With investor’s growing interest in the recent years, impact investing has showed healthier returns and better risk management, all while addressing important social and environmental issues. Deborah Spalding, Ben Yeoh, and Randell Cain join together in San Francisco to discuss a few concerns such as promoting a low carbon economy, human rights and gender pay parity and best practices related to investing in companies.
HOST: Impact investing has been an area of great interest for investors in recent years, ESG investing has shown healthier returns and better risk management while addressing important social and environmental issues. Investors from around the world have come together right here in San Francisco to discuss concerns and best practices related to investing in companies. Focused on promoting a low carbon economy, human rights and gender pay parity.
HOST: Today I'm joined by three experts who will share their insights on the ever popular topic of impact investments. From the Nasal entrepreneurial center in San Francisco. Welcome to the responsible investing master class. Well thank you guys for joining me today. Let's jump right in. Let's discuss how ESG came to be such a popular investment theme. Why is it something investors are gravitating towards?
BEN: Well I guess there's a couple of things. One is from client demands side. There's pockets of increasing interest over the last ten years. If you look at it on an individual basis, it seems to be powered by the younger generation, for those under 40 that are more interested and it's actually powered by women who tend to have more money and they also tend to be more interested in that.
BEN: On the institutional side, they're also interested because of some of the themes which we alluded to in environmental, social and governance. And because I think there's a burgeoning amount of evidence that not only can it know the risks in terms of portfolio construction and your investment process, but there's also a lot of evidence that actually some people are using it to get better returns.
BEN: This idea of alpha seeking sources. So putting that all together I think you have a powerful trend in both active and passive strategies.
RANDELL: And I would agree with that in that in the past, much of what we would probably think of as ESG from a euphemism standpoint we would consider to be socially responsible investing. Which is more of a negative approach to investing basically saying don’t own these type of companies, don't own these type of sectors and don’t' own these type of industries. But, instead as my colleagues alluded to, the research has indicated that ESG investing itself has shown alpha generated potential.
RANDALL: And so I would envision it being an evolution of investing, another step forward from social responsible, but basically being able to do good but also making sure that the companies have chance to do well as investments also.
DEBORAH: And I would agree. I think that the tools for analyzing ESG and determining distinguishing companies that adhere to ESG principles and those that don't, is that they're actually getting more sophisticated.
DEBORAH: So as the tools have become more sophisticated more investors are willing to adopt them. But I also think, we work with a lot of foundation and endowment clients. And foundation and endowment clients, they face a certain amount of reputational risk if they invest in companies that are inconsistent with their mission.
DEBORAH: And now, as you think about it ,we are in a connected world and I think there's some agree of reputational risk uh ,that they are concerned about and so that's leading them more into looking into ESG in their investment program.
HOST: That's an interesting point. There's so much encapsulated in ESG. Let's also think about what ESG is not. What's the difference between socially responsible investing and ESG investing?
BEN: So the root of a lot of this was from an exclusionary basis. So you had often a faith based, very mission aligned movement which started in the 50s and 60s which decided that either because of principals or values or a religious basis, we said we're not going to do this. We're not going to invest in pork, we're not going to invest in tobacco. Some sort of kind of, I guess people called it ethical. But from that root we've had an evolution.
BEN: So that's still I guess under the umbrella of what you might call sustainable ESG responsible investing. But it's actually a relatively small part of what we consider in todays eco-system. And that's evolved into this idea of ESG, environment, social, governance. Where you are really looking for material business factors. Sometimes they won't be material, and you're looking at positive material factors that great companies can do good things with. And you're also looking at negative material factors where you want companies to avoid that.
BEN: So you're looking at both the opportunity and the risk side but you are not making a kind of value based judgment on that. And I would interwove one other thing on that. Which is this notion of stewardship, which is how you guide investments when you have them. Which is interwoven into that idea. And that's something which is also increasingly taking place.
RANDALL: And from the standpoint I would say of making investors feel good um, with social responsible investing it was more or less, or has been more like an alternative investment. not you core portfolio but something that you do because you want to allocate your capital in a certain way to make sure your dollars are doing good for you. The challenge within that though, the overwhelming body of evidence is not suggesting that was going to generate alpha versus a non-restricted type of investment universe. With ESG that is not the issue. The situation with ESG investing is that for I would say, either quantitative or qualitative investors, fundamental investors so to speak. They're looking for reasons to believe that a company is a good company as an investment.
RANDALL: ESG is complimentary to that. it's not something where you say well this company is in this particular area, therefore I don't want to own it and instead you have the opportunity to see what type of things your company's doing from these different factors and areas that they’re doing it right now for the current but doing it also for the future and making a positive impact on the company longer term. So in terms of the stewardship aspect of things, by incorporating the ESG principles there's a chance to make investments today by a company that may differentiate it from its competitors that and later on down the line in the future, will show higher and better returns. Which investors regardless of the ...of the gambit that they come from, they’re actually looking for.
DEBORAH: And actually I’d expand on something that you mentioned. ESG is seen as something more positive today as opposed to socially responsible which is negative screening. But you mentioned the notion of risk mitigation. And I think there are a lot of investors today that maybe they’re not sure if they believe that ESG maybe a source of return and they may not be mission oriented. But they are concerned about the risks associated with not taking it into account. So it's moved I think beyond an ideal logical exercise to a way to access both risk and return.
HOST: What do you mean by not taking it into account?
DEBORAH: That avoiding ...that so you think of ES&G, environmental, social and governance. I think it’s fairly well accepted that companies with poor governance tend to do poorly yin the future over the long term. that it sets the company up for potential hiccups that have nothing to do with their underlying business.
DEBORAH: And so an investor may say I'm not necessarily focused on governance but if I avoid considering whether or not this company has good or bad governance it may end up influencing its share price negatively at some point down the road and I need to be ware of that. Similarly, a company that has a poor environmental record may have more legal risks or litigation risks. So even if uh, an investor doesn't want to say have a low carbon portfolio they may be concerned about litigation risks for companies that are very dirty.
BEN: And some of it is a kind of language aspect. I think, for instance, most investors would agree that strong management teams are valuable. A positive corporate culture is valuable. Well if you kind of have an ESG lens that kind of falls under a G. Well if you didn't have an ESG lens that would just fall under mainstream investing. And again, under the kind of the S you kind of think well social. Again, most people think ....if I had 1,000 dollars for every time a CEO said, my people are my most important asset, I could have retired by now.
BEN: Well again, if you think about it from a business view, everyone is thinking about employees, engagement, productivity. From an ESG lens that kind of falls under an S. If you're a mainstream guy you kind of are thinking well that's acutely just a material business factor that I should assess. How you're being systematic and how you are evolving that is that. Again on the e point you might have environmental litigation. If you have an oil spill, if you're not cleaning up after yourself, you know the regulators are going to come after you. How are you doing, your reputation. So all of that is kind of falling under that. It might acutely have been looked at by the people who don’t' necessarily think of it as under ESG so this is one of the evolutions about the evolution of language and certainly isn’t' in the same bucket in terms of what we were talking about, SRI, socially responsible in an exclusionary way.
BEN: We're talking about what are the factors which make good businesses great and maybe make sort of average businesses not so great.
RANDALL: And I think to that point one of these interesting things is, when you look at some of the good to great companies barred from Jim Collins, I think what you will find is that while certain principles and ways of doing business may not be categorized definitively and as ESG, when a company's making a decision about how to be more efficient as moving forward in the future.
RANDALL: When it wants to make sure it's being a good corporate citizen. All of these types of decisions come under ESG and so like for us when we're investing in companies we like to break them down into four building blocks for analysis. We like to look at the management, the strategy, the financials and the operations. Well if you're a company lets say in the chemical space or even though it may be consider in this group setting the dirty area of energy, for companies that tend to focus on what are the environmental impacts or the decisions that they're making because it could impact long term returns.
RANDALL: That's an ESG type of decision that they’re actually making. But if you were to approach company management and say do you want to incorporate overtly? [INAUDIBLE] they'll say, oh no we don't do that. But then when you break it down to how do you make sure you’re operating in the most efficient sound fashion, you will probably find there's more similarities than differences.
HOST: And they are actually doing it?
HOST: Are there hindrances to adopting this kind of strategy for certain kinds of investors?
BEN: Well I guess it's still la debate amongst some investors as to, is this really adding value? is this product adding value? We're seeing that. But I think one of the ways if you rephrase it in terms of difference of language, one way you could talk about ESE are these are a lot of intangibles in the business.
BEN: Some of them are harder to measure. Some of them don’t' appear on a balance sheet with cash flow. But we all know that companies can over borrow from one of these sources. You can over borrow from the environment by not cleaning up after yourself. Borrow from the future by not investing in your R&D. You borrow from your employees by cutting staff benefits and training and things like that.
BEN: And if you think about that, if you over borrow from your employees, acutely this quarter's, this year's earnings and cash flow go up. You actually report more profit in the short term. But actually, you know, in any of our organizations that benefit [UNSURE] or you thought training development is important, that's what staff really wanted and that 's what was cut.
BEN: Well they're not all going to leave you this month, that's too difficult. But actually next year you had a recruiter, a head hunter call, they might take that call and low and behold over the next 2 or 3 years you'll probably lose all of your best people and you don't get them back. So what you've ended up is destroying longer term value rather than shorter term or shorter term ...at the cost of shorter term profit. Now scoring some of these thins and assessing them whether you do qualitative or quantitative it's still being argued about. And I think this is where some of the language causes a little bit of difficulty. Because some people think about it, are you still doing this exclusion based stuff? Or is it that kind of thing.
BEN: But actually, when you evolve it to ESG and you talk in the language of intangibles or liabilities that you don't see here. Or the reverse assets you know if you’re investing in your people and you think that's really great investing in R&D. You’re creating assets that you don't see on the cash flow. That' positive at ESG. So in terms of that I think when you convince those around that then you’re generally winning people over. I think where the suspicion is, is that you now this kind of tick box fashion, or the fashion where it's just exclusionary uh, I think that doesn’t resonate with a lot of mainstream investors. It doesn’t resonate with their history and their experience. And so I think part of that kind of hindrance is just explaining what it's all about and hat that toolbox is and what it isn't.
DEBORAH: And I think very similar that the biggest challenges are around assessment and measurement. And I think there are a lot of tools that are out there today to help score companies on their ESGness but I think one of the bigger challenges is actually the data that is used to score those companies. A lot of data uh, is self reported, it's voluntary and so then the question is you can have the most robust, most sophisticated but if you're input data is very poor or if there are material gaps or there's no standardization between how one company uh, reports versus another, then you've weakened the power of that scoring methodology. And then I think from the client perspective our clients will often say we really want to do this but we're not really sure we can quantify the ESGness of our portfolio. So, it's very easy to quantify returns.
DEBORAH: Your portfolio goes up, or your portfolio goes down if you’re investing with an ESG lens it's very difficult to say I created x amount of E value or X amount of S value. And I think that really stops a lot of investors from taking that next step because it's very difficult for them to articulate to their stakeholders, this is the value we've created.
HOST: We need to put a number on it. And how do you do that?
BEN: Exactly. What does 77 out of 100 mean? What does AA mean? it's kind of not that meaningful for people so that's definitely one of the issues. And I urges the other thing is, if you look at the data or the so-called ratings agencies, the correlation that we're seeing today between ratings agencies is very very low. It's between .3 and .5 out of the two or three biggest ratings agencies. Whereas bottom rating agencies agree. So they're definitely not measuring the same kind of thing. It's much more at the moment in the stage of opinion and where we're evolving on that.
BEN: But the interesting thing again is the kind of language thing because you can flip it over and should you be addressing some ESG data points to a higher standard then financial debts? So for instance you can take a very established financial diametric like return on equity. Return on equity doesn't apply to some companies. If you're a fast growing biotech, matter of fact, fast growing most young companies they don't have any return on equity. So if an analyst would say what's the ROE of a biotech, well you should probably show them the door because they don’t really know what they're talking about.
BEN: It's not material, it’s not relevant to that company. In the same way that if you’re talking about say water stress for a media company, probably not hat relevant but we're talking about water versus maybe a soft drink company or a beer company has say manufacturing in Africa, then that's really material. In fact management will talk about that. So there is a materiality aspect when you get down to the granularity of okay, what does this mean for my company rather than saying 77 out of 100 and that's sort of saying well yeah return on equity's not always meaningful uh, sales growth isn't always meaningful and you know you’ve got to put it in the context of the overall shape of that company.
RANDALL: Well, it’s interesting because as a fundamental investor I think that there is this interplay, this interchange between art and science with investing. There are very objective criteria that you can use, but then there's also, from a qualitative standpoint, things that you might want to consider that can influence your opinion. And with ESU depending on again , you can be very sophisticated in how you put together the algorithm to give you the output but the challenge that you have right t now is a lack of standardization. Everybody doesn't agree that the output will say the same thing.
RANDALL: Because everyone’s not agreeing on the inputs that are going into it. And for many investors quite honestly I think that they don’t have the time or the interest to be as smart about everything to be able to qualify which investors are doing exactly their particular way. When we talk about priced to sales, there is an agreed upon number. When we talk about return on equity, depending on which type you’re using, there's an agreed upon number. But when it becomes ESG there’s' a lack of standardization, a lack of agreement on that. When you want to run, say regressions on returns, what do you attribute to ESG if you can't make it clearly I think more so one to one is harder to get investors to buy into it.
RANDALL: But, what we're seeing right now, the way I look at it is we struggle with things that re new and as we continue to struggle wit it because we believe there's value and then there's the opportunity for dispirited constituencies to come together. To say this is the actual number. But I think with ESG one of the challenges you have within it is if it's not viewed as being complimentary to traditional investing then it becomes an alternative investment and therefore clients have to think about what part of my portfolio do I want to carve off for this alterative investment over here because I’ve got the rest of my portfolio already allocated. ESG I believe will begin to gain more momentum as it's being viewed as complimentary to traditional investing. Another way of doing investing that is really not different. But it's something that is more of an evolution that's now getting some names and titles associated with it in a way that you can try to overtly say this is ESU's impact for investors to say okay it has this this impact and I can see it and it's not something I'm afraid of.
BEN: And it took some time, since the result to actually agree on some of the financial standards so we talked about earnings today well actually earnings on the US gap we've had to transform it into J gap or IFRS. Earnings are actually earning earnings. And companies themselves talk about gap earnings and non gap earnings. And there isn't always necessarily an agreement. it's taken a while for us to get to that kind of place so the ESG data and standards will also kind of develop to get that. I think there’s another point about maybe why it's quite good and there's something debatable about it, at least the fundamental active is there's a general thought that if information is really, really efficient than it tends to get priced. So a lot of financial information has this idea that it's been commoditized. Twenty, thirty years ago you needed to change Jcap to IFRS and do that and then you knew what the return on capital was. Today you get that information from your computer terminal in seconds. Yet things like corporate culture, R&D, innovation, employee satisfaction, things like that. That's still inefficient or costly information to get in the process even though we think its valuable and so in that inefficiency there should be some risk of return within that.
BEN: Because it's not necessarily that well known. So that's another part of the debate which I think is quite interesting.
HOST: And I'm interested in knowing ..I mean to ask this earlier. When you mentioned data and where ...the sources of data. How much does that come into play especially in the ESG space? if there is data being presented?
DEBORAH: Well I think it’s critical because everything follows from the data and I've talked to corporate management that have been frustrated that they can't always report, even if they want to. Particularly multi-national corporations that have subsidiary business they might not have the same type of data, they may not get the same type of reporting and then they have to aggregate it up and make some assessments in terms of how to fill those gaps and then they get frustrated when ...and this get back to your point about commoditization of information. When the uh, the south side analysts can appropriate the information then they get a rating of A from one analyst D from another. I actually don’t think that's the problem for the reasons you mentioned. You know some analysts have a buying stock and some analysts have a sale on a stock. So the fact that scoring is different I don't see as an issue but I think we o need to have some consistency into what is reported and how it is treated, over what time period it's reported and thresholds of materiality to return to the earlier point before we can even begin to effectively quantify whether or not investing with an ESG lens would generate alpha.
HOST: Alright. So how are traditional investors embracing ESG investing, or are they embracing it?
RANDALL: I would say it's something that traditional investors are somewhat almost being uh, forced to embrace. Um, um, again the level of sophistication that we have, in terms of investing have not gone backwards, it's only gone forwards. And any information that can show the opportunity to have incremental positive impact on investment outcomes and decisions is something that investors are looking to incorporate also. What you're finding is that some of the larger planned sponsors are actually asking for information regarding are you in corporate yes, yes, and when you say that when the people basically pay the fees for the assets on demand and start asking for that type of information it becomes more material and important to traditional investors from the firm I was at before we basically did not have a strong ESG I would say depth and breadth of research.
RANDALL: We could do the socially responsible investing aspect of it in terms of the negative exclusionary. But as far as incorporating ESG to be able to look at the different factors to try to come up with something, even if it was unique to our own firm uh, we could come up with something objective to say well this is how we do it, that infrastructure did not exist. At the firm I'm with now, Sustainable inside capitol management that does exist. And it is very robust and rich and our ability to use that to guide us in investment decisions is something that does make a difference because when it comes down to us having gone through traditional screens, having done the analysis if you get down to two companies you'll want to see what is it that I think separates one from the other.
RANDALL: The ESG scoring can be the tie breaker for you because again the way we view it is that ESG investing, when it's done the right way, uh, is something that is additive over the long term. Not just necessarily quarter to quarter but over the long term as far as strategy in implemented. And so as investors are kind of being asked to answer that question by their clients I believe it is having a stronger foothold with more traditional investors.
DEBORAH: I think from a client perspective, uh you know clients there’s a group of clients, especially in the non-profit area particularly in University endowments that are feeling the pressure. They're feeling pressure from students, particularly around climate change to invest uh, the University endowment uh, with a lens to climate change. Either to avoid fossil fuel companies or to invest in positive solutions toward a low carbon economy. And that pressure I think is causing a lot more discussion among endowment foundation clients. I think the challenge though is there's often a lot of interest but there are impediments to taking that next step and often what we find is when we work with boards of trustees there's a general feeling that these boards must think about these issues find ways to incorporate them but there's not always uniformity around the sense of urgency. There’s not always uniformity in terms of how to take that next step and o what I think we're seeing is a real gap between a recognition that we need to respond to pressures from their stake holders, but the not sort of what that means in terms of portfolio implementations.
DEBORAH: There are some investors though who do take a more proactive step and I think the challenge for those investors is finding the right investment program that actually are aligned with their particular approach to ESG.
HOST: That sort of debate between tis' nice too this versus you need to do this.
BEN: Or what I think is really adding value to a little bit [INAUDIBLE] about it. It's a deceptively simple question which has quite a complicated answer. Uh, so for instance it varies geographically, and it varies across asset class. So if you think about it, we've actually talked a little bit through more of a US focused lens, but for instance, in Europe, it's very much a must have. I don’t think there's any institutional RFP that I’ve seen over the last two years which doesn't have a whole long section on ISG or a long section on stewardship. That's less so in the US. You also split it by different investors. ENS space, corporate space, high net worth space. They’re all a little bit different and then you actually ask how a traditional asset manager is thinking about it. They’re thinking about it differently within fixed income, within assets, within direct infrastructure, with inequities.
BEN: But actually, we're all thinking about it to some extent. Even if you decide to actually maybe know you've been posed to question somewhere along that. And then your response, if you are going down that is tempted to be one of two or three things. Either you first of all area starting with policy and ten you’re either starting with an ESG team or a separate team with a separate overly which is feeding into inputs with a portfolio manager or decision making team. Or you're actually saying I’m going to take some of these techniques which are coming through to this toolbox and integrate it into how the portfolio manager is thinking today with the fixed income or private equity or however some sort of emerging debate as to which one of those is best and in our team we do all of that graded assessment ourselves, we will read proxy vows, we'll do our own stewardship. We think having it completely integrated within that is the best way forward in terms of sort of a concentrated equity portfolio. But actually that's not going to be possible in a passive way of doing things.
BEN: You know, a team of 35 looking at 17,000 companies they’re going to have a very different way of doing it. So it's kind of a deceptively simple question but it has many many different evolutions depending whether you’re passive, you're active, you have a fixed income, your equity or geographic mix. What your clients are thinking and through their lens and there's a lot of detail into how we're thinking about it, but we're all thinking about it ,and we're all progressing foreword.
HOST: For my own interest, really quick, elaborate how geography matters.
BEN: Because this is your different asset owners. So the people that actually own the money think about it differently in their different geography. So it takes something like Nordic land, as I was saying all RFPs include something on ESG. IN fact they would also be very pro thinking through a lens of global compact and they're also looing at things like UN sustainable goals. SDG's. Actually in the US or North America in General not so keen on global compact SDGs are interesting at a kind of company level in terms of a process. An individual sort of a government mandate is also different. We take the Norwegian government pension fund which is now about a trillion dollars.
BEN: They’re also very interested in it. The Japanese GPIF, the Japanese government pension fund have also signed up to UNPI very interested in this So, their also a trillion dollars is moving very much towards an ESG type of thing, and they're putting it in their RFPs. Other countries and geographies less so.
RANDALL: And I think just picking up on what was just said, as you start seeing some of he large sponsors domestically and globally incorporating what I believe will happen is ESG will start to move from more of a fringe type of interesting thing to talk about and yes that sounds like something we should be doing to more of a function within RFP's and RFI's. How are you doing it? Because one of the things I think about, as a traditional manager. I'm not asked to manage money in the same way as any other managers asked to manage money. I'm asked to manage money according to my particular style.
RANDALL: And it's up to the client to assess whether or not the way that I approach it is something that they’re comfortable with. Within that I believe the ESG component will simply be another part, component of how investors evaluate a managers strategy. Not whether they have it or not, an expectation over time, likely, hopefully will be that it's there but how do you do it, versus someone else? And one's not viewed as being good or bad, it's just viewed as being different.
RANDALL: But, the odd manager out will likely over time be the one who doesn't incorporate ESG at all.
HOST: Alright, so much of what we talk about in ESG and impact investing is the terminology itself. Tell us how an ESG investor is different from one that embraces ESG principles.
BEN: How and ESG investor from one who embraces ESG ...
BEN: I think that's pretty similar. I would say there are more differences between impact investing and ESG. But I think if you’re embracing ESG principles then you probably could call yourself an ESG investor. Whether you want to [UNSURE] yourself as ESG, then that's a difference it's like for instance management. Most fundamental active people ...in fact all around would say management or governance is important. Whether you called it as the E part of ESG. And most people would say if you got 100 million dollar fine for something that's pretty important. If I happen to be through ha chemical or an environmental spill well okay so that's E. So uh, I think there is this cross sectionalist and there's some naming on language but I do think if you’re embracing these principles and you are putting it within your investment process and philosophy and it's coming out then you're using the ESG toolbox as an investor.
HOST: Well I think what it is ....what the question’s relating to is again the need versus the want. Is somebody going to actually label themselves as an ESG investor or somebody who says well this is nice and I think it's important, but do I want to invest in it? I'm not sure.
RANDALL: Well I think it gets down to how ...I guess what is the demarcation that your 'trying to draw? For example, you could say I'm a growth investor or I’m a value investor. From the elk that I come from, if you’re not a value investor, you're not really an investor. Because you're looking for companies that are sound fundamentally that are trading at a discount to what those fundamentals actually merit. therefore if something doesn’t fit that criteria it's not a value investment. It's not a value opportunity. When it comes to ESG investing, I think it can be a matter of are you kind of waving a banner that will clearly distinguish at the front end you're seeking to use ESG principals and therefore everything that you do people will say okay you do that as an ESG investor.
RANDALL: The difference being, for example, uh, from a very rudimentary standpoint if you just use valuation as a way of investing you could say well again I’m a value manager. But then you think about the evolution of Warren Buffet what he used book value and basically we're looking at a balance sheet and getting it down to what the break value of a company. Basically looking at a balance sheet and you get it down to the breakup value for a company and did that for a long time until he evolved into looking at the long term opportunities vesting in sound companies that some might call a quasi growth company. Trading at reasonable prices. And seeing the compounding effect allowing [INAUDIBLE] for a long time. But he incorporates that he owns some companies that don't look like traditional value companies but he's still considered to be the world's greatest value investor.
RANDALL: I think that the difference is you can have managers who will overtly say well yes I am an ESG investor because I'm only looking at certain crimes to fit this criteria, versus there are other managers that will go through the additional investment process and this is just another complimentary tool to pull out of the tool kit to help you make a decision.
DEBORAH: I think uh, investors that label themselves as embracing ESG principles take a broader philosophical view of their investment programs to say this is important, um, there's many different ways to thin about it, we think that it adds value in terms of how we commit capital but then as Ben pointed out, being an ESG investor is really then committing that capitol in ESG type of product. And I don't think that one is better than the other. I think that those asset owners that say we embrace ESG principles but then don't necessarily invest in ESG funds, a lot of that is because you're looking at multi asset portfolios and recognize that embracing ESG and equity markets is very difficult in seeking to have an ESG lens in head funds or private equity. And so you can embrace ESG principals but also manage the feasibility of implementing that is actually very challenging in some cases.
HOST: Okay how does your firm evolve its thinking about ESG over time and if you can provide any examples that would be great.
BEN: How has it evolved over time? Well we increasingly have created an ESG toolbox so back 10 years ago we wouldn't have signed up to UNPRI. We're now signed up to UNPRI. As we eluded to earlier the data sources have come through. So ten years ago there weren’t really SG rating agencies, now there are. There's now some ESG data although transparency and quality is still an issue. Ten years ago there was very little. So that's come into it and all of our investment teams have been asked to think about how does the ESG toolbox like how can it augment your philosophy or your investment process. And as we spoke about earlier. Whether you then say okay this is part of our philosophy and we think we can create alpha or mitigate risks, that's one part and the second part is even if you’re not necessarily putting into in terms of your philosophy is there parts of this toolbox that you think can do that will make it better. I mean you can think about the reverse. Who wants to be invested in a poor management team with high employee turnover which is causing a lot of environmental damage?
BEN: I don't actually think that many people would want that as an investment. Those are parts of your toolbox which would come through which maybe weren't around so much. So we've evolved that into our thinking. Everyone at RBC has integrated some aspect of ESG toolbox into that thinking.
RANDALL: I would say um, that sustainable insight, the firm was founded with the interest in being on the lading edge of sustainable investing, ESG investing. And the evolution that continues to take place in the organization is that um, the thought leadership within the company is one that is pushing towards not just making investments but also coming together with other bodies and organizations to reach out for standardization of the information to come out.
RANDALL: For example, one of the things that leveled the playing field for publically traded companies was reg FD. To where companies would basically no longer need to depend on this particular analyst to give you the whisper number. Because they had certain people within management but now any information is out there and has to be available to all people at the same time. In terms of reaching more standardization for ESG, the company is working to help push for that notion that companies should be providing certain type of information. again that presses through a certain threshold of materiality so that that becomes a part of public disclosure.
RANDALL: And so, to some degree it's not that the firm as an active investor, but it is very active n pushing forward and helping to evolve and make ESG investing more mainstream. Similar to what you would have with other types of reporting.
DEBORAH: Our ESG thinking has evolved as our clients needs have evolved and as we've assess the opportunity set for ESG in the marketplace. And so, perhaps a decade ago most of our clients interested in ESG were looking at exclusionary type of portfolios. Um ,and then as that grew then there ...to more of a positive approach many clients wanted to have a bit of a sleeve that was ESG to perhaps look at it as something they could perhaps expand but they still looked at it as a very isolated part of the portfolio.
DEBORAH: And we can design programs for that. However, I think there is a recognition among investors who are looking at ESG that an integrated approach is perhaps a more substantive way to integrate ESG into you know into a total portfolio program. So as our clients have asked for a more integrated approach we have looked at it from the perspective of okay, how do you integrate it within each asset class? Uh, are there certain asset classes or certain types of investments that are more ...that more lend themes to a more ESG type of strategy? And as par of that, I think a very critical part of the thinking is, ultimately our clients want to generate returns They have missions that they support, they have scholarships that they give out, and they need to have the uh, the funds to be able to do that. And so returns ultimately trump all.
DEBORAH: And so, when they try to balance that need to have ESG in the portfolio, without wanting to sacrifice returns, one of the things that we've looked at is to say, okay if you construct an ESG portfolio say for example on the equity market, what factors ...what portfolio factors or portfolio tilts are you likely to have? Tilts that have been unintended because you've been focused on ESG. So a lot of our investment thinking has evolved around what biases are imbedded in ESG portfolios and how do we re-optimize that portfolio to ensure that the returns remain competitive and focused on the traditional benchmarks that they are supposed to perform?
HOST: So let's move on to incorporating ESG into the portfolio. Should ESG investing be considered a mainstream approach or an alternative one?
BEN: I think it's a mainstream approach because what you’re looking for are great companies and what you're trying to avoid are bad companies. So you know you're looking at this through a certain lens. So there are actually any sources of capital. There's a couple of interesting books that have just come out. One is Capitalism without Capital by Jonathan Westlake and Jonathan Haskle. And they point out that a company today, about 80-90% of its value is within intangibles. And if you look at those intangibles, a lot of them fall under this ESG rubric. Corporate culture, brands, R&D, software. Your database, your branding, your website. All of that is actually intangible. It's ESG information. And you can over borrow from one of those sources. You can over borrow from your human capital, environmental capital, regulatory capital. You over borrow from society .
BEN: And if you over borrow from one of those you kind of create a contingent liability. A liability which doesn't appear on your balance sheet. So, from the environment you have you over borrow, you produce a spill, you don't clean up after yourself, you get a fine. You ding your employees, your employees will leave you. If you ding the regulators or social contract you get legislated away, you can't do the same sort of business. But for all of those companies which might be cutting corners and creating these kind of contingent liabilities, you actually have the people who are investing the other way. They're creating these contingent assets and investing in their people. They're investing in R&D. They have a good relationship with society. And the other stake holders. That actually costs money to do and doesn't necessarily appear as an asset on the balance sheet.
BEN: But we know it's producing a very good and positive return in the future. And that lens, if you can see that, that's why we think that actually you can create alpha through that side as well as minimizing risk by avoiding the poor companies.
HOST: That's so interesting. Deborah or Randall do you guys want anything?
DEBORAH: I think that the ..it is possible to either take an integrated approach or to think about it as an alternative approach. I think the reason for that is that ESG is very complex and it encompasses a variety of issues some of which we would say are more investible than others. We have a foundation client that is very very concerned about poverty alleviation and they think about that as a core part of their ESG philosophy. In constructing an equity portfolio around poverty alleviation is very difficult because what does that mean? How do you define that? how do you tease that out of corporate releases?
DEBORAH: We have suggested and in some cases where those missions are very much aligned with what they're trying to achieve that perhaps they take that ESG focus and implement it at an organizational level And so make grants ...focus their grant making or do more impact investing around areas that I think are very difficult to express in a portfolio and then concentrate the ESG portion of their portfolio in something that they can actually measure in traditional capital market investing.
RANDALL: I think that um, what, what Debbie said um, earlier was really the key. Um, if ESG investing does not prove to be a tool for alpha generation then it is an interesting tool to satisfy some other extraneous desires that plan sponsors may haves it . And if that is the case then it will remain an alternative investment. To the extent that it is to produce returns um, the approach and again we can speak about it here as if it's a common approach that everybody's used but everybody does it differently and I think that the differentiation is actually an opportunity for strength rather than one of weakness that from managers that can incorporate the ESG principals in a way that does generate alpha, then for those clients seeking alpha then they will want to embrace those managers.
RANDALL: And the more of that type that you have the more mainstream it actually becomes and so I think that long term it really comes down to, as they say you know, the proof in the pudding is in the eating. Um, if we're generating alpha using ESU principals then clients are going to want to take advantage of that. If it proves that that is not the case then it will be very interesting and very thought provoking, but again if it does not tie into somehow a risk adjusted alpha generation then it will be something that will stay on the fringe elements.
HOST: So for clients that aren't necessarily onboard when it comes to ESG investing. What are some sort of acceptable measures that need to be taken in order for them to understand what it is, what ESG investing is, and what it means fro their future as far as investing goes?
BEN: Well there are different ways of doing it, again depending on your asset class and whether you're doing it actively or passively or things like that. Uh, but I think there's a lot of evidence which shows that some of these factors are very material and that should be looking at it. So we've given examples like employee turnover and how you’re investing in your employees or management or governance or things like that. And there's now just coming out and we have some at the PRI this week. A lot of academic evidence that it's showing alpha or good risk adjusted returns. And t that point I think it's going to drive people into it. Because if they’re saying okay this makes sense from a philosophical point of view, you benefit your stakeholders, they're prepared to pay for that. Customers are pretty much only people who give money to companies. That's how they generate revenue. So you want to treat your customer well. And that's generated by employees. That's going to go through.
BEN: There’s been papers that have shown higher employee satisfaction leads to higher accounting returns, leads to better stock returns. The same with material ESG factors in terms of sustainability. You do better on them than accounting returns but stock returns you've shown the academic evidence that companies have moved to long term incentive plans and long term censors also produce better accounting returns and better stock returns. And if the plethora of data comes out and it's coming from the academic world and seeing that, I think you’re going to see more and more investors do that.
BEN: One of the difficulties though is a time horizon type thing. Because a lot of these things tend to play out over a longer term horizon. Not always and we can debate how efficient markets are because they are meant to price longer term factors than today in terms of present value. But a lot of these intangible ESG factors take their example of employees.
BEN: They can’t all leave you that quarter. They might not even leave you all that year, but your best employees probably leave you over 203 years. You lose your customers if you give them poor customer service, not immediately. And that takes time to play out. So those strategies that tend to be more short term orientated. Who tend to not probably use much of the ESG toolbox because they never have. And that's fine, there's liquidity, there's an event arc, there are other ways of inefficiencies in the market.
BEN: But if you're interested in owning pieces of company or interested in owning business over the long term term, then I think these factors have always been of interest and are going to continue to be of interest. And therefore those asset owners or pension plans are coming to it from that lens are going to have to be interested in these ESG intangibles. I think picking up on what Ben is saying it's a matter of you know putting the cart before the horse. In some cases the intellectual approach to ESG is what is put in front of people and for those who have a strong desire for the scholarly and the academic, the ivory tower type of approach and immersion index that ESG is going to garner a certain amount of interest.
BEN: The average trustee for a plan doesn't have the time and doesn't necessarily have the interest in getting educated about that. They basically will come to the consultant and say does it work? And I think that the thing about it is that for all of the papers that are written when these two really come out is the output. If it shows that it works and it shows it can work in different asset classes where there may be the opportunity or the traditional approach or an ESG incorporated approach and the ESG incorporated approach is the one that is winning at the end of the day, then I think for the very simple ...not simple minded, but the very simple investor will look at that and say why aren't we doing that ?And then when those who need the data to back it up, then the scholarly research comes into play. Putting the research out there for some is not going to frankly cause them to want to invest.
BEN: In many cases it can confuse them because with the issues you were asking about, kind of the lexicon and language surrounding it, it can be like learning a new language. And so for those who don't have the interest in doing that um, be it either the time or just expertise and exposure then it can be a bit daunting to say let's just keep doing what we've been doing. And why bother with that? And so I think the opportunity is there but first and foremost it has to prove that it works. And if it proves that it works then it gives people reason to want to dig deeper to find out more.
DEBORAH: The studies that are out there that show ESG adds value have very different conclusions. Some say that it adds a tremendous amount of value some say that it adds a little bit, some say it's inconclusive. And so it can be very overwhelming for an investor particularly an investor that is not gravitating towards ESG to navigate all of these complicated studies and in fact it can actually turn them off because they want to make money and the want to know that they're not giving anything up to invest in ESG. So I think, from the perspective of an investor that is unclear whether it's appropriate to move forward, I think the best thing that they can do is to ...it's a very complicated topic, is to find those elements of ESG that are most important for them. So for universities it's often low carbon or climate change.
DEBORAH: And isolate those factors that an investment committee or an asset owner can agree that this is an issue that we're interested in, whether or not to invest in it. And then to look at the products that are available uh to providing solutions to investing in that issue and watch them over time, and see if they actually earn a competitive rate of return. Because until an investment vehicle, that is aligned with any particular ESG issue is shown to actually generate returns that are combative with traditional investment products, it will be very difficult for that investor that is on the fence to actually take that next step.
BEN: I would just like to say though, I don't know if you want to hold this to a higher standard than anything else because for instance fund manager's skill is still a big thing. I've always said you give someone a better tool doesn't mean that they'll do better. If you give a bad surgeon a better tool he'll just cut your arteries off quicker, he kills you quicker. It's the same. So, you know, looking at these studies there's some studies that show value investing doesn't work, or traditional value investing doesn't work.
BEN: The same with growth investing. In fact, there's a plethora of studies which show in the US that all average active managers are outperforming their benchmarks, yet you can find exceptional managers which are outperforming their benchmarks. So I don't know why you should hold ESG to the ... to a different sort of standard. Like we've sort of said earlier, if you’re using something like an ROE, what is an ROE of 8% mean? Are you a quality investor if you're just looking at ROE? So all of these terms and things. But yeah, are those things which make sense in terms of investment philosophy in the process? I think ESG has more than met those hurdles over the equivalent sort of asset classes or things that they're debating in terms of that. And I think it's somewhat unfair to say well look ESG is that.
BEN: You can say the value ...you can say the same against growth, you can actually say the same thing against passive investors that there’s the whole idea of tracking error was invented because they never tracked their benchmark. So all of these things I think are in this complicated mix and I actually think this education at the trustee level is that we've got to ...or investment consultants of people have got to prepare or give them the time to educate them and say look, this is what it's about. These are the differences and these are the nuances and this is why you might want to consider it going forward.
RANDALL: And I think this is what Ben was saying about that is very interesting because he's saying that ESG shouldn't be held to a higher standard and there’s scrutiny about some of the traditional asset classes out there right now. I think in picking up on that perhaps ESG just needs to be put into the same bucket with everything else.
BEN: It shouldn’t be a lower standard, for sure.
RANDALL: To see how it actually works because I think the challenge with what Debbie was saying with isolating certain issues, that actually goes right back. It doesn't move us forward. In my opinion it really moves us backwards. To really social responsible investing. Saying I want companies to have a low carbon footprint is like okay then what you're saying is there's certain companies you do not want to own. Well, if you had a big enough percentage of the investment market to do that then that would have an impact on those companies, market capitalization.
RANDALL: Instead, what you have is, a certain percentage of investors who don't want to say own energy companies but the energy companies are able to garner billions of dollars in market capitalization. And in some respects, what may be more effective is don't label these companies as being bad companies on ESG scales or scores if they rank low. See if they’re doing things that help them as sales get higher scores and move up the scale. Because that way you're dealing with the companies that may be some of the greatest offenders by trying to work with them to help them to be better at what they're doing because they're going to continue to do it anyway.
BEN: And that's actually something we haven't touched on, a big debate within our world is, engagement versus divestment. So this is the idea if you use fossil fuel free, fossil fuels as an example. Everything in this room ahs been touched by energy, and if you want to still have cement, plastic, travel in the air and things like that you’re still going to need vast amount of energy from fossil fuels. Which experts say is probably at least 50%. 50% can go renewable. Therefore, do you want to try to engage with companies and try to make them better, or do you want to try to take a divestment kind of approach?
BEN: And maybe, again this depends on your mission alignment or your strategy but both of those might be possible. I mean sometimes it's a little bit like a marriage. Maybe you’re saying okay this is really really poor, it's time to call it a day, maybe divorce is the answer. Or maybe you know what? When you first hit the slopes and think things could be better, maybe you should go to relate ...you should make that into a better relationship.
BEN: Because there is no perfect person, there is no perfect company but I think actually we can all improve on that and that's where the stewardship engagement arm of this piece which is you know, we were talking earlier, maybe there's an extra S on ESD, the stewardship piece is so important, regardless of how you actually do that. And that's why it should be a mainstream piece. Because regardless of where you sit on that, actually everyone can always improve and that would be the importance of the engagement type of strategy, say a divestment strategy which actually we're not going to be in that.
HOST: What are some specific execution challenges you've observed in incorporating ESG or other responsible investing criteria?
BEN: Well one big challenge actually, which we refer to uh, earlier was on the data sets. So, uh, that starts at company reporting level, where the data often isn't very good, it's very rarely audited. There's very many geographic instances. So transparency is very poor. Then you've got this element of how do you score it? Different scoring methodologies and things like that. Actually, I think there's less of a problem, or a plethora of opinion and information on that. But it is an implementation issue whereas actually there's a lot of agreement about how you calculate return on equity and what a good equity score might be and how you might value that.
BEN: There is less agreement on first of all, how do you get the ESG data on those sources and then how you qualitatively are scoring that. So there's a lot of implementation issues with that. And then how you do your stewardship and engagement of that is another question. And then also in your investment process because there's a difference between asset class, the difference between passive and active is a big umbrella effect. So implementation of possibilities and different techniques is still somewhat of a challenge.
RANDALL: Um, as a portfolio manager, I think one of the challenges that exist is really when you decide how you're going to try to generate your alpha, so to speak. And do so against an index, a benchmark that is diversified. For example, for the strategy that I mange it's benchmarked against the Russell 1000 value. And so within that you’re going to have high components of companies to certain degrees on like energy companies, materials companies, utility companies and these could be companies that could be perceived as some of the offenders. Well again, if you go completely to not owning those companies then you can run the risk of having embedded in that potential period of underperformance because you don’t have any exposure.
RANDALL: In contrast, the way that I manage the strategy using ESG principles, instead of saying, I won't own certain companies in this particular space, I have ESG scores related to all of the companies that are in the index and so when we try to look at valuations and fundamentals and then looking at the ESG scoring move towards those companies that have the higher ESG scores and so it's not an absolute in terms of our exposure. We want to make sure that we can put together a diversified portfolio that does not have embedded within a certain risk because we're deleting certain sectors or companies just because of what they are and what they do.
RANDALL: And still we try to find the best companies within that space that will allows us to still fulfill the mission that we have for our clients.
DEBORAH: From a manager to manager perspective, I think one of the biggest challenges are scalability. ESG means something very different to every single client and the components of E and the components of S and the components of G mean something very different to every client. And they are all appropriate for that client.
DEBORAH: Because of their mission, because of the concerns that they have because of um, how they have defined. For example, S may be birth control or S may be gender equality, or S may be poverty or health care access. And those are very, very different. and so the investment programs that you have to structure in order to align a portfolio with each of those issues is very very complicated. And so from a scalability perspective, there's no one size fits all. there's no one uh, invest manager that can do all of those and so you have to build a variety of different highly specialized portfolios which can be very difficult. Additionally, the available investment solutions for some of these issues just isn't there. And that's because the industry is still in its vacancy, but it's also because the issues themselves are very noble but they’re not necessarily investible.
DEBORAH: And I think finally, one of the biggest challenges that we see is that fees are very very high. There are a number of investment solutions out there. A number of managers that have an ESG portfolio but they charge a very very high fee. And part of that is because they are trying to scale up themselves uh, but also it's because I think there's a little bit of uh, of a thought that uh, investors that want this will pay a little bit more for it. Which I think I don't think that's sustainable.
BEN: Not me [LAUGHTER]
OST: Deborah, you mentioned non-profit a lot of times. What should be the first step of a non profit investor who wants to align its investment strategy with ESG?
DEBORAH: I think it's really defining the components of E, S and G. We worked with one nonprofit that had a very ...they really wanted to have an ESG program within their portfolio. Um, but they couldn’t move forward and I think a lot of it was driven by the fact that they could not decide on which issues were most important to them. So it sounds very simple, but actually prioritizing the sub issues between E, S and G is very very complicated and then the next step is really to determine are these issues something that they should be doing as an organization? So if they're a University and they're concerned about climate change, should they be looking to be zero emission on the campus before the want to invest in a low carbon portfolio?
DEBORAH: So after defining what issues are most important to them, determine which are better expressed in an investment portfolio and which are better expressed as an organization and the work that they do on the ground?
BEN: And I would maybe add is, they might want to think about really ...in terms of their expressive organization or ESG, whether they want to be actually doing something I would call impact, rather than ESG so something measurable, more accountable and maybe more thematic rather than a mainstream ESG. again depending on their mission. I would completely agree that they have to define what that is, but it might be that a mainstream solution is not what they're after.
BEN: They may want to be a little down to what we call impact investing. Which would measure that impact in a very different way.
HOST: Three last questions really quickly. What type of investor does ESG work best for? Investors oriented towards growth, value or [UNSURE]
BEN: In my view the one who wants alpha. If you want a good risk return then you should be looking at this from my point of view.
RANDALL: I would say that again, um, to me I think the way I think about it if you’re investing then it is a value orientation. Again, looking for that alpha generation and looking for it to be something that is repeatable, consistent over reasonable periods of time. Um and so for ESG investors, given that their mission does not typically change uh, such that it is more of a thematic approach but one that would benefit from a diversified approach to investing, I would say a value type of orientation, probably would be a better mind set.
DEBORAH: I think the ESG approach can be appropriate for either value or growth investing. I think the important consideration is to thin about the consequences of embedding ESG into a portfolio. Whether it's a value portfolio or a growth portfolio. What are the unintended consequences that could cause that portfolio to deviate from um, what is desired and the not determine what those deviations are and to re-optimize to ensure that the portfolio adheres to what ever strategy or whatever style that it intends to.
BEN: I would add time [INAUDIBLE] if you've got a short time horizon than actually this is going to be less relevant to you. Less relevant to investors. Most people do have open time horizons but these type of things don't tend to play out over the short term.
HOST: Okay when will one know if ESG is truly accepted as a successful investment approach rather than just an ideal to be incorporated wherever possible?
BEN: I think if you’re super successful you won't have ESG anymore, you'll simply be because it's a good idea, there's better risk adjusted returns, simply be an embedded way that we look at whether we look at companies.
RANDALL: I'd agree with that, I think that it will be a matter of just becoming something that is generic enough to where you don’t' talk about ESG, you talk about investing and when you talk about investing, even the language, the lexicon it may have changed to where you don’t say ESG anymore, you just talk about investing in some of the things that we discuss quantitative and qualitatively.
RANDALL: About what we consider to be traditional investing now is the same whether we're speaking about ESG investing. And again, it's not a matter of it being something embedded in an RFP as far as upon differentiation, it's something that's just expecting everyone knows you're supposed to have it.
DEBORAH: And I would say never. I think that's okay because market participants are very different. And uh, the behaviors that drive inventors and their values and their approaches to investing is very different and there will always be um, there will always be differences in terms of approaching any investment program. I think the key really is to see ESG investment programs actually outperform. And that's something that we have not seen on a consistent basis yet.
HOST: Lastly, moving forward. What will be the biggest story in ESG investing? What can we expect in the ESG space moving forward?
DEBORAH: IF there was one accepted reporting and measurement standard for publically traded corporations that um, that actually would stimulate consistent and required ...so a mandatory reporting standard that I think would help to institutionalize ESG and help take it from sort of more of a voluntary ...a little bit here and a little bit there to something that is consistent and something that is far reaching and something that is actually credible because the measurement tools and the reporting methods are accepted.
BEN: I would say where asset owners plans or individuals are putting their money. If they put their money more towards ESG integration that would be a big trend. We shall see if that will happen. I think from an ESG world, how we approach stewardship is going to be one of the major deciding factors because I think regardless of where you sit on the ESG spectrum, most people agree that stewardship, when you own that asset is quite important. In fact we're probably forward in fiduciary duty even across asset classes and so the way you do stewardship say in passive funds or even active is definitely evolving. Um, we've seen it, we've seen big heads of asset management, CIOs, CEOs also corporations, companies talk about this. Talk about wider stakeholders and how that's going to be.
BEN: So how that stewardship over the long term is going to be evolved I think is going to be one of the big things which will be nice for everyone inside of the investment chain.
RANDALL: I would say that uh, picking up what Debbie was saying, one when you have companies giving quarterly earnings announcements and you go through the financial statements and the annual reports and there's an ESG section in everyone. That everyone can go to and pull out the information that they need to assess that particular part of the story regarding a particular company. Um, and then I think the other aspect of it, likely will be when you have a manager out there who are multi billion dollar managers and they are considered to be the mainstream. And they're not considered just to be the one offs who just happened to get it right but there are enough out there doing it to where there is no differentiation and really the concept of ESG will probably be the biggest thing when we're not talking about it. We're talking about something else because we've already crossed that particular hurdle.
BEN: maybe that will be never [LAUGHTER]
HOST: Well thank you guys so much for sharing your insight with us and thank you to the viewers for tuning in. Make sure to take the corresponding quiz on asset tv.com for your continuing education credits.