESG. And many companies are becoming aware that this is important to shareholders and

stakeholders and are becoming more proactive about how they're managing ESG risks. Just last year, more than 500 pre-existing conventional mutual funds in the United States added language in their prospectus saying that, yes, we now do consider ESG factors in our investment process. So you can check to see if some of the conventional funds that you already hold may have moved in this direction. It's possible that you're already holding some ESG consideration funds. So you can check the prospectus of any fund that you're holding to see whether or not they consider those ESG factors.

So that recap of the landscape is one of the major takeaways that we got from this conversation with Dr. John Hale. The next major takeaway, I'll call this knowledge tidbit number five, is that you can become an engaged shareholder. At least for now, if you own $2,000 in stock in one company for at least one year, then you have a voice and you can use that voice to propose a shareholder resolution. Now, as John noted, the SEC is considering a rule that would increase this $2,000 limit up to $20,000. But that rule has not been adopted yet. So right now, if you want to become a more engaged shareholder, you only need to be $2,000 worth of stock in that company for one year?

It's possible for anyone who has owned at least $2,000 worth of stock in a company for one year to propose a shareholder resolution. So it's not just a fund company or a fund or a big investor that can do it, but a small investor can do it. So that is a really interesting takeaway from this conversation. And finally, the sixth major takeaway is that it is a myth that ESG funds. underperform. There is an impression out there that ESG funds do worse, but that is actually not the case. Year to date through February, ESG funds on the whole had outperformed. And in fact,

I looked at core large-cap ESG index funds through the end of February. Every single one of them had outperformed the S&P 500 in the international all but one. So I think it was 11 out of 12 outperformed. And even in emerging markets, there are three ESG index funds. And all three of those outperformed the emerging markets index funds. Now, that being said, the ESG funds that are out there are pretty young. So it's yet to be seen how they will perform in a bare market or in a recession. We're about to see that right now. So wait six months and ask again, we're about to witness how these funds perform in a down market.

But what we do know is that during the bull run that just ended, these ESG funds outperformed. And the myth that ESG funds underperform originates from a time back when tobacco stocks were excluded from funds. 25 years ago, the performance of tobacco stocks were excellent. And so excluding these high-performing tobacco stocks from funds, it seemed crazy. It seemed like that would drag down performance. That was how this impression that ESG funds underperform originated. But now, 25 years in the future, that's an antiquated idea. And for what it's worth, tobacco stocks have now underperformed over the last 10 years.

So if you want to invest in sustainable funds, don't assume that that necessarily means that you're going to be giving up some performance for it. Again, these funds are young. We haven't yet seen how they're going to perform in a bare market or in a recession. We're about to find that out. But what we do know is that when the market was doing well, ESG funds were doing even better. So that is our show for today. We will be airing an episode on Thursday, PSA Thursday, in which we talk all about the current economy, the bare market, the upcoming recession, how to build an emergency fund in the middle of an emergency. We're going to cover all of that on the upcoming PSA Thursday episode.

So make sure that you hit subscribe or follow in whatever app you're using to listen to this podcast so that you don't miss this Thursday's upcoming public service announcement episode that's aimed at helping us all together get through this pandemic. As most of you know, I tested positive for COVID-19. I am recovering. As I've been recording this, I keep hitting pause and going into coughing fits. My microphone is probably a biohazard at this point. So, yeah, I'm recovering, but it's very slow. I'm still coughing a lot. I'm still fatigued.

I have a fraction of the energy that I used to have just a couple of weeks ago. But I'm one of the lucky ones because I am recovering and because I didn't have to get hospitalized. That makes me one of the lucky ones. And again, I want to thank everybody who has reached out with a message. of support. People have been so overwhelmingly kind and generous and supportive. So thank you to everybody. And I will see you in the PSA Thursday episode. I want to give a shout out to the sponsors who made today's episode possible, Billy, Policy Genius, Radius Bank, and Gusto. I'm especially appreciative of the sponsors sticking with us right now at a time when, you know, times are tough

for a lot of companies. We've had a lot of sponsors pull out. ask if they can cancel their contracts because they themselves are in a bind. So again, a big thank you to Billy PolicyGenius, Radius Bank, and Gusto. If you need any of their services, please show them your support. And for a complete list of all of our sponsors, including all of the deals and the discounts that they offer, you can find all of that at afford anything.com slash sponsors. That's afford anything.com slash sponsors. If you want to talk to other people in the community, this is a time when a lot of people are joining

together online to talk about how they are handling everything, from working from home, to finding sources of side income, to deciding what to do with their money if they should hold it in cash or invest it or use it to pay off debt. So if you want to talk to other members of this community about that, you can do so at afford anything.com slash community. That is a very active platform that we have in which our community gets together to talk about all of these topics and more. So again, afford anything.com slash community. It's free. And it's how you can connect with other people in this community to talk about money and work and life. Thank you again for tuning in. My name is Paula Pan. If you enjoyed today's episode,

please share it with a friend or a family member. And I will catch you in the PSA Thursday episode. See you there.