Explore the Thinking behind our investment approach

The month of May brought us another climate-related executive order, stating it is the administration’s policy “to advance consistent, clear, intelligible, comparable, and accurate disclosure of climate-related financial risk…including both physical and transition risks.”[1] This latest order specifically directs financial market regulators to assess climate risks, including how they impact the financial stability of the government and the financial system in the United States. Treasury Secretary Janet Yellen, who leads the Financial Stability Oversight Council (FSOC), will convene other agencies, including the SEC, to deliver a report by November. Public and private company disclosures could be impacted by any changes. Climate disclosures and related regulation have been increasing around the world and are seen as critical to improving capital allocation decisions. S&P recently reported that “data shows that the five largest U.S. public banks reduced their exposure to energy and utilities in 2020 compared to 2019. With this latest executive order putting increased emphasis on the financial risks of climate change, we expect this trend away from financing fossil fuels to continue.”[2] So far, so good. However, the New York Times reported that, counter to the pledges, orders, and other talk, this “administration has quietly taken actions this month that will guarantee the drilling and burning of oil and gas for decades to come.”[3] Politics, notably trying to secure support for the infrastructure bill, is unsurprisingly in the mix. A lawyer quoted in the article called the administration’s actions, “carbon bombs.” A low carbon transition is hardly an easy project. And, as we asked earlier this month, until a carbon price is in place, how effective can theses orders really be? ESG at the DOL Another part of the executive order explicitly asks the Department of Labor (DOL) to “suspend, revise, or rescind” the Trump administration rule that constrained ESG under ERISA. One of the options is the proposed bill, The Financial Factors in Selecting Retirement Plan Investment Act, which has been endorsed by Morningstar, US SIF, State Street Global Advisors, and the CFA Institute, among others. Jon Hale of Morningstar explains how the bill would amend ERISA in this recent article. Given the potential valuation impacts of increased climate-related disclosures, the opportunity for individuals to use ESG and climate-aware products in their retirement savings is a welcome development.

Advisors may believe that their clients prefer that they manage investments in-house, but recent research from Adhesion Wealth states that only 17% of clients feel this way. In fact, more than half of the clients “had no preferences ‘as long as my investments are secure and performance is satisfactory’.”[1] So, why outsource, and especially why outsource ESG options? Costs and Efficiency We’re stating the obvious here, but it’s worth reiterating. As fees compress while competition increases, advisory firms are under pressure to provide value-added services without compromising the overall cost base. Investment management, including time input, costs for technology, staying on top of market trends, and attracting and retaining top talent, is expensive, and can divert valuable resources from other services. ESG integration, for reasons further described below, is even more expensive. Outsourcing, on the other hand, can be very cost effective and less time consuming. Alongside the handling of the investments themselves, advisors may also gain access to value-added research, education, and thought leadership that would be challenging to produce in-house. Providing Clients with Choice and Quality The ongoing digitization of the advisory business has led to numerous marketplaces where advisors can find investment choices for their clients. For advisory firms that don’t specialize in ESG integration, but are serving clients with individual values, preferences and sourcing investments externally can help an advisor meet the needs of their client in a scalable way. The flipside is ending up with a multitude of bespoke investments that are increasingly challenging to manage unless you have sophisticated technology and operational support. Our growing suite of SMART Investing Solutions are available through multiple custodians, with some models also available on Envestnet and other retirement platforms. Our SMART Unified Managed Accounts (UMAs) are also customizable, enabling individual clients to exclude companies or entire industries and sectors. Rebalancing is taken care of, and our custom solutions are supported by powerful overlay management technology provided by our partner, Natixis. This also includes tax management functionality that can be very valuable for higher net worth clients. Maintaining a Market Leadership Position Unsurprisingly, this is the most important one from our perspective. The rate of change in the sustainable investing space is incredible, including the global growth of assets invested according to ESG principles, the rapid expansion of data providers, indexes, and other tools, as well as the expanding and deepening of topics and themes under scrutiny. In short, ESG requires dedication. Yes, it’s possible to make ESG models out of passive ETFs, but we believe that ESG necessitates rigorous active management. As such, manager diligence is more complicated than it is for traditional investment strategies. To effectively understand a manager’s sustainability philosophy, portfolio construction, and management, it’s imperative to also understand the underlying issues and data sets. Otherwise, you run the risk of providing greenwashed investments to your clients. Over the last several years, we have invested heavily in our in-house ESG capabilities and investment platform. We’ve tested and acquired data sets, nurtured relationships with managers large and small, built out our team, including the recent hire of Jessica Skolnick, CFA, as our Director of Investments, and developed a robust research and product development approach. It’s a significant undertaking and there’s no room for complacency. We’re committed for the long haul.

During our most recent RIA Channel ESG Playbook, David Callaway agreed with Jeff Gitterman that financial assets face repricing as climate change becomes better understood by the markets. The asset management industry is already adapting by creating new investment products that reduce risks and provide exposure to solutions. Ever-improving data sets and metrics will help advisors and investors determine the utility of certain products over others, further refining the outcomes. As advisors begin to engage more with these new products and tools, they will play an increasingly larger role in helping to educate and position their clients with respect to the retirement implications of climate change. Once the “average portfolio” incorporates climate change, repricing really takes hold. If you’ve yet to consider how climate change will impact your portfolios, please book a call with us to talk about our SMART Climate UMA models and how we’re thinking about climate change more broadly. Responsible Water Investing We regularly talk about water as it is a key theme in our SMART Investing Solutions. During last week’s event we heard from Alexandra Russo, Global Thematic Equity Product Specialist for the Virtus AllianzGI Water Fund, which is one of the holdings in our SMART Managed Mutual Fund Models. Water scarcity is inextricably linked to climate change and is exacerbated by a growing global population with rising living standards. Higher protein diets, electrification, and clothing production, among many other products and services, all rely on water as a key input. Source: AllianzGI; Water Footprint Network (2008); Ecolab, Closing Keynote Presentation from the Financial Times Water Summit from Doug Baker, CEO of Ecolab (October 2015) Another key challenge relates to the proliferation of contaminants. This is a significant domestic issue, in addition to being a global problem. Chemicals enter drinking water supplies from agricultural fertilizers, as well as other sources such as chemicals used to melt snow or put out fires. The probability of exposure to dangerous chemicals, which can lead to serious disease and birth defects, is heightened by an aging infrastructure. In the U.S., core municipal water infrastructure can be over a century old in some areas, unable to meet the needs of larger populations and potentially containing a myriad of new pollutants. Municipalities with insufficient funding to replace pipes and water treatment facilities may turn to private capital to upgrade the systems, providing opportunities for investors. Alexandra sees the water theme as a way to generate “environmental and social alpha” given its link to a multitude of other fundamental aspects of human wellbeing. The increasing attention on water infrastructure in the U.S. from the Biden administration, as well as in other jurisdictions such as the E.U., will likely result in water investing becoming even more topical over the next decade. Other factors that may stimulate this investment theme include increasing soft commodity prices, which provide funds for farmers to invest in water efficiency, as well the growing focus on the impact of climate change on the hydrological cycle.

At the Earth Day summit, President Biden announced that, by 2030, the U.S. will cut greenhouse gas emissions by at least 50% from 2005 levels and will double climate-related financial aid to developing countries by 2024. Both proclamations bring the U.S. back onto the road towards meeting the ambitions of the Paris Agreement. However, lofty goals bring challenges and trade-offs, one being profound changes to the mix of energy sources in the U.S., and another being how we use land. Taking data from Princeton University’s Net-Zero America Project, a Bloomberg article stated that, “no matter how you slice it, the U.S. will need to rethink land use for an emissions-free future.”1 The current energy footprint of the U.S. is “about the size of Iowa and Missouri combined, covering roughly 4% of the contiguous U.S. states”.1 A low-carbon transition would require significantly more land to house solar and wind, even when considering offshore wind farms and rooftop solar. Additional land-use challenges will come from building the transmission infrastructure needed to connect renewable energy with end-users. The Net-Zero America Project has created pathways to illustrate what the transition to a carbon-free U.S. could look like from now to 2050. The pathway that uses the least amount of land increases dependence on nuclear energy and natural gas plants that use carbon capture technology. Neither of these options come without controversy. The same Bloomberg article notes that, “expanding nuclear power will present serious land-use challenges. While no one wants a power plant in their backyard, many people don’t want nuclear power on their planet.”1 Wind power, the pathway with the greatest additional land-use, would quadruple the current energy footprint, with the potential for wind farms to cover an additional 250 million acres. Land-use challenges aside, some stakeholders question whether the U.S. goals are realizable without a carbon price in place to provide a key market incentive. Last September, the Commodity Futures Trading Commission (CFTC) became the first U.S. regulator to call for a carbon price, describing it as the “single most important step to manage climate risk and drive the appropriate allocation of capital.2 More recently, the American Petroleum Institute professed its support for such a mechanism in its newly published Climate Action Framework. John Kerry, Special Presidential Envoy for Climate, stated in a briefing in India that, “President Biden believes that at some point in time we need to find out a way to have a price on carbon that’s effective. He hasn’t decided or made an announcement about it, but we all know that one of the most effective ways to reduce emissions is putting a price on carbon.”3 In the meantime, other jurisdictions are ramping up their carbon trading activities. The EU will expand its Emissions Trading Scheme and China will establish a national one for the first time. Global commodities traders and financial institutions are predicting carbon prices could rise to $100 per ton in the nearer term, a price that would be highly disruptive to multiple sectors and regions. As you would expect, new carbon-related investment instruments and strategies are coming to market as we are now “entering a period of expected future scarcity.”4 NET ZERO ASSET MANAGERS Climate commitments are proliferating across the financial services industry. The Net Zero Asset Managers Initiative, launched last December, has already attracted 87 signatories representing $37 trillion in assets under management. Managers signing up commit to “help deliver the goals of the Paris Agreement and ensure a just transition.”5 We are proud to work with several of the managers listed: Allianz Global Investors, Boston Common, Calvert, DWS, Sage, Vert Asset Management, and Wellington Management. Check out the full list and the commitments here.

Our March RIA Channel ESG Practice Playbook catalyzed several audience questions related to ESG engagement and divestment. Below are a couple of (slightly edited) questions we received: How can investors influence companies to be even better in ESG performance? How can advisors get more information on the proactive efforts of ESG funds that try to drive positive change? Great questions! One major way of influencing company behavior is via engagement, which encompasses everything from direct dialogue with a company to the filing of shareholder proposals to voting proxies. In our SMART Investing Solutions, we favor asset managers that incorporate strong engagement practices into their overall approach. For example, Green Century Funds, a manager in our mutual fund models, puts engagement central to its strategy. It states that the companies themselves “may also gain from strong relationships with their stakeholders.”1 The firm has deep experience in efforts to reduce deforestation, especially with respect to palm oil, which has led to tangible shifts in corporate behavior. In session one of our ESG Practice Playbook (video playback still available!), Martin Jarzebowski, CFA of Federated Hermes, a manager in our Climate UMA, said his definition of engagement is “a collaborative dialogue with the board of directors and with the senior leadership…to really better understand their ESG risks and opportunities, but also very importantly to be able to have a seat at the table to advocate for positive change.” Engagement enables an investment team to see the progress on the ground and potential “ESG momentum.” Engagement is a powerful tool, but there may be good reasons to consider divestment, especially when the issues go way beyond a single holding, or if an entire sector is in question for ethical reasons. In the 1980s, divestment was a contributor to the end of apartheid and, more recently, divestment movements are influencing change with respect to the use of the fossil fuels and the private prison sector. The choice to divest, engage, or both may depend on various considerations including firm values, investment thesis, and theory of change, along with the circumstances of a specific situation. Circling back to engagement, when dialogue fails, an issuer may be subject to a shareholder resolution and votes that go against the preferences of company management. According to US SIF, The Forum for Sustainable and Responsible Investment, “such resolutions are a meaningful way for shareholders to encourage corporate responsibility and discourage company practices that are unsustainable or unethical. A shareholder resolution need not win a majority of the shares voted to succeed in persuading management to adopt some or all of the requested changes.”2 Sometimes, simply filing a resolution brings a company back to the table for discussion and the filer may withdraw the resolution in response. We are now in the 2021 proxy season, which according to Barron’s, “looks unusually active.”3 The resolutions currently on the table show that several large companies are getting requests to conduct racial-equity audits, with others facing political spending and “Say on Climate” proposals. State Street Global Advisors will vote against “nominating and governance committee chairs at S&P 500 companies that don’t disclose the racial and ethnic makeup of their boards this year.”4 And, unsurprisingly, given the increasing focus on climate change, there are a number of resolutions in play asking for climate disclosures and ambitious emissions reductions. For those of you looking to follow how the season unfolds and more generally understand how managers engage and vote, there are several places to check: Managers with strong ESG integration and engagement practices often publish information on their websites regarding proxy voting policies, votes, engagement outcomes, and resolutions filed. For example, Federated Hermes, Calvert Investments, and AllianceBernstein. The Principles for Responsible Investment (PRI) has a shareholder resolution database where you can see which companies have received filings from which managers. Proxy voting service providers such as Glass Lewis collate the trends of the past season and the previews for the current season.

This Earth Day we’re encouraged by the proliferating commitments from financial services firms, regulators, policy makers, and corporations, in support of protecting and valuing the climate and natural ecosystems. Although there is much to be done, including greenwashing to discern, an increasingly bright spotlight is shining on climate, which illuminates interrelated environmental and social issues. One of those issues is the management and protection of natural capital resources, which is the focus of this email and a key theme in our upcoming RIA Channel ESG Playbook iSummit on May 12th from 12:00 – 2:00 PM US ET CORPORATE NATURAL CAPITAL MANAGEMENT In March, BlackRock released Our Approach to Engagement on Natural Capital, noting the connectivity between natural capital and climate, with a particular focus on biodiversity, deforestation, and freshwater and oceans. The report stated that “heightened awareness of the economic and social impacts of unsustainable natural capital depletion could accelerate policy actions that either introduce or increase taxes on the externalities from which companies currently benefit. This has the potential to significantly impact the economic viability of some business models.”1 BlackRock underlines the need to appreciate critical social aspects. Beyond supporting food systems and livelihoods, biodiversity, for example, is “an integral part of religious, cultural, and national identities throughout society, and provide[s] sources of recreation, knowledge, and inspiration.”1 Companies should therefore see natural capital within this broader lens and focus on their impact on communities in addition to disclosing their reliance on natural capital. These topics are gaining more priority from a standards and frameworks perspective. The Taskforce on Nature-Related Financial Disclosures (TNFD), which emerged from discussions at the January 2019 World Economic Forum (WEF), aims to leverage the structure of the Taskforce on Climate-related Financial Disclosure (TCFD) and emulate its rapid path to industry acceptance. TNFD expects to deliver a reporting framework in 2023 which will guide “corporates and financial institutions to assess, manage, and report on their dependencies and impacts on nature, aiding in the appraisal of nature-related risk and the redirection of global financial flows away from nature-negative outcomes and towards nature-positive outcomes.” As with TCFD, “[i]t is expected that complying with the recommendations of the TNFD will initially be voluntary for financial institutions and corporates. Over time, mandatory disclosure requirements are expected.”2