ETF Edge - ESG & Consumer Confidence

Episode Date: June 1, 2020

CNBC's Bob Pisani spoke with Mona Naqvi, head of ESG product strategy at S&P Dow Jones Indices, and Tom Lydon, CEO of ETF Trends to discuss ESG's recent outperformance. Hosted by Simplecast, an AdsWizz company. See pcm.adswizz.com for information about our collection and use of personal data for advertising.

Welcome to ETF Edge, the podcast. If you're looking to learn the latest insights on all things, exchange-traded funds, you're in the right place. Every week we're bringing you compelling interviews, market analysis, and breaking down what it all means for investors. I'm your host, Bob Pisani. Today on the show, we delve into ESG, Environmental, Social, and Governance Funds, what it is and why it's outperforming the broader market so far in 2020.

When we see that momentum continue? It's a very timely discussion. Don't miss it. Here is my conversation with Tom Leiden. CEO of ETF trends, and Mona Nockvi, the head of ESG product strategy, North America, at S&P Dow Jones Indices. Mona, let me start with you. Can you address, and I'm wondering, I don't want to stretch this analogy too much, but could you address ESG in light of the protests that have been gone,

going on over the weekends, particularly about the need for more inclusiveness. That seems to be a major issue of the governance part of ESG. But I wonder if you can explain how you can incorporate some of those concerns, obviously, people. people have expressed in some of those protests? Absolutely, Bob. You know, I think what these protests are demonstrating is that people really do have very strong convictions about these types of issues.

They really do care deeply about all of this. And ESG is investing. It's just another channel through which people can align their values with their actions by incorporating these types of considerations into their investments. In terms of how we look at ESG, when it comes to the S&P global ESG scores, we do take into account things like how companies are behaving.

with respect to their overall stakeholders, so not just their employees and their shareholders, but how do they interact with their broader community, which is really important in terms of building goodwill in times of stress like this. It's also important through ESG to take into account things like diversity. You know, how does a company actually hire, what's hiring practices, is it diverse throughout?

It's a broader business operations. And I think these are all the types of issues that these protests are demonstrating are very important to many people that ESG can help help. Yeah, and I want to get back to that. I want to talk about some of the philosophy behind ESG. But Tom, I want to just turn to you. I wonder if we've seen inflows this year in ESG. We've seen them for the last several years. I used to say two years ago that everybody talked about it, but nobody ever did anything about ESG. It was like the weather. Everyone complained about it. Nobody ever did anything about it. And that note, it didn't attract much money. Now it is attracting money. It has been in Europe for a while, but even in the United States. I'm wondering if the events we've seen over the weekend will accelerate that. interest. I don't want to try to stretch this analogy too far about what's going on with the protests in ESG, but there is some kind of tangential relationship, Tom. Is this going to bring even more money into that and maybe even accelerate more discussion about environmental, social, and governance

issues around investing? Well, Bob, I think you're right. I mean, it comes at a difficult time, as many companies are struggling with the effects of COVID-19, but there's never a better time to improve corporate values. And obviously, their racism has... has no place in America in the events of last week, kind of give corporate America an opportunity to reaffirm that their clients, their employees, their shareholders, where they stand on this. So I think we'll come out of this on the other end much better and with a greater commitment to both environmental, social, and governance issues. As you point out, we've seen some good flows so far this year, but up until last year, there's a little over 20 billion in ESG ETFs in the U.S.

which is a bit of a head-scratcher. So many financial advisors have had interests, but haven't made the commitment. I think coming out of this, not only are self-directed investors going to be more committed, but advisors are going to be more committed because their clients are going to demand it. Yeah. $20 billion, you said, it was a bit of a head-scratcher. You mean a head-scratcher in that it's a fairly low number, $20 billion still, compared to what we've got invested at $3 trillion in ETFs in general,

and, you know, a $35 trillion equity market at this point in the U.S. Well, there are many choices, and that's the idea. Today, when people take a step back and say, okay, how committed am I to values? And now, as you look at how much money is allocated to the S&P 500, for example, how much is allocated to high correlation of the S&P 500, it's in the trillions of dollars. But now with all the choices between all the ETF issuers out there, all the index providers out there, the money managers out there that all have their own versions of ESG, there are a heck of a lot of choices.

And with the fact that you can take allocation to the S&P 500 and shift it over and not have to pay a lot of money, 11 basis points, for example, and actually in some cases have better improvement in your portfolio. deal. Yeah, yeah. Mona, I know you have repeatedly said that the purpose of ESG is not to try to outperform the indexes or the S&P 500, and I agree with you that should not be the purpose, but it is actually outperforming this year, which is always a nice little thing. And I'm just looking at a couple. I know the X tracker is S&P ESG, because it's indexed to the S&P 500 that you run S&PE. That's only down, oh, about 3%, 4% this year. The S&P is down about

about 6%. So on a relative basis, my point is the ESG funds are generally outperforming, including the one that your firm tracks here. I think the problem that I have always had with ESG, and the problem people sort of come up to me and say, you know, Bob, this is nice you talk about ESG, but if you really look at what's in these things, they're basically mega-cap growth funds, essentially. So even in the SNPE, it's Microsoft is the largest holding, Apple, Amazon, Alphabet, and Visa, that really is quite a mega-cap. It's mega-cap growth. It tends to be tilted towards technology, underweight energy and industrial. I guess that makes some sense if you think of what ESG is, but what do you say to people who say, oh, yeah, this is a tech growth fund,

essentially? Is that a fair criticism? Or what's the right way to look at this? Look, when you think about something like ESG, it still means different things to different players. And that's okay. You know, as an index provider, we continue. muta cater to the needs of various different investors through a spectrum of ESG indexing solutions. What we're offering with the S&P 500 ESG index is a sustainable alternative to the iconic S&P 500, as Tom was speaking to you earlier. So at very low levels of cost in terms of low levels of tracking error, and the objective of this specific index is to offer comparable risk in return. It's welcome that actually over the past year we've seen some upside performance, which is great to see,

and that this has been driven through a rules-based selection criteria that is in driven by ESG principles. But in terms of the overall sector allocation, sector exposure and allocation, the objective of this index is to sort of be broadly sector neutral through its index design that lends itself to similar levels of comparable performance. But notwithstanding this tool, you know, there is a lot of evidence out there that suggests that ESG can indeed drive out performance. So it really depends on how the ESG data is being integrated and what you're trying to get out of it. But in our instance, what we're trying to do is

really offer a core replacement. So for any investor that would otherwise look to the S&P 500 for getting their core U.S. equity exposure. This version that offers numerous measurable positive impacts from an ESG standpoint, offers at least similar, if not better, as we've seen, in terms of returns, which makes it a very compelling tool that helps to dispel the myth of an ESG versus performance trade-off. I guess the question, though, is in terms of like saying, well, look, people say cynically, Bob, why is, you know, alphabet considered a great ESG company? I guess the answer simply is that on the metrics that we are using and measuring, environmental, social, and governments, and with the way it is weighted, they are indeed better companies, and they do have a better weighting. Isn't that the answer? Now, you can say, well, we should change the way they're weighted, for example, ESG, or we should change the criteria, or how we quantify that. But isn't that the answer? The reason they're weighted heavily is because they do indeed perform better on the scales that you have created around them, around environmental, social, and governanceization.

Well, so here's the thing. When it comes to ESG, it is actually a very industry-specific thing. So while ESG, coming back to this kind of initial question of how this relates to what's going on at the moment, ESG is about aligning your investments with your values, but it's also much broader than that in terms of simply incorporating more information into the investment process for generating value as well. And so when you take a very industry-specific view on ESG, you're looking at non-traditional sources of information that are considered extra-futable. financial to various different industries that are still financially material. So you're not necessarily judging a tech company by the same standards. You're judging an energy company because they have different risks and opportunities that are relevant to their specific industry. E.S.G is simply the practice of putting more of this information into the mix and making a more informed investment allocation decision. It just so happens that a lot of these issues tend to align with people's values as well. So when you're looking at something like Alphabet or the various different companies you mentioned on what it is that makes them better than some of their industry peers, you're

looking at an industry-specific relative comparison. Do they perform better on those environmental, social and governance issues that are more relevant to the long-term success, sort of financial success of those businesses relative than their industry peers? And really, that's what ESG is ultimately about a more informed investment decision making, that it takes all of this information into the mix. And Bob, if I can add to that for a second, just a couple points. When we talk about the outperformance, it's because of the reduction of the energy stocks, and we know what's happened to energy stocks, we know what's happened to oil prices,

and they may not be out of the woods. Unless oil gets back above 50 bucks a barrel, oil companies are going to have problems, and they're maintaining these high dividends at the risk of losing long-term shareholders. if they don't maintain them, which is digging into their cash flow. I mean, you and I could talk 10 minutes on that. At the same time, pointing out the high conviction, some of the companies, for example, in S&PE, those top four companies account for 25% of the market cap. It doesn't mean that they're doing that because they have more conviction there.

It's because they have less conviction on the energy stocks, which allows them to have more allocation. to the right companies in those areas. Right. But, Mona, I would note, you're not eliminating oil stocks, for example. There are oil stocks in the ESG index, right? Precisely, yeah, I was just about to say that actually, as I mentioned, every ESG index has a specific objective,

and the objective of this index is to as closely as possible track the underlying S&P 500. And so with that comes a similar level of sector exposure that you get with the 500. Instead, what we're doing is targeting the best, performance or rather removing the worst ones within index industry groups. So what you end up with is something that is broadly sector neutral, you still have similar levels of exposure to energy companies that you have with the S&500. It's just that you've got exposure to the ones that are better for any of the system. So the point here is that Exxon might be by market cap, the largest stock in the S&P energy

sector, but in fact in your index, I'm not sure about it, but Occidental might actually have the biggest weighting because it outperforms on ESG metrics. Am I correct on that? So actually, the weighting is based on free float-adjusted market cap. So it's really just a rules-based selection criteria driven by ESG principles to determine whether a company is in or out. And once they're in, the weights are redistributed according to their market cap. So if you have a big weight in the S&P 500 and you make it into the S&P 500 ESG,

you're going to have a big weight in there as well, perhaps even a bigger one. Yeah, I get. So I guess, Tom, the key point here is, is all of this going to provide an additional boost to ESG? I think we've heard about the growing interest in it. I've heard about the commentary around it, that is it really capturing everything everybody needs? And as you see, Mona says,

you can do a lot of different things, you can be a lot of different things to a lot of different people. Do you think the investment in ESG this year is going to increase significantly? You mentioned the rather small sums that still exist there, Will we see a double this year? What will we see this year? Well, it should at least double, Bob.

And, you know, as you know, we're talking with advisors who are coming to ETF trends and ETF database all the time. And you're starting to see just by the nature of them reading more ESG-related stories and looking at more ES3-related ETFs and digging down into their makeup, that there is definitely more interest there. The fact that there's been a little bit of outperformance is, is also great. And then on top of that, the higher conviction to work from home companies, companies that are doing more business online like Amazon, just look at, from a comparative

standpoint, the NASDAQ 100, 47 percent of that allocation there is with Fank stocks and Microsoft. And those are the companies that not only are doing well in this coronavirus environment, but probably coming out on the other end of this are going to continue to do well. And if those have high ESG scores, which they do, that does nothing but help improve the confidence of the average investor there. If they can not only invest in good companies from a profitability standpoint, but good companies from a value standpoint, it's the best of all worlds. Yeah. Mona, people ask me this all the time about what exactly, you know, you know, determine the weightings to be in these. So we know this vague phrase, environmental, social,

and governance. Can you tell us with this particular index, how much does environmental count versus social versus governance? It is a one-third, one-third kind of thing. I often get comments like, Bob, you can't really quantify this. A lot of this comes out of qualitative analysis, like what the company's perception is in the public's eye or things like that. Is it possible to quantify, to, excuse me, quantify what is essentially qualitative analysis. I know you're trying to do that, but do you feel you've been getting better at it? And briefly describe how the weighting goes in environment, social governments in this particular index we've been talking about. Precisely, yes. So what you've just touched on is really the difference between, what I would say,

a two schools of thought on this. Some do you take an equal weighted approach to ESG, primarily those that have a very strong desire to express their moral values through their investments, where they hold all of these issues equally important. But the second is a materiality-weighted framework. So if you come back to this definition of ESG as I do, which is that rather than simply or solely values-based investing, it is the practice of incorporating more relevant financially material information into the investment process, happens to align with our values in some cases.

But it is, in fact, very relevant to the overall. financial performance of companies, and this isn't necessarily something that's traditionally captured by standard financial analysis. So once you take that view of ESG, then you start to understand why sometimes different issues will matter differently to different industries. We might all care about something like gender diversity, but it's not necessarily the most financially relevant issue for all different types of companies. It's going to matter a lot more for those companies where having a more diverse workforce is really important for thinking through different scenarios more creatively. So it would be better for companies that have heavy exposure to R&D

or risk management. So you can start to see how there is a real mechanism or channel through which ESG can be financially relevant. So our approach at S&P Global is to take a financially material approach to this. We're really fortunate that the scores are based upon the renowned SAM corporate sustainability assessment, which we acquired this year, formerly part of Robico Sam, an asset manager. And so their approach to defining what is the most financially material issue. industry by industry has been honed over more than two decades of real-life investment data. So looking at the portfolio and seeing what works and what doesn't work from a materiality standpoint in order to warrant its admission into the overall scoring process,

whereas a lot of other ESG data frameworks sometimes rely on purely academic or theoretical approaches to defining what is material. But make no mistake, ESG is about financially material information, even if it comes from non-financial sources. Yeah, so your point is that you can, quantify this stuff, even if it comes loosely from a qualitative analysis. Tom, Moeem made a good point. I think it highlights the strength and the problem with ESG, which is, the problem being is it can be a lot of different things to a lot of people. Her point is

ESG actually incorporates a fairly wide series of metrics. Some of that would be diversity and inclusiveness. But if you're a person who says, oh, I'm looking at these protests, I want more diversity inclusiveness, I'm going to go to ESG. You may or may not be getting all of that, where you may only be getting it in a very small parcel. Do you understand what I'm trying to say? Because people can ask me about this with different social metrics. And I'm saying the problem I've had with ESGs, it can be a lot of different things to different people. And index providers have different scoring methodologies as well.

Managers have different scoring methodologies as well. But I think the key thing here, Bob, is there's more discussion about it. There are more people interested in. But there are more people writing about it. Based on what we've gone through this last week, it's going to be interesting, Mona, to see how corporations actually try to integrate some of these global concerns that we're seeing right now into their corporate governance and what comes on. And I think, Bob, to your point, companies will be more vocal about it. I've actually talked to a few corporations this past weekend were involved in the retail space that were affected by looting. and you know what, they're very compassionate.

You can imagine that they would be upset about what's going on, but they're compassionate to what's going on with Americans and racism. And I think we're going to see this opportunity where corporations are going to step forward, and they're going to say, we've done this so far, but maybe it's not enough. We're going to take it a step further. And folks like Mona and their ratings will really, really be helpful in guiding these corporations to do it. in the right thing.

Mona, final word with you. Just give us the little, tie a little bow on this whole thing. Do you agree that the events over the weekend, however unfortunate they are, particularly the looting part, is going to accelerate interest in social justice and inclusiveness, and ESG will be a beneficiary of that in some way? Or do you feel that there's sort of tangential issues? More so than being a beneficiary, I think ESG is going to be the tool. It is the roadmap that is going to allow investors in society more broadly to hold companies to account to make sure that the issues we care about throughout society, be it social justice, be it inequality or diversity, or whatever it may be, is actually reflected in the companies that we're investing in.

And ESG is rather the toolkit to allow us to do that and make sure that companies are held to account. And we actually have some ability to influence them through our investments. Thanks very much. Very stimulating discussion. Very timely. Now it's time to round out the conversation with some analysis and perspective to help you better understand ETFs with our Market's 102 portion of the podcast. Today we'll be continuing the conversation about socially responsible investing and why the space is gaining traction. Once again, my producer, Kirsten Chang, joins me now.

Bob, let's hone in on ESG, one of the hot topics, of course, of today's show. ESG stands for environmental, social, and governance, and it's been gaining serious traction in the wake of the coronavirus. Why is that? What's the narrative driving investors to pour money into ESG in these turbulent times? Well, ESG has done a little bit better in the last few months, but it's not because of any particular magic of ESG. I have a sort of love-hate relationship with ESG. I mean, the reason there's a modest outperformance is ESG, environmental, social and governance,

is heavily exposed to things like technology and health care. And the companies that they own have been less exposed to, you know, the social distancing, in lockdown measures here. So if you look at like some of the big funds, what do they own? The big ESG funds. They own Microsoft. They own Google. They own Visa. They own Procter and Gamble. These funds have all, these stocks have all done great. So it's not because they're brilliant. It's just because they own stuff that's in telecommuting and telemedicine and those trends are accelerating. So I think that's good. So the other thing I would say that why they've outperformed is most of them are not heavily invested in the oil and gas sector. And that's been a terrible

performer. That's another reason the S&P has, you know, had trouble, even if it's only a small percentage of them. So in general, if you want to make a generic comment, ESG does tend towards companies that have what you call higher quality. They have better balance sheets in general. They tend to operate more efficiently. So there's some reasons why. I mean, look at some of the big ESGs. They all own Microsoft. They all on Visa. It's kind of funny what they own. It's like high-quality mega-caps. With that said, I have some problems with ESG. It's a very, very fuzzy business. Remember, there used to be three ways to analyze stocks. There was three buckets here. There was fundamental analysis. And then there was technical analysis, which is based on pricing.

And then there was what we call quantitative analysis, which is based purely on numbers, relationship between stocks and whatever other data people could find a relationship. It was purely numbers. ESG came out of a fourth metric that was very fuzzy. We used to call it qualitative analysis. So qualitative analysis uses just subjective judgments like brand association or how perceptions of how the management is doing or their trustworthiness or customer satisfaction or the company culture. These were very fuzzy metrics. So what ESG is done is they're trying to quantify these fuzzy metrics. And then they try to expand them into a broader web that includes social and governance and environmental. So they try to talk about the company's interaction with the environment

and other social metrics like inclusiveness or the company's composition of the board, for example. Well, you can see what's happened here. Out of these qualitative analysis, which is really fuzzy, you couldn't put a number on it. You expand it out and then you try to quantify it a little bit. That's essentially what ESD is. Now, I think it's terrific. I back the goals and the concept behind it, but it's still a very fuzzy concept,

and they're still trying to figure out how do you actually measure this stuff very well. And if you really get into the weeds on this and nuts and bolts, you find it's not that easy to figure things out. I mean, you could have a simple metric like saying, oh, we want 50% of all the people on the board to be women. Most of them don't have those kinds of metrics. They're a little fuzzier.

And my point is, it's a lot better than it used to be, this fuzzy qualitative analysis. ESG is an improvement on that, but it's still got a long, long way to go. And if you really look at these funds, most of them, just mega-cap companies that are known to have good management. Well, that's nice. It's called quality. That's good. But I think that's my point here is I support ESG and I support the concept. There's a reason it outperforms because they own high-quality companies, but it's still a very fuzzy business.

It's gotten popular because people think, oh, yeah, of course, I support environmental responsibility. I support social responsibility. I support more women on the board. Of course, who doesn't support that? But a lot of companies are going towards that direction regardless. So let's keep an eye on it. I think it's a great thing. People are generally in favor of it, but let's not get too overly enthusiastic. And let's keep trying to refine the metrics a little bit. That's it for today. I'm Bob Bizani. Thank you for listening. And make sure you tune in next week. And in the meantime, you can tweet us your questions or topic ideas at ETF Edge, CNBC.