Explore the Thinking behind our investment approach

While interest in sustainability and ESG is on the rise within the financial services and broader investor community, corporate boards are lagging. In a Harvard Business Review article, Tensie Whelan, Clinical Professor for Business and Society at NYU Stern School of Business, shared the findings of research showing “that many boards have little ESG-related expertise and many do not even recognize the need to pay attention to material sustainability issues.”1 In fact, fewer than one-third of 1,188 board directors studied had ESG expertise and very few have experience in the most material issues for their sector.1 Current boards “have a preponderance of former CEOs on their boards. Those CEOs were in charge 10-20 years ago when ESG issues were not specifically identified as financially material and may burden boardrooms with an out-of-touch mentality.”1 However, in research conducted by PWC, female board members were found to be “more likely to say that material ESG issues like climate change and human rights should be part of business strategy.”1 On a positive note, board training on ESG topics is now available. Helle Bank Jørgensen, CEO and Founder at Competent Boards, has created the ESG Competent Boards Certificate Program and says, “I would look at the proxy statement and in the governance section on websites. In the coming months, you should be able to spot board of directors who have achieved the ESG Competent Boards Certificate and Designation (GCB.D).”2 Jeff also recently interviewed Caroline Abramo, Chief Investment Officer at Pana LCE (Low Carbon Economy) Investments, on TheIMPACT TV show. Caroline talks about the “Green premium” emerging with respect to company valuation, how fossil fuel companies are investing in technologies to help lower carbon, including sequestration, and the potential opportunities and jobs that could manifest from enacting sustainable infrastructure legislation.

As one year closes and another starts, financial services firms memorialize their economic and market expectations for the upcoming year. Over the last few weeks, we’ve reviewed several papers and news items, and talked to experts in order to summarize some key ESG themes for 2021. 2020 saw record flows into ESG mutual funds, and ETFs continue at a record pace. As 2021 unfolds, MSCI sees market maturation with “both hype and skepticism giving way to a more nuanced understanding of when and how ESG has shown pecuniary benefits — and when it hasn’t.”[1] They go on to say that “investors no longer need to “believe” in ESG, or not. A sharper understanding is emerging as to which ESG approaches are financially relevant and which are more focused on social objectives, allowing investors to more precisely build their own strategies based on a track record.”[1] All of this should further support overall growth in sustainable investing. MSCI also highlights the following trends: Climate: Several companies have made ambitious targets, but a broader failure to adequately decarbonize could leave investors “with a dwindling investment universe of companies that meet the 2°C or 1.5°C targets.”[1] This could mean increasingly concentrated portfolios over time. Biodiversity: With many plants and animals at risk of extinction, biodiversity is seeing greater focus from regulators and investors. As with climate change, the impacts both on companies and those effected by companies vary based on sector and region, with the food industry especially vulnerable from both angles. “ESG Data Deluge”: In unwelcome news for many companies, pressure to enhance ESG disclosure will only grow as new regulations are implemented and stakeholders become more educated. MSCI notes TCFD becoming mandatory in certain countries, potentially including the U.S., in the not-too-distant future. Social Inequalities: Income inequality and racial justice concerns became more prominent in 2020, along with “S” topics in general. Noting that, “action is important, but there are limits to what individual firms can do to address the underlying root causes,” in 2021, MSCI sees “investors venture into new approaches, including financing vehicles like social bonds, to address a challenge that extends beyond the neat boundaries of individual companies.”[1] With respect to climate change, which is core to our investment philosophy, we’re already seeing new data initiatives from firms such as BlackRock as well as from companies driving innovations to support their net zero targets. And, as expected, the Biden administration has already moved to rejoin the Paris Agreement as well as moving to cancel the Keystone XL pipeline, among other measures. Climate-related subthemes such as water and sustainable infrastructure will be in focus, alongside continued pushes towards electrification in energy and transportation. These are themes and topics that are covered by the managers with whom we partner for our SMART Climate Unified Managed Account (UMA). In addition, given the political climate in the U.S., two particular ESG topics are already front-and-center for 2021: Political Spending: Company reactions to the insurrection and riots at the Capitol were swift. Numerous companies halted political donations to Republicans who supported overturning the election results, and some companies stopped all donations while they undertake reviews. The long-term impact may be “more symbolic than consequential”[2] given that corporate political giving is relatively small compared to other channels. However, this may catalyze a broader conversation about money in politics. Social Media Responsibility: Already under criticism for their roles in fomenting political polarization, several social media companies moved to de-platform President Trump this month. In their recent brief, Democracy Disrupted & ESG Risk, Truvalue Labs restated their earlier observation that “it is hard to imagine a business with more significant tail risks than social media.”[3]

Jeff recently chatted with Julie Cooling, CEO of RIA Channel, about our SMART Climate UMA and why there is more alpha potential available in a UMA (Unified Managed Account) comprised of SMAs (Separately Managed Accounts), as opposed to mutual fund models, including tax alpha from the overlay capabilities.

According to Fidelity, “ESG investing is far from a passing fad.”1 It won’t surprise you that we agree with this statement, but even we are (pleasantly) impressed by this year’s fund flows. While 2019 saw net inflows into U.S. sustainable funds of $21.4 billion – over four times higher than in any preceding year – by the end of Q3 2020 inflows had already reached $30.7 billion.2However, many advisors and asset owners still find themselves on the sidelines, unsure how to integrate sustainable investing into their businesses. Alleviating this confusion is why we focus so much of our attention on education. And, why we were grateful to be asked to share our experiences in Fidelity’s recent whitepaper, “ESG Investing: An Advisor’s Guide to Strategies, Paths, and Approaches,” which provides practical tips to help financial professionals navigate their own, authentic path.The sustainable investing landscape has evolved so much in the last decade. From the evolution and increased adoption of standards and protocols to the propagation of new data sets, there are more ways to create an ESG portfolio than ever, and this is unlikely to slow down. So, knowing where to start to diligence the universe is a big task in and of itself.Fidelity suggests getting philosophical as a first step and poses these questions2:Why do you want to offer ESG investing as a firm, and what goals will it achieve?Do you want to add an offering to stay relevant to evolving investor needs?How does it align with your firm’s existing philosophy and approach?How will you define success with respect to your firm’s ESG strategy?These may seem obvious but, given the myriad of exciting ways to implement ESG investing, asking the right questions at the outset will help ensure strategic alignment. We also recommend ensuring everyone on your team is using common definitions of all terms. While “ESG,” “sustainable investing,” “impact investing,” and “socially responsible investing” are often used interchangeably, even small nuances in how each person understands these terms could result in challenges when moving to implementation.We define ESG as the GPS of Investing® and consider it a foundational data set upon which all our sustainable investing portfolios are built. It is both connected to, but can be distinguishable from, values-based investing and impact investing.Once you’re clear on your internal positioning, subsequent decisions that determine your approach should be easier to resolve. Fidelity suggests the following questions2 to help clarify how you will create your offerings:Where does your firm see itself on the ESG spectrum: Will you outsource ESG investing, use a do-it yourself approach, or help investors make a direct impact?What resources will you need to be successful? (Presumably, you will need more resources and expertise if you are not working with a third party.)Are you willing to hire more staff, train and educate them differently, buy new data sources, etc.?What is your time frame for launching even a “minimum viable product” ESG offering?How will you measure success?When you’ve clarified your philosophy and laid out your plan, communicating to clients takes center stage. As Jeff Gitterman shares in Fidelity’s paper, it’s important to understand why and how ESG investing may resonate with your clients, as well as articulating why it resonates with you. Discussing these topics can be a great way to connect with your clients and bring new prospects into your firm.

Despite an increasingly polarized political landscape, one area where there is bipartisan support for governmental intervention is climate change. A Pew Research survey in June of this year found that “a majority of U.S. adults want the government to play a larger role in addressing climate change”, with around two-thirds saying that “the federal government is doing too little to reduce the effects.” Unsurprisingly, given the proliferation of wildfires, hurricanes, drought, extreme heat, and other impacts, most Americans “continue to say they see the effects of climate change in their own communities.” For those actively focused on climate change, the last few years have been devastating when it comes to U.S. climate policy. Pulling out of the Paris Agreement and the rolling back of regulations have put the country further and further behind the progressive efforts of other regions. However, 2020 has also brought some glimmers of hope, one being a report published by the Market Risk Subcommittee of the Market Risk Advisory Committee (MRAC) of the Commodity Futures Trading Commission (CFTC) in September. The CFTC, which regulates the U.S. derivatives market, was not the most obvious messenger of the seminal work, Managing Climate Risk in the U.S. Financial System. Jeff Gitterman recently interviewed Bob Litterman, founding partner and Risk Committee Chairman of Kepos Capital, and chair of the CFTC’s subcommittee, to discuss the process. The subcommittee, a diverse group of participants ranging from agricultural and energy companies, NGOs, academics, and financial services firms, “voted unanimously 34-0 to adopt the report” and its 53 recommendations. This bipartisan consensus was achieved by focusing on where they could secure agreement among the participants. One of the primary conclusions is the simple statement that climate change “poses a major risk to the stability of the U.S. financial system and to its ability to sustain the American economy.” As a result, the most critical recommendation is that a price on carbon that is “fair, economy-wide, and effective in reducing emissions consistent with the Paris Agreement” is the “single most important step to manage climate risk and drive the appropriate allocation of capital.” Litterman notes that carbon pricing is “an inevitable policy response” to climate risk and that once appropriate incentives are established, the financial system will go into action. However, the report did not go as far as to suggest what that price should be, as this, and the mechanics of the policy, are the role of Congress. As a risk manager, Litterman advises that “time is a scarce resource” when you’re managing risk. The longer the U.S. waits to take decisive action, the more likely it is that we face a “disorderly transition” and sudden devaluation of assets. While many would prefer climate action to be driven solely by an intrinsic motivation to steward the Earth, progress to date suggests this will never happen. We agree with Litterman that changing behavior requires changing incentives – whether those be tax credits, regulations, subsidies, or other policy levers – and we are well beyond the time to act. We hope that the work of the CFTC’s subcommittee along with positive signals from the incoming Biden Administration will incentivize climate action underpinned by an exciting new era of U.S. innovation.

Over the last several years, ESG data has become increasingly rich and sophisticated. However, the “S” has presented more challenges in terms of data as “social principles have gotten far less representation in portfolios than environmental and governance issues.” This is because the “S” covers such a wide range of topics and because broader sustainability reporting, although progressing at speed, has not yet resulted in commonly adopted standards and best practices. However, “[t]his dynamic is changing, as asset managers, advisors, and investors demand information and flex their shareholder muscle, and as more mutual funds find effective ways to sharpen a social focus.” Read more in Barron’s to learn how Jeff Gitterman and Adam Bernstein see the change in the market when it comes to the “S” in ESG, and which mutual fund families and products are leading the way.