Explore the Thinking behind our investment approach

On Monday, Working Group 1 (WG1), which focuses on physical climate change, released its portion of the sixth assessment report (AR6) of the Intergovernmental Panel on Climate Change (IPCC). The IPCC was created in 1988 by the United Nations Environment Programme and the World Meteorological Organization (WMO) and has 195 member countries.[1] The first assessment report of the IPCC was published back in 1990, when climate models were much less advanced. It that human-caused climate change would soon become evident but could not yet confirm that it was already happening.”[2] This week’s publication emphatically states that “climate models can only reproduce the observed warming when including the effects of human activities, in particular the increasing concentrations of greenhouse gases.”2 Essentially, the 234 scientists found that climate change is unequivocally driven by human’s greenhouse-gas emissions. In contrasting current warming with historical climate change, the report states that: The world is now warming almost everywhere Warming is occurring rapidly Warming has reversed a long-term cooling trend Such warming has not been seen for thousands of years2 The message of the IPCC further underpins why we are so focused on climate. Advisors must understand climate science and climate risk, along with the opportunities for mitigation and adaptation, in order to optimally serve their clients across all their investment and wealth management needs. Owing to existing global warming limiting warming to the 1.5°C goal of the Paris Agreement is looking less-and-less achievable. In fact, the authors of AR6 “believe that 1.5°C will be reached by 2040 in all scenarios.”[3] But even though the prognosis is poor, “warming is likely to more or less stop once CO2 emissions reach net-zero, while net-zero GHGs would actually cause global temperatures to fall slightly.”[4] The scientific community is “hopeful that if we can cut global emissions in half by 2030 and reach net-zero by the middle of this century, we can halt and possibly reverse the rise in temperatures.”[5] We have technologies and practices at our disposal, but “is truly our last chance.”[6]

We are in the midst of a global water crisis, owing to climate change, irresponsible extraction, pollution, and lack of equitable access…[1] Less than 1% of the earth’s water is potable and global demand is rapidly rising. In fact, the World Resources Institute has projected a 56% deficit in water supply by 2030, putting millions at risk. Water.org estimates that 785 million people lack access to safe water and six times the population of the United States lives without a household water connection! Water is facing unprecedented demand across agriculture, industry, and domestic uses: by 2050 food-related demand is expected to increase by 60%, demand from manufacturing is expected to increase by 400%, and domestic demand is expected to increase by 300% in Africa and Asia, and by 200% in Central and South America by 2050. [2]. Changing global demographics including population growth, urbanization, and rising living standards are all conspiring to exponentially grow demand for water at a time when water resource issues are on the rise. As a result, companies addressing supply, efficiency, and quality may be timely investment opportunities with the potential to generate financial, environmental, and social alpha. This is exactly what the Virtus AllianzGI Water Fund does as one of our model managers. For example, the fund invests in Lindsay Corp. and Valmont Industries, companies that offer center pivot irrigation technology, an irrigation solution that results in a 95% improvement in water efficiency. Not only do these companies provide a meaningful solution to water scarcity, but they are also two of only three companies in the world that offer this solution. This is especially essential during periods of prolonged drought, such as the current megadrought in California. Given that California is responsible for two-thirds of fruit and nut supply and one-third of the vegetable supply in the nation, water efficiency technologies are essential. KEY FUND FEATURES Precision exposure to sustainable water Targets and invests only in pure-play companies, committed to solving water scarcity, increasing water quality, and enhancing water efficiency. A resilient portfolio in ever-changing market conditions The Fund focuses on high-quality water stocks backed by strong structural drivers, seeking to deliver stability in difficult market environments while generating attractive long-term growth. Time-tested experience in water investing The investment team has over a decade of experience in water investing and engages in a recurring dialogue with global water leaders. The Virtus AllianzGI Water Fund is included in the SMART Fossil Fuel Free / ESG Mutual Fund Models. To learn more about our SMART Investing Solutions and the managers we work with, schedule a strategy session with Penelope Jackson.

"Once mainstream market participants wake up to the risks and opportunities posed by the physical environment and our attempts to manage it, it will become one of the common lenses through which risk is evaluated.” – Alicia Karspeck, Ph.D.[1] At Gitterman Asset Management, we believe that climate change is our most critical systemic challenge. To that end, as well as being the biggest trend in the investment management industry, sustainable investing is also our highest purpose. We’re therefore committed to educating advisors so that they can participate in this shift and contribute to the purposeful direction of capital. In April, Cerulli Associates found that, notwithstanding client interest, “many advisors are still reluctant to offer ESG strategies in client portfolios.”[2] This is at a time when ESG strategies have been growing in availability, showing no signs of slowing. This only steepens the learning curve for advisors, especially as quality is not a given under rapid proliferation. Climate-specific investing, and, especially that which leads to tangible outcomes, such as the transition to net zero carbon emissions to align with the Paris Agreement, or adaptation to the myriad physical risks we are facing given just existing global warming, requires another leap in technical understanding. If advisors are not yet able to authentically serve clients with a general ESG interest, how will they serve clients who are specifically attentive to, and perhaps more knowledgeable about, climate? Certainly, in the numerous events we’ve held in partnership with RIA Channel, we see many of the same foundational questions showing up in the Q&A. A significant portion of our audience comes from large firms, which begs the question as to whether those organizations are prioritizing the necessary investments in advisor education? Without sufficient technical understanding, discerning between greenwashing and truly intentional investment products is tough. Marketing language, especially that propagated by big budgets (yet sometimes built on small ambitions!), may set off endorphins, but after that initial warm feeling, what are you left with? Tariq Fancy, former CIO of sustainable investing at BlackRock, recently shared that he was “rebuked…for going off script” when asked by a client what the impact of investing in low-carbon funds would be. His colleague, “told him that he should have stuck to the talking points by simply saying the funds are a way for clients to contribute to the fight against climate change, even though there wasn’t an explanation of how.”[3] Interestingly, sustainable investments recently “shrunk” in Europe, going from $14 trillion to $12 trillion from 2018 to 2020. This is not due to waning interest, instead it’s a result of more stringent definitions on what constitutes a sustainable investment under the E.U.’s SFDR. That’s not to say E.U. regulation has got it all right, but the subsequent change in assets does point to the wider problem of definitions and intentions. Put simply, voluminous data and elegant marketing do not automatically lead to a decarbonized world any more than a shelf full of unread books increases one’s intellect. We’re not saying this is easy – in fact, quite the opposite. In our industry conversations, experts who’ve been working in this space for years comment on how the level of information and new insights can be overwhelming. Prioritizing time to learn can also be a challenge for a busy advisor. Moreover, the trade-offs and complexities associated with mitigating and adapting to climate change should not be underestimated: as an industry and as a global society, we are going to make mistakes along the way. Learning is always a continual process and not an end. We can, though, avoid certain missteps, such as naively piling assets into inadequate products with cool monikers rather than diverting capital towards products with robust philosophies, demonstrable intentionality, and verifiable outcomes. Immersion in the subject matter, asking lots of questions, and retaining healthy skepticism in the face of clever marketing are three ways to mitigate this. Our upcoming event, The Great Repricing: Financial Advice in the Age of Climate Change, is aimed at helping advisors and other financial professionals achieve the former. We’re convening climate scientists, data providers, leading asset managers, and private companies, all of whom are focused on climate change from risks to opportunities. Join us for an immersive online experience, during Climate Week, from September 21 – September 24. For $99.95 you get four half-days (10am – 2pm ET of climate-focused content, opportunities to interact live with sponsors and select speakers, as well as access to the videos for 12 months.

As the summer heats up, we are taking a virtual trip around the world to introduce you to select managers in our SMART Investing Solutions suite. One goal of our diligence process is to find managers who make a positive impact through active shareholder engagement, alongside security selection. Green Century, a manager in our Fossil-Fuel Free managed mutual fund model, hosts an award-winning, in-house shareholder advocacy program. The firm engages over one hundred companies every year, pressing them to improve their environmental policies and practices on a wide variety of issues, from protecting tropical forests to reducing their climate impact. Among the firm’s noteworthy advocacy achievements is its campaign to prevent plastic pollution. Eleven million metric tons of plastic end up in the ocean each year1, which negatively impacts the environment in myriad ways, from harming wildlife to threatening human health. Green Century tackles this problem at the source by urging portfolio companies to reduce their use of plastic packaging In just the last year, Green Century secured plastic reduction commitments from five major corporations, including Coca-Cola and Mattel: Coca-Cola, named the “largest plastic polluter on the planet for the third year in a row,” agreed to reduce new plastic use by three million metric tons by 2025.1 Mattel “was extremely receptive” to engagement and will begin disclosing metrics illustrating their plastic footprint.1 To learn more, check out this video with Annalisa Tarizzo of Green Century: Convincing Coca-Cola and Mattel to reduce their plastic use.

When the term “ESG” was coined back in 2004[1], the goal was to focus “on issues which have or could have a material impact on investment value” over “longer time-horizons (10 years and beyond) and intangible aspects impacting company value.”1 In contrast, SRI (Socially Responsible Investing), was mostly synonymous with values-driven exclusionary investing styles. In the years that followed, the distinction between values and value has often been upheld, but in practice, the boundaries are more ambiguous, especially as data has grown in depth and breadth, and as these investing styles have become more popular. We see ESG as the underlying dataset that can be leveraged to make a wide range of investment decisions, depending on the investment philosophy or focus of a portfolio manager or asset owner. For example, ESG data can be used to create an S&P 500 index-tracking strategy that has, say, a lower carbon footprint and/or better board diversity than the underlying benchmark. Or ESG data could be used to construct a thematic strategy focused on water investing that makes active bets on which companies are creating the best or most scalable technological solutions to water constraints. Or, it could be used, as with SRI-styles, to remove an entire sector or group of companies based on a personal preference, which might be religious, political, or otherwise determined. Over the years, despite frequent calls to define terms, sustainable investing definitions arguably have become murkier. Many platforms that provide custom indexing and other personalized portfolio construction use “ESG” and “values” interchangeably, which can confuse both advisors and investors. Widely held societal values are important. They are part of a company’s operating context and can become financially material. Climate change and social justice are two topics that have gained increasing prominence in recent years, but other values-based topics may be more niche and less likely to impact company financials and valuations. ESG is now part of the mainstream and product options are growing by the day. Some are truly authentic, created by firms that have an ethos aligned to their marketing messaging. Others are, put simply, a cynical asset gathering tool. It’s therefore important for an investor to know what they are really getting when they put their money into an “ESG strategy.” Some tools and strategies take a more passive investment approach but allow investors the flexibility to exclude and include certain companies based on controversy data, industry-level data, or other variables. The underlying data enabling these decisions may be highly sophisticated or more superficial. Understanding what data is used, how it is collected, and whether it’s forward or backward-looking, is therefore key to advisor-investor research. As many ESG topics are complex and often interlaced with other topics, deeper analyses may be needed to make optimal long-term investment decisions. Take fossil-fuel divestment, for example: some investors believe it’s imperative to exclude the entire oil and gas sector, as well as other companies that are high emitters, such as cement and aluminum companies. However, some managers believe that a select group of these companies have the ambition (or potential) and the balance sheets, to be a significant part of the low carbon transition. Conversely, some consumer goods companies perform very well on social issues and may therefore be included in a portfolio of companies that also have high “S” scores. But, when considering plastic, water usage, and questionable nutritional content, an entity’s impact on the world may look much less positive. Given the breadth and depth of data available, it’s incredibly challenging for any individual to be able to sufficiently consume and synthesize the entire picture and then make an investment decision. Our investment philosophy, which is centered on climate change, amongst other ESG topics, looks at climate risk from a physical and transition perspective and incorporates adaptation opportunities as well as climate mitigation. The inherent uncertainties, trade-offs, and challenges within this space necessitate working with active managers who understand the ever-evolving climate datasets available and have teams of people continually updating their analyses. Our ESG process, therefore, is mostly diligence of the managers themselves to help ensure that their stated philosophy aligns with their actual portfolio decisions. However, what’s exciting for advisors and investors who work with us is that we’ve made it possible to marry the sophisticated work undertaken by our active managers and allow individuals to reflect their personal values and preferences. Our Unified Managed Account (UMA) models are powered by Natixis, which integrates a range of MSCI data points, allowing an individual to also determine whether they want to exclude certain companies from the overall portfolio.

So much financial advice is predicated on caring for your future self. Your present self must resist temptations today to protect tomorrow. But it’s hard. Granted, some of us are naturally wired for saving and discipline; however, others find it almost impossible to forego instant gratification. The long-term can be easy to ignore. Climate change poses similar, and bigger, psychological challenges. As climate scientist, Katherine Hayhoe, stated in a PBS interview, “It turns out, in the U.S., almost three-quarters of the people would say, oh, yes, climate change is real, it will affect future generations, it will affect plants and animals, it will affect people who live in countries far away. But when you say, do you think it will affect you, the number drops precipitously to just over 40 percent. That gap is our biggest problem, not the gap of people who say it isn’t real, the gap of those of us who say [it] is real, but we don’t think it matters.”[1] In his solstice update, Spencer Glendon refers to those who believe in climate change but don’t act because it’s a “someone else” problem. He goes on to state, “Collectively, we are inconceivably powerful while individually, we feel atomistic. We often don’t know whom to turn to when we are lost or frustrated or when something doesn’t work, and when people turn to us, we can confidently tell them that they are actually looking for someone else.”[2] But we are the people we’re looking for. There is nobody else. Katherine Hayhoe goes on to say that, “We have to prepare for the changes that are coming” across infrastructure, food, water, security, and other critical systems. Adaptation is part of our future irrespective of whether we can speed up mitigation via a swift low-carbon transition. She also encourages that “Every single one of us can make a difference.” So, how do we make a difference? Spencer says, “Stop doing things you know are wrong… Start by figuring out what you’re doing that is pretty obviously wrong.” But what is “obviously wrong” from a climate perspective? Is it eating food in restaurants that was flown halfway across the world? What about going on vacation via long haul flights? What about buying a brand-new pair of jeans or anything else that uses an enormous amount of water in manufacturing? And what are the trade-offs and second order effects from climate solutions? On that point, we previously wrote about some of the potential land-use trade-offs that may occur from shifting the U.S. energy mix to achieve net zero. At the very time we need to think deeply and openly discuss these big questions, we’re being continually distracted by the Internet, including ever more sophisticated digital marketing that taps into desires we didn’t even know we had. Our political climate, domestically and internationally, is fraught with mistrust and divisiveness which is hardly conducive to fostering collective ambition. We’re connected and simultaneously disconnected from the planet, from each other, and even from ourselves. These are challenging times with seemingly insurmountable obstacles, but there is always possibility. As Jeff has articulated before, “[we] have a tough road ahead, but we believe there are amazing feats along the way. Human potential is always in abundance.”[3]