ETF Edge - Examining ESG, What's Ahead in 2021

Episode Date: December 14, 2020

CNBC's Bob Pisani spoke with Morningstar’s Jon Hale, MSCI’s Linda-Eling Lee and Main Management’s Kim Arthur. They discussed the world of ESG - environmental, social and governance - what's behind the boom in assets this year, what's ahead for 2021 and why all ESG funds aren't created equal. In the 'markets 102' portion of the podcast, Bob continues his conversation with Jon Hale from Morningstar, 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 while you are in the right place. Every week, we're bringing you interviews and market analysis and breaking down what it all means for investors. I'm your host, Bob Pisani. Today on the show, we'll be delving into the world of ESG, environmental, social, and governance with three experts in the field of ESG.

We'll talk about what's behind the boom in assets this year, what's ahead for 2021, and why not all ESG? funds why they are not all created equal. Here's my conversation with Kim Arthur, the CEO of Maine Management, John Hale, the Global Head of Sustainability Research at Morningstar, and Linda Elling Lee, the global head of research for MSCI's ESG Research Group. Linda, I want to start with you. Can you just sort of sum up ESG developments this year?

I find it rather extraordinary. Two years ago, everybody was interested in ESG and there was really no money attached to it. That's really changed rather dramatically. thoughts as we end 2020 and some brief thoughts on 2021. Oh, absolutely. So 2020 has been an extraordinary year. We were not necessarily expecting this to be the year where ESG really takes off, but clearly it has attracted a lot of attention, both in terms of the companies and what they're doing from an ESG perspective, but certainly from a flows point of view. In terms of going into 2021, we did just publish our annual ESG Trends to Watch report and really at the top of the list of what

investors we think are going to be paying attention to in 2021 is actually the topic of climate change. And that's because, you know, despite all the lockdowns that we've had this year, we're still on track for a world that is going to be too warm to sustain life as we know it, according to climate science. And so, you know, I think that, you know, the climate, the Paris climate agreement, which was signed five years ago, you're going to see lots more investors really shifting capital towards less carbon intensive assets. So I think that, you know, one of the really big focus areas will be in climate change. Yeah, I want to return to climate change and some other issues.

I think are going to be hot like diversity. But, John, I wonder if you could just comment on just the whole ETF business and what's going on with ESG in general. What's amazing to me is how much money some of these ESG funds, these ESG ETFs have attracted, and also just how diverse they are and the different performances. For example, I see returns for the five largest ESG ETF funds out there. I see I-Shares USA Leaders, ESG, S-USL, is up 9%.

And then I see the Vanguard ESG is up 21%. That's quite a different diversity in returns overall. Can you sort of address the fact that it's sort of hard to pin down exactly what ESG is when you're actually buying these funds? Yeah, that's interesting, Bob. I mean, you know, all ESG index funds certainly are not alike, and that's, you know, what we have on the ETF side of the ledger there is our passively managed funds. But yeah, there is a range. I mean, it ranges from, you know, what I would refer to. And actually, I shares have started doing this as well to sort of ESG-aware portfolios that are just, you know, they're sort of slightly tilted towards ESG, trying to focus a little more. in terms of over-wading companies that do better on ESG measures, underweighting those that don't. And while other index providers and index funds are, you know,

taking it a little bit further and maybe focusing more on ESG leaders, avoiding laggards altogether, different ESG funds also have different exclusions that they use. So they can be quite different. I think the best way to think about it is that, you know, you can add ESG onto a number of different investment styles and approaches. And even in the case of indexed investing, it's sort of the same story there. So you can have kind of ESG light, a stronger ESG component. And you can also combine that with different types of underlying investments. Yeah.

Kim, you're the guy who manages money. I mean, how do you address this problem? When a client calls and says, I want ESG or more ESG or less ESG and want some advice, what do you put them in? Do you have to ask what kind of ESG they're talking about? How do you as a money manager handle the diversity of ESGs that are out there? Hey, Bob, thanks for having us on and great to hear your voice. Yeah, that is the big gorilla in the room there. First of all, as John just mentioned, there is no, like, we subscribe to multiple databases.

There is no easy button to screen for ESG. I can screen for sectors, geography, duration. Can't screen cleanup for ESG. So what ends up happening is since there is no standard definition, each client that comes in, it's almost a bumper sticker. Some want exclusionary. They want no casinos. Some want single themes.

They want food production. or plant-based protein or lab-grown protein. And then some want just best in class where it's almost a relative game. So it's not easy. And I think that's one of the reasons that scalability has been a little more difficult because if I go to my client, each one again, like I said, that bumper sticker is sort of what they are looking for. And it's very unique and very individualized right now.

Yeah. So, Linda, how do you address that? I mean, you're in charge of helping figure out ways to make ESG more available to people. Some people will say, look, I want to go back the old-fashioned way. I don't want tobacco companies and I don't want energy companies. Other people will say, well, listen, I want clean energy. So if Occidental Petroleum is doing more clean energy work or has a lower carbon footprint than ExxonMobil, then maybe we should include that in an index.

There's not a lot of agreement on this. How do you address that? Or are you just comfortable with the idea, you know, there's a diversity of voices out there, and let's see what the public really wants? Look, I mean, you know, MSCI calculates over 1,500 ESG equity and fixed income indexes,

and the reason there are so many and they're growing rapidly is because they provide choice. They provide choice to investors who want different approaches to incorporate EG considerations. Now, sustainable investments is just a very broad category. It's not a binary proposition of whether, you know, a company or a fund is ESG or not ESG.

But now there are a number of industry bodies and regulators, particularly outside of the U.S., that are pushing to standardize the market towards a common language, describe some of the key subcategories that are under Sustainable Investment umbrella, and that's going to help allocators make choices. So, for example, you know, a core subcategories is ESG integration approaches. So those are the financially focused ones that are only considering material ESG issues, which ignore a lot of other EASC topics that some investors might care about personally, but they're not financially material. So this subcategory has probably gained the largest traction because they've shown strong performance.

They don't necessarily entail too much deviations from the broad market returns. But you also have EASG approaches that are designed to increase exposure to narrower themes, like clean technology or diversity. So those are closer to, you know, thematic. indexes or strategies. And then, as you said, there are ESG approaches that are more traditional. They're more ethically, you know, oriented and you can screen for businesses with activities. Some investors object to, whatever that is. It could be child labor. It could be tobacco. And those, it's really important to know that those screens are not incorporated into indexes or

funds with the goal of enhancing risk of performance, with the goal of aligning with investors ethical values. So it's really important not to mix the apples and oranges when you're talking about these different ethical strategies that may or may not have any element of incorporating financially material ESG factors. So I think the standardization around these subcategories of ESG investments, they are going to help allocators to be clearer about what it is they're choosing or not choosing with respect to both the ESG exposures that they're taking on, as well as as the risk and return profiles that they should or should not be, you know, expecting from any given approach. Yeah. You know, John, it sort of makes sense what Linda is saying. I mean, she's at MSCI.

And of course, MSCI is investor agnostic. Their position is we provide the tools and you decide what you want. But I'm wondering how what you see here. Is there any indication that investors want a specific kind of ESG? I'm just talking about follow the money. I mean, do they want, you know, as Linda said, some just want more traditional things. I want to exclude carbon companies that have bad carbon footprint or, too high a carbon footprint, or is there new stuff emerging? What is the public indicating that they

actually want, John? Yeah, I think it's a great question and great comments so far. I mean, I always urge financial advisors to simplify this. I mean, one thing that I think has happened in recent years, as we've seen more and more interest in sustainable investing come up, is that the early adopters, the ones that come into an advisor's office and say, you know, I want an ESG portfolio, I want a sustainable portfolio, they're the ones that are going to have maybe thought this through, and maybe they do have a set of very specific sustainability preferences that they want to then, you know, they want their advisor to then address for them. That can be hard because it creates, you know, kind of a momentum for, like, you know, bespoke portfolios for every single client,

and every single client can't really have a bespoke portfolio. But I think as this becomes more mainstream and more people just become, you know, aware of the fact that, yes, I'm someone that has a sustainability preference, you know, to the way that I buy any product or service out there. And I've learned that I could do this in my investments. That's really what a lot of people are bringing to the table now. And so what they're looking for from their financial advisor is them to say, okay, we can do this. And here's my recommendation for what you're interested in. So a lot of times I think when somebody has a specific issue that they bring up and they come to the table with, that may just be the only issue that they, you know, know, know to bring up.

It doesn't mean that they're necessarily going to be opposed, for instance, to a, you know, a broad-based, diversified portfolio that emphasizes, you know, ESG, kind of broadly speaking, and not necessarily focused just on a list of things that they personally would want to excise from their portfolios. Kim, same question for you. It sort of goes back to the question I asked you before, but what are you telling people, you know, they want ESG? What are you recommending? What do you see they want? Is the public voting with their feet in terms of what style of ESG they want?

Yeah, Bob, definitely. I think there's clearly a huge overlap with ESG and quality and growth. That's good. And that means if we break the E and the S and the G up and take the two bookends, the E, the environmental that we talked about, that tends to be companies that are disruptive technologies that are doing something good. I'd mentioned before food production, plant-based protein or lab-grown protein, that's going to be less water that's used, less land that's used,

methane gas that's going to be emitted. So that's a growth industry because it's disruptive and people are moving that direction. And then when you look at the quality side, that kind of covers the G, the government side. And again, it's historically been that governance is best practices, and that means, like for myself, if I do, Sherry, and if I are the companies I'm investing in or treating employees well and treating the clients well and treating the community well, those companies are probably going to do well. And so I think what ends up happening from a broad-based perspective, Bob, we get people will come in and you look at something like DSI, which is probably one of the oldest ESGs.

But it's two-thirds technology, health care, and consumer discretion. And it's a reason. Those are the quality and the growth areas that come out of it. And then if you look into the ESG emerging, the ESGE, which is only about four years old, well, that's overseas emerging. It's about 53%. It's actually outperformed its peer in the emerging market category. So we definitely have that.

We've seen people for animal pet care, PAWZ, pods, right? That's doing something good for themselves, doing something good for the animals. So I think we're seeing a lot of that, and we have a sector rotation strategy, SECT, that's the same thing, technology, healthcare, consumer discretion, two-thirds, and a lot of them are EFT compliant pieces. And yet, John, am I being curmudgedly by pointing out that among the largest ESG ETFs out there, they all own essentially the same things in terms of their top holdings? Look at the top five or six ESG ETFs, the U.S.

They all own Apple, Microsoft, Amazon, Facebook, Google, Procter & Gamble, Johnson & Johnson, Visa, and most of them own Tesla as well. These are all great companies, but there is a – am I being curmudgeonly pointing this out? I think a lot of people would be shocked to find out that Microsoft is such an ESG favorite, and so is Apple, for example. Well, I think it is true that when coming to the table, I think a lot of investors, think that they may be asking for a really fundamentally different kind of portfolio than they would otherwise be getting in a standard, you know, in a standard market-based mutual fund. But I think it's probably better to both, you know, explain to those investors as well as just to think of it in these terms, that it's really, you know, an investment first and the ESG tilt is secondary to it.

I mean, primarily what you're doing. It's like buying a Tesla. You're primarily buying a car, right? And so I think with your investments, you still need, and most investors still need, right, core exposure to major asset classes in the marketplace. And you can do this through traditional investments. You can do it with an ESG tilt. And the advantages, I think, of having ESG tilt are, as Kim mentioned, the sort of long-term

quality component. I think if there's anything that ESG indicates, that's one of the things does indicate it also intends to include or in terms of probably overweighing in most cases exposure to the sort of cutting-edge companies that are going to be delivering the products that are going to really drive a sustainable economy in the future. And then there's also this other component that we call stewardship or active ownership or shareholder engagement that some ESG investments do more so than others. And this can be very impactful as investors are essentially pooling their money

and the investment manager is engaging with companies about their ESG practices, encouraging them to do better. And we've seen a lot of indications that that's been successful. It's been happening more often. The proxy voting is more – there's more shareholders voting proxies in favor of ESG resolutions, now. And so that's a differentiating factor that could also be, you know, that could also come into play and selecting investments that are ESG-oriented. The, I think just to conclude my curmudgeonly commentary on this, I'm not the first one to notice that the biggest ESG funds tend to mimic quality funds, Q-U-A-L, that kind of thing.

And that probably is a good thing. But I stand by my assertion that a lot of people be very surprised to find out that Microsoft and an and Apple and Google are favorites of the ESG investing. Linda, let me just move on to you. Before we conclude, I just want to get your thoughts on another key area of ESG, and that's diversity. So NASDAQ announced diversity targets for their boards of directors or companies that list on NASDAQ. The theme here, they seem to be trying to nudge companies

along on the diversity issue and hiring women on the board. Linda, what did NASDAQ do? and how successful do you think that kind of nudging is going to be? Is that what we're going to be seeing in the future, that kind of action? Well, the diversity push will only get stronger. I think the NASDAQ move is one example of that. Now, oddly, you know, the progress actually has been extremely slow, even though we've already seen this kind of push for several years.

So our research team, I just published our annual Women on Board's Progress Report, which you've been doing since 2009. And what we've seen is actually there's been a slow down in the rate of increase for female representation on boards with a gain of only 0.6 percentage points among constituents of the MSCI Accuette Index. And if you take this kind of trend of progress over the past four years and you project it forward, it's going to take until like 20, 29 for women to comprise 30% of the corporate boards. So I think that the kinds of moves that you're seeing at NASDAQ and maybe among some of the larger institutional investors that are, that are, that. that are agitating in some ways to push progress along is because the progress actually has been pretty slow. So I definitely think that this is an area

that will continue to get a lot of scrutiny. So Linda, we hit briefly on environmental and we hit briefly on diversity. What else in 2021 are gonna be hot themes? I mean, that seems to be very clear, environmental issues, climate, particularly, as well as diversity. Those seems like very obvious hot topic buttons for 2020.

21, particularly with the new administration coming in. But what else might be on the, on the broad ESG palette that could come to the four as a major issue? Anybody can jump in. But Linda, let me start with you. Well, I think that diversity is the one that is really specific. However, the larger topic is really around inequality more generally, right? So COVID has had this effect of really shining a light on the health and the economic disparities in our society. We expect that the incoming administration's focus on economic inclusion and on social issues, it's going to mean that companies should not really take their social license to operate for granted. We have seen this year that investors, you know, of all sizes from the largest pension funds to

retail investors, they care about how companies treat not just their workers and how diverse their workforce is, but whether their businesses prey on consumers or suppliers or whether they actually create value that is shared across stakeholders. So we think that this is really actually going to amplify and intensify over the coming years. And in response, what we're seeing is that companies are going to get more creative about how they can actually better beef up their social credentials with investors in the public and maybe actually get out of the crosshairs of policymakers. You're going to see, I think, growth in new types of financing instruments like social impact bonds or sustainability bonds and even sort of share issuances that are linked to sustainability goals. So these are ways that companies are taking to make a more direct link between its business and the social value that it brings more broadly. Yeah, just one other thing that what Linda was talking about, if you think about the inclusiveness, and I'm looking at the big globe as a whole, 7.7 billion people, 4 plus are connected, three are not connected yet.

Again, it drives towards technology connecting these people, bringing them into the ecosystem. system. We've all seen what a what a Siri or a smartphone does when you take it out to somewhere to a small village in Africa and all of a sudden there's somebody who may not be literate, all of a sudden they can move up the food chain dramatically by being able to talk and get things done. So I think again, that's why it drives towards the future technology keeps playing a bigger and bigger role because it's enabling more inclusiveness and a broader reach. Okay. Thanks very much, guys. John, appreciate it. Linda, Kim. Always a pleasure to talk to all of you. Now it's time to round out the conversation with some analysis and perspective to help you better understand ETFs. This is our Markets 102 portion of the podcast. Today we'll be continuing the conversation with John Hale from Morningstar.

John, thanks very much for sticking around and having an extended conversation on ESG. This is what you do for a living cover in the whole ESG space. I'm wondering, what you might see happening in terms of the SEC in 2021. One of the commissioners there, Democratic Commissioner, Alison Herron Lee, published a paper and has suggested that the SEC should make inquiries about what policies companies have about climate change. This is very interesting to me. I mean, this is not really regulation. They're simply making an inquiry saying to the company, well,

could you tell us what of any policies that you have? Can you comment on that? This seems very interesting to me because there's no real regulations. They can say you're not enforcing. They could just ask about it. But isn't this a form of nudging as well? Your thoughts? Yeah. So, Bob, I mean, I do think we're going to see moves by, if not just the SEC, then from the Biden administration more generally towards greater disclosure on the part of corporate entities on climate risk in the coming years. And, you know, the SEC will have to decide what form that takes, whether it's, you know, at first, an inquiry might be sort of, you know, information gathering on their part ahead of a potential disclosure requirement. But I think that, you know, we're seeing quite a lot of movement in that

direction. It's happening in Europe. I think both in just already with the SEC, they're both investor and asset management advisory councils, which, you know, provide advice and guidance and recommendations to the SEC, have recommended some form of climate disclosure. So I think we're going to see that being looked at very closely in the next administration in the SEC. Yeah. So what's interesting, here is there's a jurisdictional question. Do they even have the jurisdiction to ask this? So there's a certain mandate they have to maintaining fair and orderly markets and protecting consumers. And obviously there are people, some people there who feel, well, part of our mandate is, you know,

to protect consumers is basically to inquire about climate change because that's an issue for consumers. I would say that's a fairly interpreting a mandate fairly broadly, wouldn't you, John? I mean, are other people going to push back and say, wait, minute, wait a minute, this is not part of the mandate of the SEC. Yeah, no, I think that the SEC has a mandate to help make sure investors have the kinds of information that they need to make good investment decisions. And so I think that something like climate risk disclosure kind of hangs on that idea. And, you know, I think we've seen examples, you know, with their advisory councils, they're not asking the SEC to do things that are

outside of their mandate. They're saying, you know, this is what a significant portion of investors would like to see. And, you know, the reason that that we need to see it, I think, is to help standardize that information for investors so that, you know, it doesn't come from all kinds of different ratings agencies and different companies doing it different ways. I think increasingly we'll actually see companies wanting to have, you know, a standard for how they need to report this kind of information. And so you think this could be helpful in, if the SEC got more involved in this towards standardization of what exactly ESG is. That's a very interesting idea. I would, I'd support it just for that. I guess I just have a, I understand people who say, well, well, wait a minute.

here. Just the process of you asking the question, oh, we're not telling you you're violating anything. We're just asking a question. What, if any, policy do you guys have on climate change, for example? Right. And just asking that question in his sense is forces the company say, well, what policies do we have? And are we doing anything that we should not be doing? Or should we be doing something else. It's a nudge in a way. And I understand people who say this may be a nice policy to have, but is it necessarily within their jurisdiction? I know you answered the question, but it's an issue that floats out there. Well, yeah, and I think, you know, the watchword here is materiality, right? I mean, so, and some of the, some of the, you know, opposition voices to this

are saying, might say, you know, it'd be great for companies. to tell us more about their, you know, environmental and social policies that they have. But for the SEC to require disclosure of that nature, there needs to be some nexus to financial materiality for companies, you know, is this information that will help investors materially as they make their investments? And luckily, what's been happening for the last 10 years or so is that a group of investors called the Sustainability Accounting Standards Board, SASB, and it rhymes with FASB for a reason, has been sort of painstakingly going about the task of going industry by industry and saying, what are the material ESG issues that each industry

faces, and let's develop a framework for how to report around those issues. So, SASB has been working on this for about a decade now, and, you know, you can go to their website, sasb.org, and see their, what they call it their materiality matrix, what issues are material to what industries. And I think it forms a, you know, a pretty good template for companies to disclose material ESG risks. Yeah. And what is the website there? Is it SASB.org? SASB.org. Yeah. Okay. Well, anybody's interested in check that out. I certainly support moving towards a clearer standards of what constitutes ESG. I want to go back to the question we had in the show, and I'm sorry to keep picking on this, but can you explain how it is that there are 10 or 15 stocks that show up on all of these ESG screens all the time? And they're mostly quality, large-cap quality stocks. It's the Googles, Amazon, Microsoft.

Procter & Gamble, Visa, Tesla. Why do they all keep showing up? Are they really all that good on an ESG screen? Is there nothing else that's out there? It just sort of surprises me. Yeah. Well, you know, the way the most of the company ESG ratings and assessments work, and these are kind of the underlying basis for a lot of the ESG indexes,

is that you'll go industry by industry and look at the best practices, again, on material ESG issues within each industry. So every industry has got kind of a different sort of footprint, if you will, of their material ESG issues. And as you evaluate the programs and the operations and just sort of the ongoing experience of the different companies on these issues, just they, you know, they kind of shake out from a best in class to worst in class. It's not always something that every ESG Raider agrees on, but in some of those cases that you mentioned, that typically is the case. And so it's not surprising to me that you find some of these same companies in ESG indexes, you know, across different ESG indexes. Now, the other thing that can happen, though, and this is why it's important to really understand, you know, how, any particular ESG index is structured, is that some are just what I would call tilted indexes.

So they may have all of the same companies in the index that a standard index has, but they're just overweighting certain companies and underweighting other companies in the index. So, you know, it's somewhat difficult to tell. But when you're investing in an ESG index, you're actually not investing in solely in the Tesla's of the world, the companies that are making products that are specifically, you know, products that are going to take us into a, you know, that are going to flourish in a low-carbon economy, you're investing in companies that are judged to have the best overall set of ESG practices relative to their industry peers. And yes, those tend to be quality companies. In fact,

one way to look at it is to say that, you know, until we had ESG data at hand, really the only way we could assess quality in a company is through financial metrics and through sort of very qualitative assessments on the ground by analysts, you know, going to the company, kicking the tires, figuring out how well they, you know, they like management and think management's effective. ESG data really is, it's not financial data about companies, it's not data about stocks and stock performance, it's about company operations, how they run their business in these different areas. So it's, yeah, it's no surprise that it's a quality-oriented thing. Right. Are we making progress towards quantifying qualitative measurements? By that I mean, A lot of this is qualitative.

It has to do with, you know, particularly when you get down to, like, leadership, for example. What do people think of the board? How much leadership, you know, is the board providing? How active is it in the community, for example? These are qualitative measurements. Is there ways to quantify that and assign a score to it? Are we getting better at doing that? Yes, I would say absolutely we're getting better at it.

I mean, if you, you know, I think we're getting better at it as a, you know, in the big picture, too, with big, with big, with, with, with, with, with, with, with, data and being able to bring data to bear on areas that we didn't maybe think we could do in the past. I think, however, on the other hand, this is also one of the reasons why all ESG ratings or evaluations don't agree with each other because at base, at least some of the attributes that you're trying to measure are qualitative in nature. you know and so you're going to you're not going to find a consensus or you may find a consensus on on ESG for a company but you're not going to find you know absolute agreement all the time

yeah good point all right john thank you very much for joining us you've extended our knowledge and information base we really appreciate that you're sticking around for us and thank you the listeners for tuning into our ETF edge podcast each week you know we're going to be dark the next couple weeks, but we'll be back January 4th, 2021. Remember, in the meantime, you can always send us your questions or topic ideas. Tweet us at ETF Edge, CNBC. Happy holidays, everybody. Take care.