Self-Directed IRAs: Challenges and Options
April 13, 2018
Jenna Dagenhart: Hello, you’re watching an exclusive S&P Dow Jones Indices Masterclass focused on Core ESG. The S&P 500 ESG Index has redefined mainstream access to sustainability. As the ecosystem surrounding the Index continues to expand, global investors are using a range of ESG solutions including ETFs, derivatives, and structured products to align investments with their ESG values while managing risk.
Hello, I'm Jenna Dagenhart with Asset TV. Joining me today to take a closer look at how and why the S&P 500 ESG Index is defining the sustainable core are Mona Naqvi, Senior Director and Head of ESG Product Strategy in North America at S&P Dow Jones Indices. Scott Ladner, Chief Investment Officer at Horizon Investments. Peter Horacek, Executive Vice President at Axio Financial, and Bob Smith, President and Chief Investment Officer at Sage Advisory. Mona, setting the scene here, what is ESG and why has it gotten so popular in recent years?
Mona Naqvi: That's a great question. It's the topic on every investor's lips these days, Jenna. But ESG is really just a subset of sustainable investing, which has, in one form or another, been around for many, many decades.
It first rose to prominence in the 1960s, in fact, with the precursor to modern day ESG, socially responsible investing or SRI. But as folks who remember the days of SRI will know, this was seen as a pretty risky investment strategy for a lot of investors because essentially what SRI amounted to was screening out sin sectors to avoid sin stocks in the portfolio. But this loss of diversification at least implied the possibility of lower investment returns.
So sustainable investing for the longest time got somewhat of a bad reputation for being solely ethical based investing, and not consistent with kind of return maximizing fiduciary duty of responsible investors. But as time has gone by a lot has changed in the space. And we've seen the emergence of a whole set of new tools and data disclosure from companies, really kind of giving into a lot of investor pressure, asking companies to be a lot more transparent on their corporate sustainability performance.
And with all of this new data, we now have really high quality and granular building blocks to create much more nuanced approaches to modern day ESG integration, really incorporating these non-traditional sources of information or non-financial, that are, in fact, potentially financially material into investment decision making processes.
So ESG is really adding a lot more color and texture to the investment process. There's a lot of research now coming out that shows that this stuff is potentially financially material. But on the back of all of this data that's emerged, we've seen innovations in the construction and methodologies of the indices themselves using this data as a core building block that need not imply that inherent performance trade off. And we'll see that as we talk more about the S&P 500, that this is a really good example of this that's helping to break down the barriers to entry making ESG more accessible to the mainstream, because of the fact that these tools are dispelling those myths of an inherent performance trade off.
Jenna Dagenhart: Following up on that, can you walk us through the S&P 500 ESG Index methodology.
Mona Naqvi: So the S&P 500 ESG Index is the sustainable version of our iconic S&P 500. It's a really reliable index for getting core US equity exposure, while at the same time getting meaningful enhancements in sustainability. We achieve this by making some exclusions that are generally considered to be unacceptable for an ESG index. So we remove companies with involvement in tobacco, controversial weapons, and thermal coal. More also excluding companies that might lag behind international standards in terms of really important issues like human rights, labor issues, corruption and the environment through a UN Global Compact screen.
We're also excluding the bottom 25% of ESG scoring companies within the global gigs industry group. And so what we're left with is then an eligible universe of constituents that we can use to construct the ESG version of any one of our indices. So in the case of the S&P 500, of the constituents that remain, what we do is we then make another sweep and we target the top 75% of market cap, where companies are ranked again by our ESG scores and selecting those.
And because we're doing that within the index industry groups, what we end up with is a broadly such unusual index that really closely replicates the underlying risk and return profile of the S&P 500. But at the same time, generate some 9% absolutely issue score improvement over the index over rule. But if you look under the hood, you start to see really tangible metrics in all of the ESG areas. For example, you get 7% more exposure to females and senior management positions across the business, not just at the board, as we commonly find elsewhere.
We're also getting more exposure, I think 10% exposure, to companies with really explicit commitments to reducing their greenhouse gas emissions. So there's a whole litany of ESG impacts that we can measure with this index series. But at the same time, the historical performance and the risk of return profile is very similar to the S&P 500 making it suitable for investors looking for core US equity exposure and little sustainability boost at the same time.
Jenna Dagenhart: Scott, how does this index design help make strategies built on the index more usable in portfolios?
Scott Ladner: Jen, it's a great question, because really, at the end of the day, we are practitioners of these things. And so in order to use something like the S&P ESG methodology or products that are based on it, it's important that we understand exactly what they're trying to do and how they're getting at the thing that they're trying to achieve, which in this case, is enhanced ESG scoring.
Their methodology in particular is helpful because we can really isolate the factor of ESG. And without getting any sort of latent bets or unintentional bets associated with the portfolio, such as having a sector tilt or kind of a growth value tilt, or just some other kind of latent factor that we don't really understand what it's there for.
The fact that they've got a fairly low track of the S&P 500, actually have a very isolated bet on the emerging factor of ESG. Because we do have a firm view that ESG is an emerging factor, an emerging fundamental factor, which is simply something that is a set of firm characteristics that investors are going to place a premium valuation on. And that's something that we find attractive for long term hold boards.
Jenna Dagenhart: Peter, I would love to get your perspective as well, as a practitioner.
Peter Horacek: Thanks, Jenna. Just as Scott mentioned, the ability to closely track the iconic S&P 500 on the ESG side is extremely important in the structured product space. Over 25% of all structured product issuance is, or has, I should say, the iconic S&P 500 as an underlying security. So therefore, as advisors move to ESG investments, having the ability for large global banks to issue structured products on the S&P 500 ESG index is extremely important for the structured product space.
Jenna Dagenhart: Bob?
Bob Smith: Yes, Jenna. Sure. At Sage, we've been an ETF strategist for probably close to a quarter of a century, and ESG, in particular over the course of the last five years. We're really attracted to this particular index and this approach for a variety of reasons.
First of all, just choice architecture. In today's market, there's probably well over 125 different ESG equity ETFs for anybody to pick from, with all kinds of different constructs and risk profiles, but the one thing they have in common is they're all ESG. So how do you pick?
I think that in a category like this, where 97% of the index choices at the top 24, 25 are passively managed, what becomes really important is the index methodology. And then secondly, what becomes equally important, in some cases, even more important is the source and the nature of the data, the consistency of that data. And these are the things that we think are particularly strong about the construct of what Mona has been talking about today.
We feel that this is a very good core ESG optimized ETF because of the methodology, and because of their source of data. Unlike many other competitors that purport to be a good core representation, we think that the basic construct of really screening out clearly some of the most undesirable companies in terms of well-being to society and so forth, things like tobacco and so forth, we fully understand, we subscribe to that.
But I think also what's more important here is to really try and separate leaders from laggards with a very deliberate mechanism. And that's what's in force in this index. And so we're attracted to it for all of those reasons. We think this is something that's been a very large missing part to the puzzle in terms of the makeup of the ESG market.
Jenna Dagenhart: Scott, are you using them as core replacement, a compliment to the core, or more tactically?
Scott Ladner: Yeah. We are a very tactical manager, but in this case, we're actually using these as core replacements. We do see an S&P 500 exposure, broadly speaking, as something that pretty much all of our investors are going to have as part of their portfolio.
But there's really no reason, in our view, to have that part of the portfolio to be represented by simply the market cap weighted S&P 500. When you can have a superior construct and superior long term exposure to something that we think is going to be a really attractive factor exposure, in terms of ESG, that's got a lot of tailwind to it, and a lot of reasons for that.
And so as far as our core S&P exposure, we prefer to use an ESG sort of expression of that, rather than just kind of have a plain vanilla expression of that for our clients.
Jenna Dagenhart: Peter, how are you using them?
Peter Horacek: We talk to advisors like Scott and Bob, who use ESG and are focused on ESG in their portfolios, or executing ESG products in their portfolios every day. But some advisors are not. So we use it as an entry point conversation starter to get advisors to start to think about how they connect with their clients with sustainable investing.
It's interesting, because in some advisors practices there's these different segments of their clients or practices more concerned with it, like 20 to 30 year olds, for example. I spoke with one advisor the other day, very concerned that their investments mirror their values. The 30 to 40 year old segment is definitely concerned about ESG values as well. But kind of the older generation, maybe not as much.
Some advisors are very reactive in this space, some are very proactive, like Scott and Bob, as they interact with their clients. So we use it as a conversation starter and kind of point out that structured products can be used to mitigate risk in portfolios, again, in that core allocation of US equities. But how are they making the jump from the S&P 500 to an ESG version, which certainly fits squarely in the middle of the core allocation, in our opinion.
Jenna Dagenhart: And I think the question on a lot of people's minds is performance. Mona, how have the indices performed?
Mona Naqvi: Well, as I've said Jenna, the index objective is to closely replicate the underlying risk or return profile of the S&P 500. And indeed, it has delivered on that objective. But if we look at the last one year of live performance, it's actually been really interesting to see that the S&P 500 ESG index has not only delivered on that objective, but it's also outperformed. And there's a lot of questions as to why is that the case?
We've heard about whether ESG might be a factor, what is driving this out performance? And so we've looked under the hood to try and kind of piece this apart. We did some performance attribution analysis and we saw that actually, this is really a story of selection, which perhaps isn't that surprising, because we know that the index design lends itself to something that's 40 sector neutral. But the reason that's important is because we often hear a lot of market participants think that the reason ESG indices are outperforming is because they must be overweight tack or underweight energy. And that just simply isn't the case in this index anyway. It's broadly sector neutral as I've said. What's clearly driving the performance is the selection of companies that are performing better, driven by a rules-based ESG selection process.
We also looked at the underlying factor exposure to see if maybe there was something there that can help us explain this. And we looked at the underlying factor exposure according to quality, momentum, value, all the typical things. And we found that it was more or less in line with the underlying S&P 500. There was a slight discrepancy as it pertained to size, but that's perhaps not all that surprising when we know that larger companies tend to be able to devote more time and resources to actually performing better on sustainability issues. But the fact that the underlying factor exposure is so closely aligned with the benchmark 500, does show that the index is poised to do precisely what it was intended to do.
Last but not least, we've also had a number of third party advocates looking into this index and saying, for example, the DWS Research Institute said, "What role does chance play in all this?" Right? It's all very well and good to discount certain things by process of elimination, but we can't forget the role that chance could easily play. And actually even accounting for chance, there is still a statistically significant out-performance associated with the strategy that isn't explained by any of the variables we've just talked about. So there is something there. It's very exciting and interesting. There's a lot more research to do to look into why that's the case. But it is a welcome result that the index not only delivers on its objective, but it's clearly driving some out-performance as well.
Jenna Dagenhart: Yeah. As Mona mentioned, 2020 was certainly no cakewalk, yet ESG weathered all this volatility quite well. Bob, has the positive Performance story during this stress test period, that Mona mentioned, expanded your potential use cases for these strategies?
Bob Smith: Oh, absolutely. There's no question. I think one of the things that I think is, and I think Mona has been very modest about, what is the grace and wonder of this particular index? When you look at the ETF world in terms of ESG alternatives, you'll find that amongst all those dozens of different choices that all claim to be an ESG large cap core oriented kind of product, there's a massive divergence in security concentration across the spectrum, going from 150 names to 300 names. And it can vary quite dramatically one to the other. And that's a big source of risk as far as we're concerned, and that's something that as a strategist we want to be looking at.
What is really remarkable about this is that going through their screening process, essentially, what they've done is they've eliminated about roughly 195 companies, roughly 25% of the index at any given moment in time. And you're saying, "Oh, my goodness, all I have is 300 or so names left to compete with this index, it's very robust." The beauty of this is the tracking error. A 1% tracking error, which is something which is almost 100% reflective of the S&P 500 in terms of how it moves through time, is something that everybody would like to be able to call reliable.
And in the world of ESG, reliability gets scattered hither and yon, because everybody's seeking ESG optimization, but that's beauty in the eye of the beholder. And here, this is a very good solid, what I would call a cornerstone construct for anybody to use in their portfolio as a core holding, and then as we do, build satellites around it.
Jenna Dagenhart: Peter, how are you building your satellite, so to speak, around this?
Peter Horacek: Again, we can speak with advisors every day. And I think just going back to the misconception that you have to sacrifice performance when you invest in ESG indices or ETFs. I think that that misconception is still out there. The story that Bob's telling and Mona's telling, I think it needs to be told, and as the index grows, appears in more databases, comes up in more searches, I mean, the institutional side has embraced ESG investing for a long time. I think the retail side has been a little slow to recognize that you don't have to sacrifice performance when you align your values with your investments.
No one wants to hear, but it takes time and the adoption's coming. And we take pride in being able to go out and tell the story that Mona is telling, and Bob's telling to other advisors, because advisors need to hear and are very keen on what other advisors are doing and how they're positioning ESG with their clients in the space. So trying to dispel the misconception that you have to sacrifice performance when you invest in ESG for your clients. And like Bob is saying, the methodology that S&P has built with some really is a solid, solid methodology.
Scott Ladner: I want to pick up on a couple of things that both Bob and Peter have mentioned, and Mona as well, obviously. Peter mentioned earlier that he uses ESG as sort of a hook to get clients in and kind of start a conversation. And while that's well and good, for 20 and 30 year olds, you'd be somewhat hard pressed to find a lot of 50 and 60 and 70 year old people who would be moved by that, at least as a starting place.
But the thing that moves everybody is performance. Like Bob alluded to, the very tight tracking error on this product, it allows an asset manager, it allows investment managers the ability to allocate meaningful resources to it as a core replacement. Because if it's a core replacement, sort of, by definition, that's a big part of the portfolio. And as asset managers who charge a fee for our services, we can't be having cores, large parts of our portfolio that we expect to drag. We can't expect to underperform based on a core holding.
Part of the reason why we're able to use as a core holding is not only the very attractive tracking that Bob and Mona talked about, but also just fact that we do have a long term expectation for out-performance for this, because we do think that investors over the next 5, 10, 15 years are going to place premium valuations on companies that have these types of firm characteristics. But that's something that you can't really tangibly trade around. You really just sort of got to put it in there and let the story play out and play through over time.
Because it's not something that you're going to make 1,000 base points in a quarter, it's one of these things that's going to kind of bleed through time. And that's the experience that we've had thus far. And the experience through 2020 has been particularly impressive, just because of everything going on and everything being wild, and nothing's making any sense. And here's the inaugural ESG just plugging along like that's just gaining traction over time, over time, over time. And you look back, and you've had a great year. And we think it's doing a lot because of just this long term effect that people are saying, "These firm characters do matter. And we think they're actually going to drive value at the corporate and the profitability level for a very long time. And so let's go and get on this train because we think it's really going to a pretty good place."
Jenna Dagenhart: And some would say that in 2020, ESG, proved that it wasn't just a bull market luxury.
Scott Ladner: Absolutely true. I mean it outperformed on both sides of it, which is frankly kind of rare. And it's something that low vol didn't do very well in the downturn. These things don't always have consistent performance expectations associated with them. But ESG, at least from what we've seen so far, it looks like it might have that sort of characteristic, which is pretty attractive.
Bob Smith: I think to add to that as well is that if you look at what we've gone through over the course of the last year, there's one thing that bubbles up out of this particular index construct, is that quality pays, quality protects, quality secures the value, the capital value of your investment. And that is what this index is really underneath it all designed to do, is to permeate and bubble up to the top the quality that's within the index, and the quality of earnings, quality of company. All that emanates from very strong ESG principles that are being executed on a daily basis by these companies.
And so if you're looking for factors and what drives in our estimation, yes, it's a large cap growth, and so forth, and all those things that are geared towards that kind of a factor, but it's really quality at the end of the day. And that is the one thing that you want to be thinking about in terms of ESG. In the conversations that we've had with advisors, it isn't necessarily alpha generation because you've taken on a tremendous amount of beta, it's alpha generation because you've avoided all the beta that gets unrewarded in your portfolio over a longer term. That's important to understand about this index. That's exactly what it's trying to get you to do.
Mona Naqvi: I think that's a really great point, Bob. And actually, it speaks to the technical reasons as to why this stuff works. People think of ESG as a wishy washy, tree hugging concept, but it's actually rooted in really deep research and data about industry specific risks and opportunities that impact different types of companies differently.
And if we look at the way that corporate valuations have changed over the years, if you look at the S&P 500, as it was valued 50 years ago, the majority of the value of those companies were coming from tangible assets, assets on the balance sheet, financial holdings. But now what we're seeing is there's been a reversal in that trend today, intangibles are what's really driving corporate value, things like reputation, brand loyalty, consumer preferences and goodwill. And it's ESG that's precisely speaking to those topics, as things that we all care quite deeply about.
I think that there is a real transmission mechanism through which ESG sheds light on the types of risks and opportunities that standard financial models, which are simply failing to see. And they're really capturing the sort of ever shifting global macroeconomic landscape. If you look at the financial models of the past, they are heavily predicated on historical backward looking information. But we all know that we're facing unprecedented risks and opportunities, things like climate change, things that we've never seen before.
And so it doesn't pay to look backwards, it actually pays to start looking at what are the types of risks and opportunities, and what are the characteristics of companies that mean that they're resilient to these new risks and opportunities. And that's precisely what ESG is trying to do.
Jenna Dagenhart: Mona, what is the S&P 500 ESG index ecosystem look like today?
Mona Naqvi: Jenna, it has grown tremendously since we launched the index just a little over a year ago. It's been incredible to see. Since launching the index, we have now an entire ecosystem of ETFs listed across multiple regions. We've got a number in Europe, several in North America, the US and Canada as well. And the combined of these ETF products is well over several billion now in that short space of time, which is truly an achievement. And it's interesting to see that if you look at the major, some other ESG ETFs out there that are tied to some of the other index providers methodologies, the majority of those indices with similar flows have actually come from single institutional seed clients, typically a lot of European public pension funds, which have certainly been really important in terms of helping to catalyze this space.
But what's interesting about the source of the flows in ETFs tied to the S&P 500 ESG, is that we're actually seeing that this is coming from lots of dripped allocations from across the market. These are ordinary investors who are choosing this index as a really common starting point for their ESG investments, which is wonderful, and really helps to demonstrate that this is becoming a really key foundation and building block for investors around the world.
Alongside the burgeoning ETF market, we've also got a growing derivatives ecosystem as well, CME. We launched futures tied to the index at the end of last year, and already we've seen them surpass the one billion mark in open interest. I checked just the other day and it was over 1.25 billion, I believe, in open interest. That's a really significant milestone, adding additional liquidity to the market and making this index more usable.
Alongside the futures, we've also got options with CBOE and a number of structured products and mutual funds, as well. So really, the entire ecosystem is helping to make a very accessible source for core US equity exposure in the ESG space. And it's not just ESG ETFs, we're also seeing a growing derivative ecosystem and a number of futures and options contracts tied to the index that have seen really significant success in the year to date, as well as a prevalence of mutual funds with structured products. So really the index overall is across a number of different channels.
Scott Ladner: Yeah. Look, the liquidity characteristics of both the kind of cash instruments and the derivatives instruments are very important to be able to get clients into these types of securities. I mean, without an increasingly liquid ecosystem, both on the cash and the derivative space, market makers and APs aren't really able to make good markets in the securities that we want to actually trade into.
This entire ecosystem is important towards advancing the cause and actually letting more people access some of the wonderful things we think that they can benefit from exposure to the ESG side. I know Peters got a lot more experience on the structure product side of this, and he probably has something interesting to say, but it matters. Every single piece of the liquidity ecosystem matters. And we're actually trying to get clients into these types of positions.
Jenna Dagenhart: Before we talk about structured products, Bob, how's the ecosystem and liquidity helpful for you and your clients?
Bob Smith: It's been very helpful. I think that the broader this becomes, the more each asset class and each ETF that's brought to the marketplace, if done right, has the ability to help all the others that are out in the marketplace. I mean it's just a broad embracing of the notion that ESG is now mainstream. It is no longer a fad. It is no longer a passing fantasy. And if it's anything, it's on the ascendancy. And we know this that from a political perspective, in terms of where we've come from and where we are headed, changing the administration in this country, perhaps a change in the attitude on the part of the Department of Labor, if that does come about as expected, this will only serve to really provide a very strong foundation for immense growth.
And right at the center of this, is going to be this particular index and anything built around it because it's core and it's ESG core, and it responds to all the basic requirements that we as strategists need, in particular, can I do this for a $25,000 client? And can I do this for a $250 million client? Scalability is going to be extremely important.
And the fact is that everybody knows this index. The rules base construction here, that's very clear, it's very dynamic, it's very straightforward, and conservative in certain ways, I think is exactly what the doctor ordered in terms of really promoting growth and development and really fortifying ESG across the broad public.
Jenna Dagenhart: Peter, what about the S&P 500 ESG index characteristics made it a good blueprint to build structured products?
Peter Horacek: I think it goes back to a year ago, August, just in terms of just the attitude, when 181 CEOs got together and kind of redefined the mission of the corporation. They redefined it, that corporations are not only an existence to reward shareholders and increase profitability, they have to have a stake in their communities and their environment.
I think it starts there. I think that you look to Mona's point, these data points, and being able to evaluate these data points in the analysis are becoming, if not more, just as important as traditional financial analysis when security's reviewed.
You see asset managers making big changes in the way they do that across the board. To Bob's point, with ESG being ascending, it's absolutely correct. I agree 100%. The retail markets are a little slower to get there, but I think we'll get there. But in terms of derivatives, it is extremely important to be a liquid options market on the ESG 500 index, and any really ESG type of ETF or security. This way the banks can hedge the position. And that's how structured products are really created.
The structured products that are out there are pretty much growth oriented and define the outcome on the S&P 500 or ESG 500, so you can put a buffer on a position, where you can protect some downside, mitigate some risks, so not only are you mitigating risk when you invest in ESG, because Bob and Scott don't want their clients' companies that they invest in, or their ETFs that they invest in, to have negative ramifications of not helping their communities, helping the environment, and really being a social player in the market.
It's so important that we mitigate risk in portfolios by utilizing ESG. And then structured products are just another layer on that. But you need those derivatives, to Scott's point, to be able to create structured products, to define the outcome, because it gives some clients protection on the downside when they invest in that core growth allocation.
Jenna Dagenhart: Peter, what types of clients are you implementing S&P 500, ESG with? And what are those conversations look like?
Peter Horacek: A great question. We market structured products to advisors, like Scott and Bob, so we're talking to advisors. We're not implementing them specifically in portfolios. We'll leave that to the experts like Scott and Bob in their firms. But we are really engaging and getting advisors to think about how they engage their clients and discussions around ESG. What's important to their clients? And a lot of advisors out there are really not doing as much as they should to engage their clients in asking these questions.
I think that, like I said earlier, we're using ESG as a conversation starter to help advisors engage their clients what questions they should be asking their clients. How important is it to them to align their values with their investments? Having the discussion about what's going on in the marketplace, how corporations are changing their goals, and defining really the definition of corporations, and how they go out and speak to their clients around that. And how you don't have to sacrifice performance to align values, or client values, when you allocate in a portfolio.
It's extremely important that we go out and do this. It's a huge help to work with companies like S&P Global and the S&P 500 because, really, it's the dominant, underlying in all structured products offered in the US. So this is a natural extension we can execute. We can give, share ideas, share stories that advisors may have with one another, because like I said earlier, advisors are very curious how ESG and other advisors are engaging with their clients. So we share those ideas and try to execute them, help advisors execute ESG ideas in their portfolios.
Jenna Dagenhart: Scott, tell us a little bit more about the conversations you're having around ESG.
Scott Ladner: Well, I mean, they're a little bit like what I've talked about so far, is that we do see ESG as a kind of a core part of people's portfolios, whether their primary goal is to make money, to protect money, or spend money, there's a core holding in there because we do think that there's going to be a long term benefit towards having exposures, difference with characteristics that are associated with ESG, with strong ESG scores.
And so for us, I mean, certainly the younger clientele and some part of the demographics of our clientele do gravitate towards the ESG story. But frankly, there's others that actually don't. They actually think, "Oh, my gosh, what are you getting into?" Then you can bring up some of the facts we've been talking about today, the fact that, listen, these are tight tracking error construction methodology, we think there's long term benefits towards having exposure towards these types of companies. Not because there's some sort of political association with it, but because it's the right thing to do and is the right way to run a company.
And we're seeing that in the financial results. We're seeing that in the market results. Don't you want to be a part of that? And invariably, when you say, "Don't want to make money?" People tend to say yes. That sort of ends that part of the conversation. Then we can get on to some of the other things we need to talk about.
We're seeing the hurdle as being increasingly low, which is nice, because people are starting to see some of the proof that's been in the pudding. They're seeing the returns. They're seeing the story play out as we have expected to, and as we've been telling them that we do expect it to. And so these are becoming more frequent conversations, and they're becoming more important conversations for us, as we move through and talk about the core parts of people's portfolios that we manage.
Jenna Dagenhart: As you said, people like to make money. Bob, anything you would add?
Bob Smith: No. I think we're a little bit different than Scott. It's not so much a one and done thing for us, is this is where you may begin. The question is, how much of it do you want in your portfolio? We're always interested in understanding methodologies and influences that are contained within a particular ETF, how you get there, and how consistent that is. The thing that I like about this particular index, and how it's created, is the rules, and the clarity about how those rules are exercised over time.
The annual rebalance is just one feature of it. The controversies that may enter into your realm and say, "Well, do I want to leave this company in the index, or do I leave it out? For what period of time?" There's so much clarity associated with their rules. And any good market, the foundation to any good market is to have solid rules and consistency of application of those rules. And this is exactly what this index brings. Different than a lot of the other ones that are out there as far as we're concerned.
Now, some days you may want to use this as core and say, "This is going to resolve a lot of the concerns that I want." But then there are going to be those times, which we often do as tactical strategists in the ESG, "I want an amplification of a theme. I want perhaps more clean energy expressed in my portfolio. But I have a certain amount that's already expressed here, can I build upon that?"
So again, that kind of core satellite or thematic amplification that I may want. Let's face it, this is a large cap growth index. We're talking about rotation in the marketplace as we go forward here. It's not a value oriented one, so how do I offset that? And what value, maybe near value components are contained within this index that I'm satisfied with, and so that I can get some good correlations working in the other parts of my ESG portfolio that I'm optimizing ESG all the time, and certain features within ESG.
Let's face it, there are people who have certain values that they want to express. This is not a value centric index construct, this is your basement, your foundational, here's where we start. So if you have a particular set of social values that you'd like to have expressed in conjunction with solid market liquidity and good foundational investing, this is a good place to start.
And so we see it as a building block, not the block. That's a little bit different than perhaps what Scott might express, but I think that's the way we think about it.
Jenna Dagenhart: Mona, I've seen you nodding your head, anything you'd like to add?
Mona Naqvi: Yeah. I would just say that Bob's picked up on a really important point here. The transparency and the clarity of the rule space selection process is really key to the proper functioning of any ESG index. On the one hand, we are trying to capture, the more resilient companies tend to score better in terms of ESG. But on the other hand, it's also about creating a system of incentives. As companies look to the index and they understand the very transparent rules based selection process, it becomes clearer and clearer as years go by what they need to do to improve their standing in the index.
And that's also the kind of flip side to ESG, it's not a solely political or social agenda, not by any means. It's very much just a due diligence, rational investment process. But the flip side is that when you start to reward companies really index methodology in areas such as gender diversity, climate resilience, waste efficiency, these issues that we ultimately care about as a society are getting... There's a feedback mechanism there. And companies are starting to pay more and more intention. As the assets are flowing into ESG products, they're asking more and more, "What do we need to do to do better?" And I think from a social standpoint, that's a really wonderful thing that we can all stand behind.
Jenna Dagenhart: Peter, going back to some of those client conversations, do you position ESG as a risk factor when having those conversations? I know, we touched on it a little bit, but I'd love to hear more.
Peter Horacek: Based off of that business roundtable a little over a year ago, the definition or the objectives of corporations has changed. And I think that it's important for advisors to have those discussions. It's a great conversation to have because you see it every day, you see it with COVID, the California wildfires, how companies react in these situations. And I think we get our best learnings out of crises.
As these situations come up in the marketplace, it provides a timely opportunity for us to engage advisors about seeing how different companies react in these situations. And that really translates in the marketplace. And you see companies helping their communities, helping their environment. It translates into value, and it's measurable. And it's really, really important for advisors to engage their clients when these crises happen, because you see what companies are made of, and you see how they've changed, and how they care about their environment, and how they care about the climate and their community. So absolutely.
Jenna Dagenhart: Yeah, Scott, we definitely learned a lot about ESG in 2020.
Scott Ladner: There's no doubt. And some of those performance characteristics were something that you would certainly be looking for out of a core investment. But it is something that you have to be wary of as well, so you have to know what the other side of that looks like. That's where a lot of the research is focused on right now. And that's something that, as Bob was saying earlier, you can position against as well with the rest of your portfolio. But still having something as a core part of it that has a fairly factor and fairly sector neutral exposure to something that you think is going to be a long term winner is still a pretty good way to adjust the portfolio.
Bob Smith: Yeah. Well, as you look forward, I think we're only a chapter one of this rather large volume of a book called ESG. We're all getting comfortable with the phraseology, the terminology. More and more numbers are coming at us. What is really pivotal in all of this is to have a well-established framework by which you can take in all this information and essentially source it and categorize it in the right way with the right weightings. And certainly, what Mona has presented today is a great initial and important pivotal cornerstone step. And from that framework, you can then build your own frameworks and make adjustments along the way.
I think that the next step for everybody, and we're going to see more and more of it, obviously, climate risk is now a headliner. This will be the climate risk administration. They've declared that. So carbon transition is going to be really important to see how companies are doing with regard to minimizing their footprints.
Net zero is a concept that we're going to hear more and more. See how it's expressed in my ETF versus everybody else is going to be important. And then lastly, which I think they already have a head start on, because everybody that's in this particular index has to have agreed to the UN Global Compact, is going to be the Sustainable Development Goals, which have been created by the UNPRI, and that as we roll forward, not only will people want to know what are the ESG values, but more importantly, what impact am I having in society, according to the 17 sustainable development goals that have been laid out and are now a global framework for us to essentially judge our capabilities and our improvement going forward?
And so I think that as I look at this index, I think this thing is already prepared to sit down and say, "Here's how we can talk to you about SDGs, and where you're having really good impact, and perhaps not as good an impact. And maybe you might want to work on that and other parts of your portfolio." That's another whole way of optimizing the portfolio but using this as a cornerstone.
Mona Naqvi: Yeah, I know. I just think that Bob's hit a really important point on the head there, which is that... It's funny, people always think the trade off with ESG is performance. That's just categorically wrong. We've heard that today. But there is a trade off when it comes to index design. And the tradeoff is between impacts and active share, right? We're not going to be able to generate the impact that's required. There is an inherent tradeoff between how far an investor is willing to deviate from the market as it is in the status quo, and the amount of impact that their strategy is going to be able to generate. Now there is a whole spectrum of solutions all along the way. On one end, you've got poor placement strategies like this that by design closely track the current benchmark but offer modest yet meaningful agreement to sustainability. On the other end of the spectrum, for those more high conviction investors, you have the higher levels of [inaudible 00:45:04], higher tracking error, but at the same time, the opportunity to make a much bigger impact.
There's no one size fits all, and there's also no right or wrong answer. As we've heard today, there are different elements of the portfolio that you might want to expose to yourself to different parts of that spectrum too.
We, as an Index Provider, do cater to all of those different corners, but the key is just to know that there is now the option on both ends of the spectrum to be able to both help shape the market and also help generate that bigger impact at the same time
Jenna Dagenhart: Given the rules discussed today, is this rules based approach to ESG make it easier to have those conversations with clients who are already familiar with the S&P 500, Peter?
Peter Horacek: Yeah, I think it does. As Bob said, you need a disciplined approach, which S&P gives. The importance of having a disciplined approach, it's a core holding and the rules based strategy is the passive strategies most structured products. The underlings are based on passive strategies. So the rules based I think really helps the conversation and it's kind of how things are done.
Passive investments have been very popular versus active, I guess, for 15, 20 years now. So this is kind of in line with the market and how advisors position or construct portfolios for clients. This is in line. We spent a lot of time talking about large cap equity, but not as much on small and mid-caps and international, which is also other indices and products that can be used in the ESG vein.
And then just to a comment before about the UN sustainability goals. We see a lot of banks embracing the UN sustainability goals and having specific bond programs earmarked for sustainable investing on the bond side. So structured products really bonds at their core, so when you wrap a sustainable green bond program, or wrap the S&P 500, or other indices in green bonds, it really gives a total package for investors.
Bob Smith: Look, as I said before, rules are the cornerstone to or foundational to a strong and vibrant market. And the clarity that's brought forward in the construct that Mona has talked about today is really quite remarkable and very much important for investors. Everybody walks in and say, "Why do I have that stock?" "Well, here are the rules and here's the reason why. And here's how they're consistently applied."
But you got to understand when you look at the universe that's out there, and what this particular index might compete against, just looking at the top 24, 25 other things you might consider in terms of large cap equity, ESG alternatives, that they're only 20 of them really only screen out controversial weapons, not all of them.
There are 20 that screen out tobacco, but not all of them. In fact, there's only seven that screen out thermal coal. You would say, "Well, that's quite shocking." Only 16 of them screen out small weapons. You'd say, "Wait a minute, I thought those were ESG oriented?" How about fossil fuels? Well, 13 out of the top 25 screen out or have some limit on fossil fuels. So there is no consistency. And so you have to look under the hood. You have to check the rules. You have to see what they're screening for. And is it an all SRI screen calling itself ESG, or is it indeed a more progressive form where, yes, I embrace certain elements of SRI, certainly as Mona's talked about today, but I go beyond that.
And so those are the things that as an advisor, that's my fiduciary responsibility, is this thing wired in a way that as a good fiduciary I can say that I understand it, I see that it's consistent, and that I know that there's a degree of predictability of outcome that I can count on for my investor? And so all of those checks have been made in the box for this particular approach, and I applaud it.
Scott Ladner: And that's part of the reason to why you can actually... And when you're talking about the different ESG approaches, definitely ESG products that are out there. Look, at the end of the day we're talking about system tradeoffs, like everything else in life. And so the rules based approach that this index in the S&P takes this approach, allows us to quantify some of the tradeoffs, and make them understandable to my mom, because mom doesn't really care about a whole lot of things, but she's not going to understand all this stuff.
If I can order things in a system of tradeoffs and say, "Here are the different things that these different indexes are trying to accomplish. And here's why they're trying to accomplish them. And here's how they do it. And by the way, here's the result of that at the end of day," which really all mom cares about. That system of tradeoffs ends up being very tangible. And it gets us out of an exposure conversation. We don't have a conversation about exposures or Greek letters with mom. We want to have a conversation about tradeoffs and about if she's on track or off track with their plan with mom. That's the only thing mom cares about. And so the rules based approach that S&P takes with us allows us to have that very quantitative. Take the thing that is very quantitative and very detail oriented, and translate it into a way that actually somebody in retail could actually access and appreciate. And therefore get comfortable with and actually end up using.
Jenna Dagenhart: And how do your conversations with mom, with clients change when you discuss ESG, Scott?
Scott Ladner: Well, they don't have time because it ends up just being occurring naturally. We're one of the premier goals based investment managers in the world. This isn't a conversation we're having tons of, "You should have a lot of small cap value, or you should have a lot of European exposure," or anything like that. We're not having those conversations with our clients. We're building portfolios, just trying to power financial plans that advisors produce. And talk people in that framework.
But within that framework, they do have to understand what's basically in the portfolio and basically why it's there. But it's not a core part of the conversation. But when somebody does see the word ESG in their statement, they're going to have questions, because that's something new. They might have heard about it as kind of a buzzword type thing, and they will have questions about it.
It is very helpful to be able to explain and say, "This is why this is in there." You don't necessarily have to understand every kind of minor detail associated with it, understand what we do and there's a reason why it's in there, but it's not going to be necessarily the core of our conversation with many of our clients.
Bob Smith: I wish I had those clients, Scott. Here's what I'm finding, when it comes to ESG, there is an immense amount of questions that are either values based or impact based. And if there is something that needs to be done in our industry, unequivocally, is that we need to have a better representation of what is going on within the portfolio with regard to impact and expression of what the strength of the ESG is in our portfolio.
We, at Sage, we do that on a ticker by ticker, CUSIP by CUSIP basis. We write reports about all the holdings that we have, that are inside the ETFs even that we manage from an ESG perspective. And we're finding that more and more advisors and institutional consultants, which is the world that we're in, that if you can't respond to those questions, if you can't talk about how I optimized for ESG values, and here's how I have attained that in the portfolio, in addition to my optimization for financial outcome, you won't get the assignment.
And going forward, if you look at questionnaires for RFPs, and assignments, and so forth, that are coming increasingly into the industry that are ESG oriented, there's amazing array of questions that you need to talk about, pricing of climate risk, carbon transition, gender equality, and so forth. I think the list goes on. And so we are only at the early stages of this. And if you're not having that conversation with your clients, wait a year, you'll be having them a lot.
Peter Horacek: No, it's interesting, because the investor or the institutional side of the RFPs, those questions are there. That's just, again, going back to just the changing nature of the responsibility of the corporation and how securities are vetted. And really the answers that high net worth and institutional investors want, because it just points out the risk. Right?
If you're not doing that, if you don't have answers for that, that's a risk. And like Bob said, you're not going to get the mandate. But on the other side, there's other opportunities out there where... Or what I meant to say is, the fiduciary responsibility of the advisor where does that go? It fits squarely into that as well, because some clients don't want to know what's in the portfolio, right? They trust the advisor to make these decisions.
And the retail level, you may see that more often where the trust is there, it has to be there, because it's somebody's money. And it's these advisors responsibility to make sure these things are thought about for the client.
Jenna Dagenhart: How do you think ESG can help interest other stakeholders in the advice, wealth discussion plan?
Scott Ladner: Well, I mean, I think hopefully, it'll actually drive people towards financial advisors. As Bob and Mona and everybody's been talking about, this is a complicated subject. There's a lot to understand within this subject. And so if somebody truly cares about ESG, it might be overwhelming for them to actually try to figure it all out on their own.
And so they might seek the advice of a professional. Somebody that really spends a lot of time and a lot of energy and has years of experience trying to figure out some of these things out. So hopefully, it will drive people more towards professional financial advice, which I think will serve them very well in the long term.
Bob Smith: I think as other stakeholders are concerned, I mean, let's face it, if you're a S&P 500 company and you're trying to attract labor, and you want to have millennials and Gen-Xers and Z's and so forth, and you're growing company, the last thing I think you would want to be is that group of 195 companies that didn't make the cut under Mona's screen. And the second thing is, is that, "Gee, what do I have in my 401k plan in terms of the choice architecture that speaks to these people that is a good solid index based mutual fund or ETF that has this as its core index?"
And so I can talk about human capital, I can talk about it from a managerial standpoint, why is it we didn't make the cut? What's going on with our company? I thought we were doing things the right way. Or there are a number of different stakeholders, the community at large in which they operate will want to know, "Why are you sort of a laggard in regard to all these things that are important to us as stakeholders?" Peer pressure, I think it's going to build tremendously because capital will flow to the higher quality producers or the higher quality companies that are really oriented in this direction.
And that's going to essentially continue to multiply going forward. And so I think there's going to be a lot of pressure to bear from a lot of different stakeholders in different ways, and you just have to look at it more holistically.
Jenna Dagenhart: It sounds like ESG is here to stay. But it begs the question, Mona, what's next for ESG?
Mona Naqvi: That's a great question. But I think, as Bob and others have alluded to, we're just at the beginning of a transformational change in the way in which we invest our money. And I think that ESG is simply a bridge from the tired financial models of the past that are heavily dependent on backward looking historical information to a more forward looking approach to understanding the economy and all the big changes that we're seeing unfold at the moment.
ESG is just a process. It's the process of adding not traditional, non-financial sources of information into the investment process to make a more informed and rational investment decision. And as investors who are just doing their due diligence come across this and see, it makes sense to actually just take all of these different information sources and just at least consider whether or not they may be relevant.
And so I think for now, we're calling it ESG, but at some point, I think the term is just going to wither away and it's just going to be called investing. And I may be out of a job, but at least the world will be a better place. I look forward to the day that we don't need to use the acronym and it's just called investing.
Jenna Dagenhart: Well, everyone, thank you so much for joining us.
Peter Horacek: Thank you, Jenna.
Scott Ladner: Thank you, Jenna.
Jenna Dagenhart: Yeah. Thank you so much for all your insights today on how the S&P 500 ESG index is helping ESG go mainstream in markets around the world. And thank you everyone for watching. For more information on how indexing works for ESG, including the latest data and research on the S&P 500 ESG index, you can visit S&P Dow Jones indices website at the link below.