ETF Edge - SEC Hearing on Deck: ESG & Crypto in the Crosshairs 4/17/23

Episode Date: April 17, 2023

CNBC’s Bob Pisani spoke with Arne Noack, Head of Systematic Investment Solutions, Americas, at DWS Group, and Dave Nadig, Financial Futurist at VettaFi.They discussed two hot-button issues on the SEC’s radar ahead of a key hearing before the House Financial Services Committee tomorrow. What can ETF investors expect to hear on the topics of crypto and ESG – and what other ways might SEC Chair Gary Gensler push for transparency among those two industries? No doubt corporate America stands ready to push back as the disclosure requirements start piling up. In the “Markets 102” portion, Bob continued the conversation with Dave Nadig from VettaFi. Hosted by Simplecast, an AdsWizz company. See pcm.adswizz.com for information about our collection and use of personal data for advertising.

The ETF Edge Podcast is sponsored by InvescoQQQ, Supporting the Innovators Changing the World, Invesco Distributors, Inc. Welcome to ETF Edge, the podcast. If you're looking to learn the latest insights on all things, exchange, traded funds, you are in the right place every week. We're bringing you interviews, market analysis, and breaking down what it all means for investors. I'm your host, Bob Bizani. Today on the show, two hot-button issues on the SEC's radar ahead of a key hearing before the House Financial Services Committee. That's tomorrow. What can ETF investors expect to hear on the topics of crypto and ESG?

And what other ways might SEC chair, Gary Gensler, push for transparency among those two industries? No doubt corporate America stands ready to push back as the disclosure requirements start piling up. Here is my conversation with Arnie Noak. He's the head of systematic investment solutions for the Americas at DWS Group. And Dave Noddick, he's the financial futurist at VETI. Dave, the Republican. are going to make a claim that Gensler lacks the authority to impose climate disclosure regulations on corporations. How much will corporate America push back and what's the likelihood we'll see,

the Gensler's proposals will even see the light of day? Just on climate now, there's 40 of them out there, folks. Okay, we lose track of them, but just on climate. On the climate disclosure one, there's going to be enormous pushback. There already has been largely because this is a pretty big administrative burden. The way this is written, whether you're a fan of ESG and disclosure or not, the way this disclosure would have to be done would be pretty burdensome. And so I think they're going to get a lot of pushback.

I think the chances they actually get something like this through this year, probably pretty low. I think we're in a little bit of a cooling off period. I think we'll see some of that challenge happen on the floor tomorrow as we hear about it. But it's an important topic. But it's one also, I think that we should point out, the institutional community is already all over. Yeah.

You know, speaking of the institutional community, Arnie, They are already positioning their portfolio on climate change, particularly over in Europe. It's a normal part of the conversation here. It's politically sensitive here in the United States. Now, you floated a new climate action ETF last week, DWS did, that already has $2 billion in assets. Explain how you got $2 billion in a week in an ESG ETF. Yeah, with great pleasure. It doesn't unfortunately happen every day.

We'll work on that for next time. But USCA is the ticker symbol of the ETF that you refer to Bob, which essentially looks at the top 50% of companies within each sector. So it is a sector neutral or close to sector neutral type of approach and still looking at which companies within which sector, within the different sectors, are best suited from a climate angle. And how this has come about is, frankly, Ilmarinen, who is the big investor in USCA, where previously, invested in USSG, which is a more broadly focused ESG type of fund tracking the ESG leaders index of MSCI. And they decided simply to hone their overall investment strategy and shift from a broad ESG focus to a specific climate.

This is Finland's pension fund, essentially. It's a government insurance company for Finnish, essentially, private sector. They were already in one of your ESG funds, and that was a broad ESG fund, and here they're just switched over to... focus specifically on climate. Is that a noticeable trend in Europe right now? I would say... I would say yes. So it starts out with broad ESG topics, looking at, you know, environmental social and governance-related aspects, and then the next steps for a lot of institutional investors,

not only in Europe, but I would argue also here in the U.S., in particular, on the coast, thinking about, you know, New York, and, you know, we recently saw that. I think last week there was an article around the New York employee retirement system. making certain declarations from a net zero standpoint, but also Californian institutional clients are looking to hone in specifically on climate as a relevant topic. I'm surprised how controversial this climate thing is, given how many companies, if you're a U.S. company in Europe, you already have to make disclosures, right? So the only thing, I mean, I disagree with Gensler and a lot of things,

but he's sort of making a point, folks, everybody's doing this. Let's standardize the process. At least that's an argument that makes some sense. Yeah, absolutely. And, you know, when we're talking about the different ways you can do this kind of disclosure, you know, the indexers like MSCI and folks, they're already capturing a lot of this data. So it's not like this data doesn't exist. And if you look at the S&P 500 companies, all of them are already disclosing this kind of data. I think the overreach here is what's called the scope three, right, where you're starting to look at the impact of your company, not just in terms of your products and services, but what your supply lines look like and what your customers do with your product.

That can be a really challenging thing to document in a really standardized way, and that's where they're going to get the pushback. Well, now you're making me work, because now we're going to have to explain scope three. We can't assume the viewers understand it. He always does this to me. He makes me work. So, folks, those of you who aren't sure what he's talking about, a lot of the debate revolves around disclosure of greenhouse gas emissions. So there's three categories of greenhouse gas emissions. Here they are.

Aren't you glad we do the work for you? Direct greenhouse gas emissions are controlled by the company. That's scope one. Scope two is indirect greenhouse gas emissions associated with the purchase of things like electricity or steam or heat or cooling. And then there's scope three, which is what Dave's referring to, which is indirect greenhouse gas emissions that are produced by customers using the company's products. So three different levels.

So dividing these emissions into three groups is the purpose here is to help measure progress in making reductions to limit global temperature rises. So remember, under the Paris Agreement, it was supposed to be two degrees. are below, that's the game here. So much of the pushback, Dave, now that we've educated you all, it's around these scope three emissions produced by customers using the company's products. And it seems to bridge too far for a lot of people. Well, I mean, imagine that you're, I don't know, AMC movie theaters, right? How do you judge the emissions of your customers showing up at your movie theater and consuming the popcorn?

That's a bit of a ridiculous example. But when you think about both the supply line, which is also part of scope three, and then the usage line out of it, it becomes quite large. And different people disagree on the best way to measure and manage that. And most companies are doing something appropriate to their industry. Otherwise, they get ignored by the ESG funds. And nobody wants to do that because he's got $2 billion showing up at ARN's funds. They have a good point about pushing back. It's one thing like, I'm Exxon.

I might have direct greenhouse gas emissions that I can measure. But emissions produced by customers, that seems like, how would we even get that, understand that, what's the measurement process, it seems like a bridge too far for a lot of people. Yeah, I would say with anything, you know, regulation straddles the line of having to be precise and specific and also practical. You know, and something like this, I would argue that, you know, measuring scope 1, 2 and 3 emissions to some degree is already a market standard. They've already alluded to that, the likes of S&P, MSCI, all major index providers in their Paris Align benchmark indices, is for the viewers who are not aware of what a Paris Align benchmark index is, it's essentially an EU regulation with a index construct that is designed to create a pathway towards a net zero

environment. And in order for those to function well, certain assumptions have to be made in order to measure scope one, two and three. And where regulation becomes useful is to level set that, to make sure that all disclosures as harmonized as much as possible meet that great objective to meet reality, obviously there will be some friction. Yeah. Now, we had this morning, we had Suzanne Clark on. She's the CEO of the U.S. Chamber of Commerce. She's on fairly regularly. Speaking very general, she decried the huge number of proposals that Gensler is floating and had this to say about all these proposals. Take a look at this. We do everything we can to work with Chair Gensler and his team. We submit comments. We have meetings. We do everything that we can to try to get the appropriate. amount of regulation and smart regulation accomplished.

And if that doesn't work, then we take them to court. Take them to court. We're going to sue them. Now, I want to make it clear. She was talking about all of these proposals generically, but basically they're signaling. This is way too much stuff to dump on us. And we think in some cases you're exceeding your authority. We think in some cases they're overreaching, et cetera.

Yeah, I don't, the lack of authority. the lack of jurisdiction. That's actually a bit tough to argue. The SEC has pretty broad mandate about what companies who trade on public exchanges have to disclose. So I think that's not where you win this argument. It doesn't surprise me people are already talking about suing on this. I think there is an administrative burden here. I think it's unfortunately going to be political, and that really shouldn't be what this is about. It should be, as Arna was pointing out, about having good regulation versus just regulation for regulations sake. Yeah. So you don't think they'll succeed. I mean, again, we're talking broad.

There's many proposals. You don't think that suing them on the grounds that they're outside of their authority will work. You know, there was that EPA, the court ruling on the EPA saying they were overreaching. Government regulators were doing too many proposals outside the original scope. Yeah, Flavor-a-months suing regulators, and I'm sure that we're going to see more of that. The SEC is already being sued by gray scale around crypto, XRP around Ripple. We've got plenty of lawsuits going on, and the SEC is not looking like they're going to win very much. like they're going to win very many of these. So I wouldn't be surprised to see Gensler and the

SEC backing up a little bit here and maybe being a little bit more thoughtful in this process. Well, how do they back up? Again, we're just sticking to the climate proposal for a minute. Would they back off on scope three and say, can you divorce that? If they took that out, they would have to resubmit the proposal, wouldn't they? I suspect we'll see a resubmitted proposal. I think that's exactly what we'll see. That it will only do scope one and two and the lead-out three. a phase in or we'll have a learning period. I mean, remember, regulation doesn't always have to be about must do this. Regulation can be about, hey, we're asking for voluntary compliance for a period of time to get information. We've seen that in market structure all the time. Yeah. And again,

we're showing you scope one, two, and three. Remember, these are different levels of reducing greenhouse gas emissions. All this goes back to the Paris Accords. And all three of these are required under against her proposal and the question is are they going to back off on this i want to go back to the old esg like we used to talk about three or four years ago and why is tech showing up in all these esg so i looked at your new um u sca the your climate action etf see if you can bring this up the biggest holdings so i see the largest holdings uh in the et f it's still big cap tech stocks Microsoft, Apple, Amazon, NVIDIA, Alphabet, Facebook, Tesla, they're all six, five, here you go. Can you explain your methodology, Arnie?

Why we had this problem four or five years ago? Why is Big Tech showing up in the climate action? How do you explain that? Yeah, so it's often a little bit of a misperception, what are climate-focused investment, what are ESG-focused investment. Sometimes I feel like, you know, different people look at it. through the lens of what they want to see as opposed to what the reality is. And the reality is that the broad field of ESG does encompass a lot of different versions and

methodology similar with regards to climate-focused investing. And what we're looking at here is still a strategy that is somewhat tied to the original benchmark index, which is the MSCI USA. So what's relevant is the starting point of the overall market. So all the big stocks of Microsoft, Nvidia, et cetera, et cetera, et cetera, they are, by definition, always relevant for something like this. But assume I'm an idiot. Don't like, well, you're laughing.

You know, I knew he was going to laugh. The minute I said that, we've never, we've always assumed that, Bob. No, and explain why Microsoft, for example, is your biggest holding. A normal person would say, oh, climate action. I don't think Microsoft, but explain why Microsoft's. Okay, perfect. So what it looks at is it looks at what are the different climate stocks or the stocks that do best for the climate of each sector.

And what features into this are the emissions, you know, scope one, two, and three. So how much does a company emit? How much do their suppliers emit, et cetera, et cetera? But then also how much is that company planning and publicly issuing and declaring and making public their plans to reduce the emissions and how credible are their plans? Do they have so-called science-backed targets? And then lastly, for companies like Chevron, for example, how much do they actually engage in in so-called green business.

How much money do they invest in the development of, you know, fossil fuel energies and other sort of sustainability-oriented businesses? And how do you account for the fact, and people used to ask me, well, Microsoft has far fewer greenhouse gas emissions than Exxon, were they're in a different kind of business? How do you account for those differences? Yes, so the measurement is not cross-sectoral. It's a ranking within each sector. So Microsoft is compared with the other tech companies.

Chevron is compared to the other energy companies. It's a like-for-like comparison, and then we select only, or the index rather, selects only the companies within each sector that do the best, and the worst within each sector are excluded. So your point is there are energy stocks in this? Yes. Is the weighting of energy is, what, 5% in the S&P? Is it weighted by energy? Roughly the same, roughly the same.

But it's interesting because you mentioned tech stocks in the beginning. The tech sector is actually slightly underweight in the USAA compared to the benchmark. Yeah. Okay. Now, just moving on for climate, staying on ESG, though, Gensler is also floating a proposal on board diversity, asking people requiring corporations, essentially, to file reports on the diversity of their boards. This is going to be voted on later this year. This is getting all caught up in ESG thing. This seems much less controversial. Yeah, I want to meet the people who say, I want, I don't want to know anything about the boards.

I want to meet the people who want. No, I think the most important topic. What's the problem with this? So the problem is that people don't like the idea that shareholders are paying attention. That's honestly the answer. A lot of the proposals we've seen are about giving shareholders more voice in the proxy process, in understanding who's on the board, and making proposals to put different people on the boards. I'm generally a pretty big fan of those things.

Who runs companies has become one of the most important topics of our lifetime. We now know the names of CEOs, Elon Musk, that we didn't use to know on a day-to-day basis because they're public figures. They are impacting our lives and policies. But are people resenting the idea that we're requiring the disclosure of it, or are they actually resenting the diversity concept? That's, I think, the problem that I'm having. Why? You shouldn't mandate more information of what your procedure?

I believe, personally, that people should always have access to information, right? So that's why the ESG stuff starts to get squirrely around that scope three, because in general, more disclosure is better. It lets people make their own decisions. It lets people build indexes and products around those things. If you don't want to invest based on board diversity, there are plenty of ways to invest not based on board diversity. All right. I want to move on here.

We can get dragged into this all afternoon. Another big issue out there is going to be crypto. And their problem here, there's still no clear understanding of whether crypto tokens are securities or whether they're currencies and still no Bitcoin ETF. Grayscale, of course, is suing them. Our friends over there. Handicapped this. Talk about the Grayscale. They're suing them arguing you can't have a futures product and not have a spot product.

It's illogical, makes no sense. What are the chances Grayscale could win? I think the chances are more than 50-50 that they could win this lawsuit. However, I don't think that means that all of a sudden we get a Bitcoin ETF. I think there's actually a higher likelihood. It means that they shut down some of the futures-based products, not a particularly popular opinion, but there's no way to force a regulator to approve a product that you can't actually mandate a regular to take an action. You can slap their hand about having failed to

take certain actions or having taken actions you disagree with. But the way they fix that problem is still up to the SEC. I suspect that even if Gray-Skill wins, Gensler is going to back even further away from crypto and not necessarily approve a spot Bitcoin ETF, but put some constraints around the futures-based products while we wait for maybe someday comprehensive crypto regulation and legislation in this country. Right. In the meantime, the critics argue that Gensler is doing regulation by enforcement. Which he absolutely is. He's actually suing the daylight out of the crypto business. And very, very capriciously, right? He is suing certain companies for certain acts,

claiming that they were doing things with securities. But leaving aside, whole other parts of different ecosystems, right? We're not trying to regulate swords and World of Warcraft, but you could argue they fail all the same tests he's arguing for. Are tokens securities or commodities? Well, the point is, Nobody knows and somebody has to create a comprehensive rule. If you're getting- The Howie test is not really not. No, why not?

Because it's not designed for this ecosystem. I'm with Hester Purse on this at the SEC. She sort of has this framework with what we should be focused on is capital raising. That's what the SEC should be worried about. If you're raising capital by issuing tokens to then go effect a purpose, okay, that's a security. We can talk about that. That's not really what the HALI rule is. the Howie rule is, and that's not really what most of these enforcement actions are about.

A lot of this would be securities then. It would be, but the point is we need legislation. This isn't going to get solved by the stroke of a pen at the SEC's desk. We need Congress to work. They already are on stable coins. I think that's where we're going to start breaking this damn open. Hopefully this year will actually get to match on that. They're starting stable.

What's the distinction here that you want to make? So stable coins are basically money market funds that you use for payment on crypto rails. They're like USDC is a big comment. Some of them recently broke the peg, as it were, when we had a little mini banking crisis, you might have remembered from a few weeks ago. A good set of legislation is on the table to basically bring them under the umbrella, actually have them being regulated by the Fed, because effectively they're going to be money market instruments. I'm a fan of that. I'm hoping we'd see some action. They actually get some votes on it. And what about the whole jurisdictional dispute between the SEC and the CFTC?

This is historic. He goes back, you know, since the dawn of the commodities markets. if these are CFTC primarily grew out of agricultural regulation. Yeah. Look, the whole, you know, is it a commodity or security thing? I think having two regulators argue about it is the wrong way to solve this problem. I think we have to have legislation that realizes digital assets are different and they need different sets of rules. And what's the chances that we're going to actually get legislation? Well, I think we'll get stable coin at least a shot at it this year.

That might break it open to be a post-campaign issue, so 2025. maybe. It's time to round out the conversation with some analysis and perspective to help you better understand ETFs. This is the Markets 102 portion of the podcast. We'll be continuing the conversation with Dave Nautic from VETify, who's sitting right next to me here at the New York Stock Exchange State. I want to just talk about flows this year.

It's a little bit unusual. We've kind of gotten accustomed to endless inflows into ETFs every year and, you know, constant. And this year is a little different. We are seeing huge inflows into fixed income treasury ETFs. Yep. But outflows from corporate uh... corporate uh... corporate uh... ETFs, corporate bond ETFs, high-yield bond ETFs, outflows. We're seeing outflows from, or is it modest inflows in the U.S. equity.

So, no, outflows in U.S. equity. Yeah. Big inflows in the international equity. Right. So makes sense of all this. Yes. So overall, let's just put it in perspective, we're about a third of the way through the year. We've had about $80 billion in net flows. That's pretty low. If we rounded out the year and call that maybe a $250 billion flows year, that would be a bad year for the ETF market. We'd go back five or six years before we've had that slow a year. We had north of $500 billion last year. Yeah. So we're used to this half a trillion

over and over again. So that's slowed way down. Now that doesn't mean money's flowing out. It just means that there's not a lot of money on the sidelines piling into anything except treasuries. And money market mutual funds. And money market mutual funds, which is effectively what we're seeing in the ETF space as well, right? That sort of two-year treasury has been the sleep spot. The ETF business doesn't get into the money market. Not directly, but if you look at some of the funds that have had just amazing flows here, things like JPST, the JPMorgan short-term bond fund, just print and flows, you know,

month after month after month. A bunch of funds like the Mint from PIMCO, very similar, these short-term cash-like vehicles. You know, they're not money market funds. They can't call themselves that. They do go down occasionally on the day by, you know, minor fraction of a percent. But for the most part, you're putting money into these things to clip the coupons, which are currently paying off, you know, somewhere between three and a half and five and a half percent, depending on how aggressive they're being with those cash-like investments,

which, you know, we're now in a world where that's a big deal. Competing for a 4 percent yield, we had Apple launch today a savings account paying 4 percent yield on your phone. This is the new the new game. The new game is arguing about fixed income and where that money should live. When we talk to advisors, when we pull them, what we hear from them is, yeah, we're parking money, we're looking for good cash management solutions, and then we're reevaluating the rest of the portfolio. So how does this account for the fact that we've had a way below average year? Is it understandable for equities because we had a 20% down year last year? What accounts for this? Yeah. So the question you have to ask yourself is where would the

new money be coming from, right? That's the logical question. So either you have to sell off your bond assets to buy equity assets. If you did that inside the ETF market, that would not show up as net flow. Or you have to be selling something that's not in the ETF market to buy ETFs. We saw a lot of that last year. A lot of people sold their underperforming, actively managed traditional mutual funds and move that money into the ETF market. There's not a clear case to do that right now. Not a lot of people are tax-lost harvesting right now to move money into an ETF as their new investment vehicle. So I think this is going to be. be a bit of a consolidation year for the industry. And frankly, when you look in the internals,

things like the reallocation into international equities, those are good signs. That means people are making smart portfolio decisions. Well, it's about time. I mean, it's only been 10 years of underperformance on international, so mean reversion would make sense. But let me just ask you about artificial intelligence. I've been playing with chat GPT. I actually pay for the 4.0 version. It's remarkably conversant, although it gets the things. wrong. Of course. Don't go by the restaurant recommendations in Italy.

But where does it play? Where does it fit in the investing community? Well, so in a couple places. So one of the things that it's really good at is helping people learn things, not because it knows anything, but because it's really good with language. So we're at sort of this, you know, beta step. The next step, which is going to be quick, it's going to be the next three to six months, is when we start taking this ability to work with language really well,

which is what everybody gets really excited about, and attaching it to actual truth, actual sources of truth. Right now, you can't ask ChatGPT for a stock quote. It doesn't have a source to go to to get one. It only goes September, 2021, right? But even then, it's not designed to find truth. It's designed to have conversations. When you connect it to something that has truth,

like, say, a financial terminal that's got all this information in it, or, say, the back history of everything CNBC did for the week, then it becomes really interesting because if you can have a conversation with, say, everything that CNBC has said today, that becomes a powerful tool. Because now, instead of having to flip back through and see all the videos you guys posted, I can now ask it a question and say, well, what was the most interesting thing about gold that anybody said today on CNBC? That becomes a really powerful tool. I think it's going to be an accelerator on innovation.

But it would have to be hooked into a more intelligent system. Which is happening right now. The whole, you know, chat GPT for, which you're paying for. That's what those connections are about. Those API connections are about connecting to sources of truth. It's getting really, really interesting. And it's going to have profound, and I think very positive impacts on a whole variety of industries from healthcare to auto manufacturing.

What about hot sectors this year? We went through so many over the last six or seven years, started with pot ETFs, The thematic tech ETFs, briefly crypto, although there wasn't much to invest in. We saw single bond ETFs last year. We got some more narrow ETFs, the big ETFs direction and other people are pointing out, are creating. What anything, anything thematically, anything dramatically? It's tough for me to say that there's a really obvious hot button where it's like every advisor is telling me they want to buy X. I don't think that's where we are.

I think what we're going to see is a lot more discussion about reshoring and on-shoring. I know that there's some products in the pipeline coming out that are going to focus on that sort of moving, whether it's manufacturing lines, whether it's semiconductor lines, back to the U.S. I think we're going to see some interesting investment plays around that infrastructure. Energy infrastructure, same thing. A lot of focus on, okay, where the pipelines, how are these things working, you know, where are we actually trading the oil? A lot of focus on that.

That tends to be a little boring, to be honest. make for great headlines every day, but that's actually smart. So I think that kind of re-industrialization of America, we're going to see in a lot of different places, bolted right on top of robotics and AI, right? They're going to be hand in hand. That's really fundamental investing. That's looking at an economy, finding the places where the growth is going to be. Some of it's stimulative, some of it's coming from the infrastructure deal, finally rolling out into the streets. Some of it's just going to be folks realizing they want to understand their investments a little bit better here at home. Yeah. It's going to be very interesting.

to see the new year, but particularly on artificial intelligence. I'm very, very interested to see that happening. Dave nodding is the financial futurist Ed Vettified, an old friend of mine. Dave, thank you very much for joining us on the ETF Edge podcast. Thanks for having me. Inves QQQQ believes new innovations create new opportunities. Become an agent of innovation. Invesco QQQQ, Invesco Distributors, Inc.