Animal Spirits Podcast - Talk Your Book: ESG Investing

Episode Date: December 11, 2020

On today's show, Michael and Ben talk with Brie Williams of State Street Global Advisors about the momentum behind ESG investing.    Find complete shownotes on our blogs... Ben Carlson’s A Wealth of Common Sense Michael Batnick’s The Irrelevant Investor Like us on Facebook And feel free to shoot us an email at [e-mail] with any feedback, questions, recommendations, or ideas for future topics of conversation. Learn more about your ad choices. Visit megaphone.fm/adchoices

Today's Animal Spirits Talk Your Book is brought to you by State Street Global Advisors. Welcome to Animal Spirits, a show about markets, life, and investing. Join Michael Batnik and Ben Carlson as they talk about what they're reading, writing, and watching. Michael Battenick and Ben work for Riddle's wealth management. All opinions expressed by Michael and Ben or any podcast guests are solely their own opinions, are subject to change based on market and other conditions and factors, and do not reflect the opinion of Redhall's wealth management, State Street Global advisors and or State Street corporations and its affiliates. This podcast is for informational purposes only and should not be relied upon for investment decisions. Clients of Ridholt's wealth management

may maintain positions in the securities discussed in this podcast. On today's talker book, we talked with Bree Williams of State Street, but all things, ESG, which is obviously a growing topic in the world of advisors for sure, but I guess investors overall. This is actually a topic that brings more extreme opinions than you would think would warrant just at face value, right? Yes. A lot of people are of the opinion that this is just nothing more than marketing. A lot of people in the investment industry, I would say, have strong opinions. Yeah. But I think regardless of what their opinions are and how it works and what the functionality of it is,

this is a real thing. Is it fair to say ESG is a form of factor investing now? I mean, it's too early to say that. But it's going down that path almost. where it is almost its own factor. Yeah, and listen, if the demand wasn't there, it's not like advisors are pitching this to their clients out of the blow. The demand is coming from investors. Yes. And I think young people especially, we get into it a little bit of the demographics here. I heard a stat the other day that in five years, 50% of all income earned across the globe

is going to come from millennials. Millennials seem to want to invest more based on their values than other generations did. Correct? I think that seems pretty reasonable statement. And whether companies or professional investors like it or not, ESG is going to be a thing. And it's going to continue to get larger. For example, the S&P 500 fossil fuel reserve free ETF, ticker SPYX. So this is a spider product. This thing had in the beginning of 2018, it was $230 million of AUM, basically. Now it's at 800.

Wow. So 230 to 800. So massive demand. Big number. So between ESG investing in index funds, the actively managed funds are not happy. This is like another thing to bolt on to index funds in some ways, right? I didn't even think about that. Yeah. It's like another thing to compete with. Now, I do wonder, how granular are these funds going to get? In other words, are you going to have S&P 500X something really niche? There probably be a lot of that. My guess is.

is most of the ETFs will stay relatively broad and you'll have a more customization at the direct indexing level. That would just be a guess. But certainly we could see a lot of ETFs take off. And it could be a kind of thing where like a them them them take off in a given year depending on what is doing good or bad in the market. A lot of it could be come down to timing luck about when stuff has released. I think one of the best use cases for ESG investors is if there is demand, strong demand from an investor that they want to invest, have their values aligned, whether or not it really matters in terms of them buying shares on the secondary market, they're not necessarily affecting the company, but fine, be that as it may. If it helps them stay the course

in a difficult market because they feel that they are investing with a purpose, then say whatever you want, but for me, that's a win. Yes. If it helps on investor behavior, I agree to that's a good thing. If it's going to help you hold longer than you would have otherwise. All right. So here is our conversation with Brie Williams. She is the head of practice management at State Street Global Advisors. Please enjoy our conversation with Bray. We're joined today by Brie Williams, head of practice management at State Street Global Advisors. Brey, thank you so much for coming on today. Absolutely. My pleasure. So ESG has had a lot of enthusiasm, at least certainly people were talking about it a lot, really over the past decade. But now people are actually putting their money where their mouths are.

We have seen a tremendous amount of inflows into ESG funds, ETFs, active funds, etc. In 2020, I think a good place to start would be, how has ESG funds evolved over the years? Well, your introduction is spot on. ESG is clearly an evolving space, and it's still relatively small. from an asset-based and product offers standpoint. However, the development is becoming much more dynamic and much more diverse. We see products launching, we've seen production issues in the space. We also see conversions as existing products to ESG.

If we were to look at some bright spots, where the assets are, most of those are in equities. Flows here are favoring broad ESG strategies over dramatic solutions, and we see a noteworthy shift is reflected by trends in assets of the management, flow. new product development I mentioned, and, of course, there's some closures in the thematic ESG ETF area. We also see the industry trending towards lower cost solutions. For evidence, with over 50% of the US ESG ETFs launched in the last two years, having a net expense ratio under 20 basis points, what that clearly says is you don't need to pay a premium to access an ESG product moving forward. And we're seeing the same management fee for both the ESG and the non-EASG

and the non-ESG version. And then the last area is with the advent of ESG ETFs, all investors now can access ESG in a cost-effective manner, which might not have been previously possible. So I think it'd be fair to say that ETFs are helping democratize access to ESG, which is enabling both the large and small investor to be in a better spot to realize their investment objectives. The whole idea of this environmental, social governance,

it can be pretty broad at times and hard for people to, really drill down. Is it actually becoming harder for people to define this stuff or it's becoming easier because there's more options to invest in? How do you think people are really trying to invest in this universe among those broad categories? The jargon's certainly been challenging. So your observation is absolutely fair. There's wide ranging ESG definitions. There's continuous debates about their terminology as well as the data. And there's an explosion of investment choices. So all of that is creating unfortunately more confusion than conviction. But when you look at the number of ESG options that are now available, you really see a reflection

of the diversity of investor objectives. Those can range from, I'd like to avoid or reduce my ESG risk, I'd like to seek measurable impact, and or I'd like to pursue better investment outcomes. Now, these motivations and goals are unique for all of us as investors. So ESG is definitely not a one-size-fits-all approach. To give you an example on that, some investors we see they can be focused solely on a financial return where others are going to value non-traditional benefits such as targeting a social or an environmental outcome as well to the point you raised earlier. So when you look at these objectives and how much they span the different ESG strategies, they vary. And they're also not mutually exclusive. You can combine multiple ESG strategies within a single investment vehicle to achieve the individual investor-specific goals.

Furthermore, you can use these strategies across different asset classes, different investment styles, as well as investment vehicles. So really understanding what is someone trying to achieve their desire to investment outcome is the best place to start. Do we know who's driving interest here? Or flow is being driven by advisors because their clients are asking for it? Is this being driven on the retail end? Where is this interest being derived from? I think the truth lies a little bit in the middle. It's a push-pull.

So you have strong demand coming from the end client, the individual investor. There's increased engagement and interest in all things, ESG investing. And in kind of respond to that kind of demand, financial advisors are working quickly to get up to speed on what ESG investing is, how to best implement that in their clients' portfolios with a long-term in mind. So we have that push-pull happening when we look at adoption. Do you find that's happening among eight? I mean, it seems to me that this would be more adopted by young people. I don't have to back that up.

Is it their demographic-based here? We can't back that up a little bit. You do see a stronger poll of interest coming from your next-generation investor. However, they're not alone in that design. to make an impact. The type of impact, of course, is where you start to see variation play out. When I look at 2020 and you're asked about younger investors being more interested, yes, would be the simple answer, but I think you'd be remiss not to recognize that they're not alone. So if you look at what happened in 2020, the human tragedy of the COVID pandemic that's been

unfolding, the increased focus, the need to address systemic racism, and this forced togetherness that COVID has provided, families are having real conversations about personal values. So this growing dialogue between parents and children, for example, flow very naturally in conversations about philanthropy, planned giving, state planning as ways to enact real societal change. So ESG can be a values bridge across the generations. Some statistics to shine the spotlight back on millennials and just to define who millennials are. You are a millennial if you were born between 1981. to 1996. We clearly see evidence that says they understand the benefits of ESG investing more so than the other generations. Eighty-seven percent of the high net worth millennial

looks to a company's ESG track record as an important consideration in their decision about whether to invest. 90% of millennials want to tailor their investments to their values and 75% of millennials indicate that it's important their financial advisor assists them. with ESG investing in their advice relationship. So I think it's a pretty strong statistics there. So speaking of statistics, in one of your reports, which we'll link to, 69% of ESG investors say that ESG has helped manage volatility. I don't know this empirically, but I'm pretty confident that that's not necessarily true, that if you're investing in the stock market, whether you have an ESG bent or not, you're getting volatility. However, there can be a huge, even if you believe it, then it's real.

So, in other words, investing based in your values matters, I think, if it allows you to stay the course during difficult market environments because you believe in what you're doing. What do we think about the non-quantifiable, non-monetary benefits of investing with your values? You're right. Perception is reality, and we can never lose sight of that. But it's encouraging to see that individuals believe that ESG will help them stay the course. And another statistic that popped out for my team, in particular, on that record was this no compromise approach when it comes to an investor's performance expectations

when they align with ESG and incorporate that into their investment plan. You see over a third of investors saying, yes, it's possible. I believe I can achieve market rate returns, investing in companies based on their social or environmental impact. I think that's pretty powerful, followed up by their desire to increase their allocations. So we see signaling in the U.S. a quarter of U.S. investors say, I'm going to be increasing my ESGA investment allocation over the next 24 months. And when you look at that outside of the U.S. to a global level, you see strong interests from two generations, millennials and Gen X, who are likely to increase their allocation levels over the next 12 months. So you can see the tangible difference they want

to make. They're not willing to trade off the outcomes that they need to successfully live their financial life on their terms, both in where they are on the journey today and where they want to be on the journey 20, 30, 40, 50 years from now. Do you find that investors that are interested in this space are going for certain factors, or is it more just the general ESG overall and they just hope to get a better tilt into their value? So how niche down are people getting in terms of what they're looking for when investing in their values? You can get pretty specific. So at a broad level, trends have been more focused on environmental aspect of the analysis, particularly when it counts to things like climate change.

We also looked at 2020 and a response to our social justice and a push for a greater diversity. Those have resulted in a broader emphasis on racial issues. And we see that in the institutional and environmental as well. Do you look more granular and look at what's popping 40 ES and G? I pulled for our conversation today three issues of importance in each of those. So at the environmental level, what's rising to the top as a priority area for the individual investor is climate change, resource management, and pollution. For the S, the social, that's working conditions, health and safety issues, and impact on local communities. And then for the G, that's executive compensation, lobbying effort, and philanthropy.

Just for clarification, those results were pre-grant damage. How sensitive to performance do we think these investors are? One of the reasons why ESG, and this is a very overgeneralization, why ESG might have had a good year in 2020, not just in terms of flows, but in terms of performance, is because the most toxic stocks, for lack of a better word, are the energy companies. They're not going to make it through many ESG screens, and they've performed terribly. On the flip side, a lot of the clean energy, the solar companies have had an incredible run. 2020, ostensibly boosting performance. How performance sensitive do you think investors are both on the upside and the downside? In other words, are they chasing and are they going to bail if these trends reverse?

Performance is always critical, whether you're talking about ESG or other aspects of investment management. So I think that the subject that you're really getting at is will the implementation of ESG investing in my portfolio to come down to if I'm investing for my values, I do or do not have to give up performance returns. So if we look at that intuitively, most investors would like to conclude, to your point,

the companies that have stronger ESG practices would outperform the broader market over the long term. Yet when you start peeling back some of these layers, those same investors are expressing hesitation because there's still a bit of that little fear that says I'm implementing ESG investing. And if I do that in my portfolio, I am going to make a sacrifice.

But when you look at the performance at a market level earlier this year is a good proxy, and I'm leveraging Morning Stars data here, more than 70% of the ESG funds across all asset classes performed better than their counterparts during the first four months of the year. So what that shows us is that ESG integration may provide downside protection when markets are struggling. And that underscores ESG's potential role as a long-term investment. So, I think we're being reminded, of course, past performance, never guarantee a future results. But we believe that enhancing returns isn't and shouldn't be the motivator for ESG investing, but rather the focus is on that long-term risk management.

One of the biggest areas of pushback you get from people on ESG is that, well, you're not actually giving money to a company or taking it away. It's money that's traded on the secondary markets. But do you find that the way that money is flowing into ESG companies now that it's actually changing the way that companies structure their governance. So companies are trying to implement some of these different characteristics just so they can be on some of these screens potentially. ESG definitely has an impact on corporate governance and good governance is not only important for corporations, but it's important for society.

So if we back up a bit when we look at what's been unfolding this year, obviously, and not specific to just this year, but you look at any corporate scandal, it sheds a light on the fact that corporations have on social responsibility. So this year, there's a renewed focus on corporate social responsibility, and you're seeing corporations increase their pressure that they're applying on themselves to improve the best practices for corporate governance with the goal of enhancing their relationship with stakeholders. And the reason they're doing that is good governance ultimately will foster sustainability. It will create sustainable values.

And it ultimately can help companies achieve their values. So they recognize they have long-term benefits here at stake, and that includes their ability to reduce risk. They want to continue to attract new investors and shareholders, as well as increase their company's equities. So this is a responsibility that they recognize they have. More importantly, it's accountability to their stakeholders. Why do we think that ESG companies are going to perform better in the marketplace?

Like what sort of correlation is there between companies being more sustainable? in their waste practices, for example, and pick anything, why do we think that that would lead to better returns? Good choices, assuming you have that good governance, the structure of your societal influence, your environmental influence, your financial responsibility. If you're using the ES&G factors as a lever to improve your decision making, then hopefully you are standing tall as a company that will be able to take both the short-term storm and weather that well, as well as continue to be successful with the long-term in mind. So using those EDS and G factors, both as the investor's guide to,

will this company be an investment for the long haul with the practices they have put forward, or will they not be in a good position? Will they have vulnerability? We saw several companies be very vulnerable to what happened due to, to the global health pandemic because they were not in a good position with how they were operating to weather what came their way. Those can be flags that an investor can use, and in kind, company can use that to help them show up where they're weak and build on some strengths that they have. When it comes to advisors that are implementing this on behalf of

clients, there's obviously a learning curve here. How do you advise advisors to talk to their clients about this stuff in terms of getting them comfortable with it and setting the right expectations for investing in this stuff? It does take proper education, both for the implementer and the investor and client that's behind ESG investing. The foundation of what are we trying to achieve and clarifying their goals is critical. Motivations are going to be highly unique for each investor. And there are different outcomes and success measures that will come into play. ESG is deeply personal. It is about both value and values. And I think when you start implementing ESG into one's portfolio for that end client, how do you help them assess their priorities? So they're

doing right by the type of capital they have to invest, but they're also motivated by the long-term possibilities of how ESG not only improves their decision-making, but can help them achieve those desired income. So their end clients going to be looking for, how do I measure this? How is this in alignment with my risk tolerance? And what type of approach are we using to achieve our end game? So if that person's objective is increasing gender diversity in the corporate boardroom, you know, an unexpected question of them when you're looking at the portfolio on an annual basis, how have we helped move the needle? How has my contribution made an impact? It may not get to down to the exact dollar amount that that individual played, but you certainly can put it to

a higher level of, in that case, as stewardship of improving corporate diversity and board level you can show progress that's being made. And the companies that are talking about index product there in that index that have made a difference. It seems like there's so much mass adoption that the lines of ESG are almost being blurred where we're going. Like every company in the S&P 500, for example, is going to adopt some sort of ESG framework. How do we think that's going to impact products in the future that screen for companies that are more responsible on the ESG front? When I look at impact on investor appetite to get at your question, the world is changing,

investor-engagement is growing, data and analytics are evolving, and our strategies are improving. So you see this acceleration. When I look at what a key driving factor is behind the start, it's most likely that investors demand for clarity, but it comes to, say, a company's stance on social issues as well as significant financial consequences as we were talking about that a company can face if they fail to adapt to changing consumer behavior. With all of that progress, we still have a lot on the table to address, for that we have these long-term sustainability targets, and the growing focus that investors have on them, demands that they're

asking us as investment managers and if the companies they're choosing to cast their dollar vote in the change they wish to see in the world, that's really starting to have an impact. So the current environment has highlighted the importance of integrating PSG factors into investment decision-making, but it's also drawn a harsher light on the fact that we have a lot more work to do when it comes to data, consistent standards, and definitions around the flow. If I were to take that one step further, I'd say this is about deeper insights into what it really means for clients and their portfolio needs. And as we come up with those definitions, how much more customization do you think we're going to see in the future? Are we still just kind of at the tip of the iceberg here?

Is there going to be so many more choices for people in the future that want to invest in specific areas? I think one of the durable trends is shaping the investment management industry over the past decade is that investors do want more choice. However, as ESG investment choice, this increase, the behavioral finance paradox of choice has resulted in some more investor inertia. I think we can all recognize that. When we look to growth forecasts in ESG and we see those skyrocketing past our post-pandemic environment, you have investment managers flooding the marketplace with new products to meet that growing demand. But it isn't necessarily about launching hundreds of ESG funds and hope that something will catch fire because that's not really serving

the ESG investor well. So greater choice isn't necessarily a better choice, but the choices absolutely need to thoughtfully align with what are the investment goals, whether that's managing risk, aligning investments of values, pursuing sustainable performance. And I think the tailoring to your question comes into the implementation. And that specifically needs to be aligned with what their role is. How do you best integrate the ESG principles effectively for that individual or that family? And is there a need in that particular individual's case to optimize ESG investment opportunities across a range of asset classes and or at the risk spectrum? So tailoring lies in the implementation. When we talk about ESG ETFs, typically I think about equities, but what about adoption on the fixed income side?

And I don't know if you have the answer to this at your fingertips, but has State Street studied at all the borrowing costs of companies that are more ESG? oriented, and do they have lower barring costs? I'd be curious about that. Me too. I don't have the answer for that one for you. But in terms of like fixed income adoption, is that a thing? Yes. Fixed income is a growing space for ESG investing. Again, most of the flows and assets line to equity space today. Fixed income, there is room to grow in terms of the number of solutions, the types of solutions in fixed income in the broad ESG category specifically. I have one more question. No, go ahead.

As we spoke about earlier, there's been just massive flows. We've seen $170 billion in assets, ESG, ETFs, and indexed mutual funds, expected to hit $1.3 trillion by 2030. Are we seeing any of the flows affecting the prices of the underlying securities? Again, that might be another unanswerable question, but what do we think about that, generally speaking? There's a bit to unpacking that question. First, flows are a very dynamic story. PSG ETF flows particular on pace for a record year, which potentially signals a long way to pay out for the products after years of pipe and muted for us. To put a number to that, if you look at sustainable funds globally, they attracted an estimated $45.7 billion in net flows during the first quarter of 2020, even as we saw the overall fund universe suffer $384.7 billion in outflows.

So specific to growth, the tipping point seems to have occurred in 2019 with net flows into open-ended and exchange-traded ESG funds, topping $20.6 billion. Why that number is important is that's four times the amount those funds attracted in the previous year. To answer your question about costs, one of the objectives we hear often from the end client, the individual investor, there's this perception that ESG investment is expensive. It certainly can be, but it doesn't have to be. Generally, ESG funds require managers to do the research. They're often working with a smaller asset base. So an individual investor may have to pay more to be in them. That's not to say, however, that all ESG funds are expensive because they're not.

The average U.S. actively managed ESG mutual fund has a total cost that is three times greater than the total cost of the average ESG indexed ETF on an asset. a weighted basis. So when you look to where investors can increase their allocation to ESG, we believe they'll do so through cost-effective ESG ETFs that can make those investment strategies once available to only the largest investors, available to everyone. So you mentioned that the tipping point might have been 2019. Like so many other things, as 2020 the Accelerant then, that you've seen this big push because there's been so many social issues brought to the forefront this year? Yes. We want to take away a silver lining of what happened to

2020, I think that one's a good one to end on. It is really shine a light on this being more than just a do-good mentality. It has put forward this new compromise approach when it comes to performance expectations. And the increasingly number amount of options that are available today are really reflecting back to the diversity of the objectives that investors have. So you see them in some looking at avoiding and reducing the ESG risk, seeking that measurable impact or pursuit of better investment outcomes. And we've seen a shift away from the thematic solutions and more into the broad ESG, which shows us the potential for that broader integrated approach when applying and adopting

ESG investing. Brie, thank you so much for coming on. We really appreciate your time. My pleasure. Thanks for having me. All right. Animal Spiritspod at gmail.com. Thank you for listening.

And we will see you next time. I don't know.