MASTERCLASS: Fixed Income - January 2020
December 19, 2019
Remy Blaire: Welcome to Asset TV. Environmental, social, and governance factors have gained traction as a way to evaluate companies at least among institutions.
Remy Blaire: Today, I'm joined by Joshua Kendall, Senior ESG Analyst at Insight Investment, Guillaume Mascotto, Vice President and Head of ESG and Investment Stewardship at American Century Investments, and Max Messervy, Senior Investment Consultant at Mercer's Responsible Investment Team.
Remy Blaire: Gentlemen, thank you so much for joining me for today's Masterclass. Well, ESG investing has been getting plenty of attention recently, but it isn't a new theme, and we've seen a lot of evolution in this space. So, Josh, starting out with you, what is ESG investing?
Joshua Kendall: Well, it might sound like a very simple question, but actually there's a lot of complexity with a definition of ESG and responsible investment. So, let me answer that in the context of Insight, a dedicated fixed income manager, and manager of more than $900 billion worth of assets.
Joshua Kendall: For us, we focus on responsible investment, and that means taking into consideration factors that can have a credit impact, and our view, ESG factors are another way in which we can identify issues that can have a material credit performance. Clients are also asking us about impact and sustainable investment, and this is actually something which is quite different to ESG or responsible investment. Impact investment is a client saying they don't just want to achieve financial objectives, but non-financial objectives as well, such as social or environmental themes. Sustainable investment is a combination of both those two things. A client is saying, "Not only do I want to achieve mainstream financial returns," but they also want to do it in a way which is recognizing their reputation concerns and commitments to their corporate sponsors.
Joshua Kendall: So, in our definition, it is mostly about risk and managing that downside risk, but it can mean other things.
Remy Blaire: And, Josh, I think you've set the stage for this discussion by highlighting all the nuances. Now, Max, you offer a unique perspective as well as a consultant, so naturally, that leads me to some of your research as well as data. What are your findings regarding adoption when it comes to ESG and sustainable as well as impact investing here in the U.S.?
Max Messervy: Sure. So, I think to set a baseline just to lay out some figures. The Global Sustainable Investing Alliance, which is a member network of regional sustainable and responsible investing investment organizations across five major markets, the U.S., Canada, Europe, Japan, and Australia/New Zealand. They recently released a report earlier this year that found that sustainable investments grew about 34% globally between 2016 to 2018, reaching $30.7 trillion in total assets.
Max Messervy: What we found actually, or what they found, is interestingly that Europe has certainly stands as the largest overall market, with about $14.1 trillion total of sustainable investment-related assets in 2018, but the U.S. is not that far behind at about 12 trillion. And the rates of growth, actually, are really quite an interesting fact as well, which is that in Europe between 2016 to 2018, the growth was about 11% in sustainable assets, whereas, in the United States, during the comparable time period, from 2016 to 2018, was 38% growth. So, while the U.S. in terms of overall assets is still a little bit behind Europe, the rate of growth is really picking up, and I think that gap will close shortly.
Max Messervy: But more of the larger point to make is that there is a very advanced group of investors here in the United States, primarily foundations and family offices, which have deserved credit for launching the global impact investing movement in a lot of ways. Some of those organizations have committed to 100% impact across their portfolios, and they're reporting out their successes and failures on that journey.
Max Messervy: So, these global trends are reflected in Mercer's own figures as well. Since 2010, we have rated investment strategies on a four-part basis for their ESG integration and active ownership approaches, which is separate from our buy ratings, which indicate a likelihood of outperformance against peers within that asset class.
Max Messervy: So, an ESG1 rating in our grouping indicates a strategy where ESG factors are essential to investment decision-making, whereas, ESG4 represents a strategy where there's little to no integration occurring. So, we consider ESG1 and ESG2 ratings to indicate higher levels of integration, and in 2018, we found that across all client assets that were dedicated to manager searches, globally, 22% of those were dedicated to highly rated ESG strategies and up from 11% in 2017. And furthermore, we've seen a steady increase in highly rated ESG strategies that are being produced by managers, from about 11% out of 4,500 total rated strategies in 2014 to nearly 18% in 2018.
Max Messervy: So, what we're seeing here is that there is increasing client demand from our Mercer clients, but also, that managers are putting out more credible ESG-oriented products as well.
Remy Blaire: Well, Max, I think it's very helpful to hear those statistics, especially as people just tend to put together trends we're seeing in the region and not take a look at that specific data. So, naturally, Guillaume, my next question is for you, and I'd like to know how investors use ESG from both the institutional side as well as for retail investors.
Guillaume Mascotto: Yeah, well, they use it in various ways. As we discussed earlier, there's different approaches when it comes to ESG investing. The definition of those approaches also vary across markets, and so when we look at the institutional space in our experience, we see definitely an uptakein terms of ensuring that not only is there a risk management component to using ESG information into the investment process but also a upside potential component. So, it's both risk mitigation but, also, maximizing upside potential.
Guillaume Mascotto: And the way to do that really is to integrate it directly into the fundamental research process. That's what we've seen from asset owners. They don't necessarily want to have what we call an after the fact integration, otherwise known as an overlay or an insert. That's mostly something that you see in the passive space, which is basically just creating an index and inserting some screening factors. They're really looking for something much more potent and much more, indeed, integrated into how portfolio managers make decisions.
Guillaume Mascotto: On the retail side, what we've seen is a little bit different. It's had a little bit more values driven, right? Values in the sense of investment values. Most likely in the private wealth domain, we've seen a lot of interest from ultra-net-worth individuals who have a lot, of course, of dry powder to invest, and for them, they might want to do this a little bit more closer to their hearts, more personal to what they feel is creating a value. And that could be in the impact investing space, most likely around United Nations Sustainable Development Goals, but also in a specific focus, in our opinion, in private equity.
Guillaume Mascotto: And so, in as much as you see a lot of uptick for impact investing, in the public's markets, but equity and debt, we think that in the retail side, there's a growing appetite for private equity. But nonetheless, whether it's a retail investor or an institution investor, the conclusion is that there's a growing, of course, interest on the part of investors at large, but also, there is a sophistication, right, of the understanding of investors when it comes to ESG.
Remy Blaire: And now that we've set the ground for this discussion, I do want to take a look at misperceptions when it comes to ESG, and we know that there are plenty out there. Now, it seems as though in ESG investing, there are a lot of acronyms. You highlighted SDG, Guillaume, but there is CSR, as well as SDG and SRI, so I do want to take a closer look at those acronyms later on. But, highlighting misperceptions, Max, what are some of the common ones you're seeing that surround ESG investing, and what do you think could be done from an educational perspective?
Max Messervy: Sure, absolutely. Well, as we've kind of touched upon here already in this discussion, a major challenge we've run up into here in the United States in particular is the kind of inappropriate conflation of ESG and socio-responsible investing, or SRI approaches, which tend to be more of a legacy approach in a lot of ways. SRI approaches really usually involve values alignment of your investments. As Guillaume was mentioning in the retail space, many investors are seeking to align their values. In the institutional space, other institutions as well are seeking to align with their values, and that usually is done through negative screening and through engagement with your underlying holdings.
Max Messervy: ESG integration, however, does not involve such moral or political perceptions necessarily. You're really looking out for risks and opportunities in those underlying holdings and integrating those factors into the investment decision-making process. So, what you might want to look for, for example, or what many managers look for is some underlying risk factorssuch as how is a food and beverage company managing water risks in its supply chain. Furthermore, if you're an apparel manufacturer and your supply chain or your labor practice is being upheld, is there any forced labor in your supply chain, for example, is a big area of focus.
Max Messervy: So, managers that are integrating ESG rather are taking the moral and political questions out of the mix, and really, they're looking purely from a risk and opportunity perspective to make those investment decisions.
Remy Blaire: Well, the common perception is that it may be easier to measure the E and G versus the S of ESG, but there are misperceptions out there. So, Guillaume, when it comes to this type of investing, performance is important. So, what are some of the top external ratings, indicators, that you think could benefit from better materiality contextualization?
Guillaume Mascotto: Yeah, well, that's a very good question. So, in our opinion, I think the underlying sort of punchline is that ESG indicators need to be contextualized per fundamentals in order for them to help indeed, fundamental analysts, whether on the equity side or credit side or a portfolio manager in that case to be able to use that information to make decisions. So, of course, in my opinion, all of the indicators could benefit from that contextualization, but if I were to sort of zero in on a couple of them, I would say the first one is definitely carbon emissions and everything that has to do with stranded assets.
Guillaume Mascotto: Typically, when you look at third-party ratings agencies, they will just measure the company's overall carbon emission externalities rather than look at the corresponding trends, and then they might also estimate, right, the emissions that are locked in into the reserves that the company, in the case of an oil and gas company, for example, holds on the balance sheet or sort of assess this as a risk, right? As a stranded asset risk potential.
Guillaume Mascotto: We believe that it's best to do that in a way that contextualizes this per pricing scenarios, right? Actual carbon pricing scenario, and then stress tests that balance sheet of these companies in order to evaluate the margins of safety that these companies have to weather any form of rising carbon-related costs, right? And then calculate the coverage, the cost coverage, that these companies have to do that, and that's what we do in our investment processes at American Century Investments. So, that would be one.
Guillaume Mascotto: Another one around governance, what we realized is the governance assessment at large in third parties, in our opinion, are a little bit Western focused, right? That's interesting, of course, if you're investing in Western Europe and if you're investing in North America, we understand that things like board independence, things like the separation of the chairman of the board and the CEO, things like, for example, independence of pay committee, audit committee, of course, that matters a lot. Even things like measuring the CEO pay relative to the median pay of the employee, right? Those are really hot topics in North America and the Western World in general.
Guillaume Mascotto: But as global investors at American Century Investments, we do sometimes invest in smaller cap companies in Southeast Asia, sometimes larger cap companies in Japan or in Korean and other regions where the governance standards are different. So, it's important for ESG-minded investors to really look at the local context, right, in terms of governance standards and understand that it might not be the same thing as a German-based company's governance context. So, that would be something that we would consider as very important to do that. In other words, ensuring that if we have a company that does not have, let's say, a certain threshold of board diversity or a certain threshold of board independence, to look at whether or not this company operates better than its home peers as opposed to comparing it with a company that might be more advanced, right, from a governance standpoint.
Guillaume Mascotto: And then, the last one over here is a bit more, we can say, technical, but the financial companies, right? So, the banks. Most likely the third-party ratings tend to just look at their size, and then they will penalize the company by their very nature of their size. They're going to look at the assets, their loans, and say, "Well, you know what? This company might have more of a negative impact if it goes under." It's going to destabilize the financial and economic system, which we understand, but we think it would benefit from more contextualization for the company's credit quality metrics, right? Looking at capital positioning, liquidity, looking at asset quality metrics, all of that is very important because you might have a company that has over 50% of assets in loans, right? Those loans might be broken down by various industrial, commercial, or retail clients.
Guillaume Mascotto: That's fine, but if we look at the breakdown, let's say the breakdown between the industrial clients, you might have a lot of exposure to sectors that might not be that at risk, right? Or, if they are at risk, they might be well rated. They might be all IG, for example, and if you contextualize this for the company's actual credit quality profile, then it provides the portfolio manager with much more, in my opinion, interesting information to indeed integrate into an investment thesis. So, that would be my response.
Joshua Kendall: As a follow-on to that, I think it's really important that as ESG becomes more critical for investors, that we move away from relying on these third-party ESG rating agencies which have dominated how investors frame ESG investing for the last few years, and at Insight, for the last three years, we actually been doing our own ESG ratings for a number of companies, especially in fixed income, which are privately held. They don't have any listed stock, and therefore, they don't have a third-party review on their ESG profile. And so, we have our own ratings for many of these companies, and in recent work, we've actually extended that to all companies in fixed income to generate our own ESG proprietary score, and this is really important because some of their contextualization issues are becoming even clearer in fixed income because the issues and the risks that we look at in this asset class are very different from what you might be looking at as a shareholder, for example.
Joshua Kendall: So, you have to customize what you're looking at. You have to be thinking about what is the drive of those risks and build that into your review process.
Remy Blaire: And now that we've highlighted the misperceptions that we're seeing in this sort of investing, I do want to open the table and ask you about some of the myths that prevail in this space. There may be retail investors watching this as well as financial professionals who have to advise their clients on this type of investing, so are there any myths out there that irk you when it comes to ESG investing?
Joshua Kendall: I think we all see them, don't we? From my perspective, what I see with institutional clients, there is certainly a view that what is the risk for performance if they apply an ESG process to the strategy that we've run on their behalf. And a lot of that is from concern that they still want to maximize return, but they also want to do the right thing by applying ESG to their mandates. So, what we do to give clients that confidence is do that research for them and explain if you are applying ESG criteria, what it will be like for your performance in terms of duration or yield or tracking era and give them the confidence actually what the impact would be. And the more we can explain to clients about those impacts, the more awareness that they have, and the morethey are actually, too, more likely to go out and run these mandates across all the asset classes that they run.
Joshua Kendall: So, for me, performance is the key issue, however, there are ways to mitigate that by engaging with your fund managers and talking about what you want. So, it's quite simple from our perspective within fixed income to apply a basic screen. A client might be concerned about managing their reputation, and so we can screen out specific sectors if that's of interest to them, or we can identify the worst performers on ESG criteria. And, we can go even one step further and say, "Why don't we just invest in the best in each sector?" So, a best in class strategy and explain what the impact would be if we were to remove those which have the lowest sustainability focus rating.
Joshua Kendall: So, the more research we do, the more we explain to our clients how we operate and what the impact would be, the more I think a client has the confidence that actually ESG's the right process for them.
Max Messervy: Well, I would say another myth that we frequently run into, and this was mentioned before I even mentioned it myself. It's just this is very frequent issue here in the United States, the conflation of the political and moral perceptions with ESG investing. And really, if you think about it in an ERISA plan, DC plan, retirement context, this is really a challenge. The way that fiduciary duty has been interpreted here in the United States has put a very strong focus on essentially creating the best performance or accessing the best performance on behalf of plan participants that one can, and other considerations really kind of just could be in violation of the fiduciary duty focus.
Max Messervy: Now, again, as Josh well put it, you don't have to sacrifice performance to seek out ESG alignment within your investment portfolios, and really, if you think about how risk factors into a long-term perspective such as a retirement plan context, assessing those emerging risks and opportunities as they come out that might be better assessed through extending your fundamental analysis process to look at these non-traditionally and financially material factors such as ESG factors, really can help ensure that over the long term, you're mitigating those risks, you're seizing those opportunities, and finding managers that can best fit those plan participant lineups that are offered by plan sponsors is something we're increasingly being asked about by clients. So, we think the tide is turning there, but it still takes a lot of education of plan sponsors in this context.
Guillaume Mascotto: Yeah. I would echo what my colleague said. I think, of course, from a performance standpoint, that's usually what happens. The clients ask us, "Does that add value?" So, we've rend data for the past 10 years looking at the MSCIs indices so that the broader market in general and cross analyzed them with their ESG-adjusted versions, and we found that over 10 years approximately six basis points of outperformance on the part of ESG-adjusted version. So, what does that mean? That means that ESG does not hurt performance per se, but it doesn't necessarily add performance as well for our client, who's really looking for a significant outperformance of the bogey.
Guillaume Mascotto: So, in that case, our answer to that is that it needs to be, again, integrated into the fundamental research process and have a clear link to an alpha generation engine. So, we have different ways of doing that per different types of strategies. If you have a one-size-fits-all approach and you apply that, then it might be disconnected from an actual investment philosophy, in which case it would be hard to demonstrate to your client how ESG actually contributed. What is the sort of ESG factor impact right on the investments?
Guillaume Mascotto: One other thing that we've realized is when you talk about the different approaches, so we spoke about screening, integration, best in class, impact, we've always seen it from sort of like an evolutionary process. I look at that. I see a lot of reports out there that says, "Well, okay. First, you start with screening, but then as you want to move forward, you know you need to get impact." We don't really agree with that approach. We think that all of these approaches are valid because you have clients who have different needs, and those needs are also evolving. And indeed, what we realized, is that those approaches could be combined. They're not mutually exclusive. We have products for our clients that have core ESG integration as part of the fundamental research process that also screen out companies that might be part of a, what we call, like a redline exclusion list, like the Norges Bank's exclusion list, for example. And at the same time, we might be seeking impact through our engagement, through measuring the impact achieved, right? So, that's three different types of approaches combined, right?
Guillaume Mascotto: So, we would encourage investors to look at the various approaches to ESG but not in a mutually exclusive fashion in a way that they can combine them together, and it's up to the manager, in our opinion, to have the capability, right, to create solutions for their clients across these various approaches.
Remy Blaire: Well, gentlemen, I think it's very important to state those clarifications and also to state what some of the myths are so we can separate the misperceptions from reality.
Remy Blaire: And now, I want to delve into the trends that we are seeing in this ESG investing space, and, Max, I want to get your take on what we're seeing in this space in terms of region. Now, I know that you highlighted some of the differences that you've seen in North America versus Europe and Asia, but what really stands out to you when it comes to this type of investing?
Max Messervy: Sure. So, as I mentioned earlier, U.S. is rapidly, it appears, catching up with Europe in terms of kind of overall size of assets that are dedicated towards sustainable investing. Japan, that same Global Sustainable Investment Alliance report found actually from 2016 to 2018, had a 320% compound annual growth rate in assets dedicated toward sustainable investing, which is, obviously, phenomenal growth. It's still from a relatively small base, but looking ahead, I think many managers would probably be wise to start thinking about how to up their ESG game, let's say, in the Asian markets and Japan in particular. So, what we're seeing generally on trend lines, they're all kind of heading in the same direction on a global basis, and that's certainly seemed like a positive indicator for the growth of this space.
Max Messervy: So, what we're seeing though, also, is that as I mentioned before, there's a really interesting history here in the United States of impact investment development, and so while we're thinking about global trends, where things go in the future, I think that it's important to also keep in mind, again, in this American space, that we've had some really interesting develops in terms of from the 1980s, you had student-led divestment campaigns against apartheid South Africa, for example. You had the development of proxy voting processes and engagement processes that are really driven by kind of legacy socio-responsible investing investors and managers driven by that, and again, this development of newer impact investment methodologies.
Max Messervy: So, again, this U.S. trend, we might be a little bit behind. On the whole, there's certainly some truth to that. The trend lines are positive in that direction, and I think that going forward, the number of managers we speak with and there's some really innovative, interesting work being done around data and really getting to that next level of material ESG information that we're excited to see.
Remy Blaire: I think it's really great to hear about the differences we're seeing based on region, and when we're talking about trends, of course, demographics come into play. Now, in general, sometimes we might see millennials getting a bad rap, but when it comes to investing, especially ESG investing, they may care more about impact objectives. So, can you tell me, Josh, what you're seeing right now?
Joshua Kendall: Well, of course, you touched on an important cultural trend which is taking place around the world. We know that millennials are this huge generation of people which are going to inherit a lot of this wealth and takeover those senior positions in jobs all around the world which will have this responsibility to tackle many of the issues that we're facing as a society from climate change, inequality, corruption. This millennial generation is going to inherit that have to find solutions to meet some of those challenges.
Joshua Kendall: And so, finance investing is one of those key ways in which millennials are thinking or actually my money can make a difference, and this is most evidenced in the interest in green, social, and sustainable bonds. And these impact bonds have become a huge part of the fixed income space in particular. In the first half of 2019, more than $100 billion of green bonds were issued alone, which is up 2/3 from 2018, and this is a huge opportunity for investors whether they're millennials or non-millennials to think about actually. These are assets which not only give you a financial return, but the projects that the money goes for can actually have a tangible impact on the environment as well. And, we've seen a whole host of companies issue from utilities and financials and most recently this year, we've had telcos issue for the first time as well.
Joshua Kendall: So, if you're a millennial thinking, "Oh, actually, I want to make a difference, and I know about these challenges facing the world," finance is a really effective way to meet some of those objectives. And it's not just those green bonds even though that's a key way within fixed income. It's also about your everyday strategy. How much of that investment portfolio do you understand? Which companies are aligned to a two-degree world? Which companies are exposed to stranded assets? The more information that a millennial has, the more they can hold their managers to account, and that's why we've been promoting transparency for our own funds in fixed income. So, all of our fixed-income clients in Europe or the U.S., we can get them an ESG report outlining what the carbon footprint is on their portfolio and the ESG portfolio as well, the ESG footprint, as well. And within that transparency is our commitment to investors out there to say, "Well actually, the decision and the opportunity is in your hands."
Remy Blaire: Well, I think it's very helpful to understand that, whether we're talking about millennials or non-millennials. And, Guillaume, moving on to you. I do want to get your take regarding corporate disclosures, so can you tell me whether you see any tangible improvements happening with corporate disclosures that can help improve the current gap?
Guillaume Mascotto: There's definitely been some developments in the United States, actually, with SASB, which is basically an organization that is pushing for adoption of sustainability indicators as part of your traditional sort of annual reporting, and we agree that this could be interesting. We also think that it would be equally important to distinguish between quantity of disclosure and quality of disclosure, and so insofar as we're seeing developments here in the United States for SEC-issued disclosure in Europe as well, right, at the European Commission level, in fact, there's been some recent developments that are moving forward with an ESGtaxonomy, right, which is basically sort of coming up with a definition for investors to rely upon. It still has to be ratified by parliament, but nonetheless, it's an interesting development.
Guillaume Mascotto: So, we welcome these developments, but we would, again, caution investors to fall back onto what really matters to them as investors, right? We've actually met with a lot of pension funds across the world, and some of them are interested in those developments, but some of them are actually looking at it more from a caution perspective because they're saying, "Well, we know really what matters to our investors. We have the definition of what we consider as financially material from an ESG standpoint. We're not necessarily interested in having a top-down sort of definition that's imposed upon us.
Guillaume Mascotto: Nonetheless, what we find that is encouraging is now investors are coming to us and saying, "We get it. You have an ESG team. You have ESG products. You have your proprietary scoring system." In fact, we have our own as well, and that's a trend that we're seeing across some of our peers. But now, the next step is to say, "Demonstrate to me how are you using this to make decisions. When did you help? When did you actually use this to buy a stock or buy a bond or sell a stock, sell a bond, for example?" Or they're going to want to isolate credit analysts or fundamental equity analysts and saying like, "Show me how you've incorporated that in your valuation process," right?
Guillaume Mascotto: So for us, what's encouraging is, again, you have this trend of investors asking to re-inject fundamental analysis, whether on the credit side or equity side, back into the equation. So, it no longer suffices to say that you have a process in place that leverages third-party data, or to say something like, "We've always looked at financial risks, be easier or not." They're really looking for that actual demonstration that this has in impact on the way you investment.
Guillaume Mascotto: And to the point that Josh mentioned around impact, we see that as well, right? You might have companies whose core assets, which is products or services, have a tilt towards one or more of an impact theme like the sustainable development goals, for example. But again, if you're not able to quantify that impact, what is the impact achieved, either achieved now or projected, right? That is something that might be incomplete, right, from an investor's standpoint. So, we do see that as an overall encouraging trend that investors are taking this very seriously. They're much more sophisticated in their understanding of it, and they actually want managers to clearly demonstrate how this adds value into their investment decisions.
Remy Blaire: And, Guillaume, before I move away from you, since you mentioned the quantifying process, what are some of the common questions that are being asked?
Guillaume Mascotto: Yeah. So, for example, we have an emerging markets SDG fund that would be launched shortly. We are growth investors. We're looking for companies that have acceleration of earnings growth," right? Looking for that inflection. And so, it's even more difficult sometimes because you're buying smaller companies, right, that are in the emerging market space, and they may not have disclosure, especially akin to the same level of the transparency that you're seeing in the western world. Some of them are currently in the growth mode, so their impact is not fully achieved.
Guillaume Mascotto: So, a good example of what we're being asked is, "Okay. Let's take a microfinance company operating in India. That company lends to women who otherwise don't have access, right, to financial services. Well, tell me. What is the size of the loans portfolio?" Right? "How many women have been benefiting, right, from this service, and how many women will be benefiting from it in the future? Right? What is the average size of the loans? Under what collateral arrangement are those loans being issued?" And so, all of that stuff when you quantify it, really helps an investor to better understand, "Okay. Of course, it's a microfinance company in India lending to women. I see the impact, but I want you to demonstrate to me what actually was achieved."
Remy Blaire: I think that's very helpful to the viewing audience. Now, circling back to you, Josh, could you tell me about ESG issues that matter particularly for corporate debt?
Joshua Kendall: Well, I suppose it's worth explaining what the objective of us as a fixed-income manager is first, and when we invest as a fixed-income investor, our priority is to understand what can go wrong when investing in a particular corporate debt instrument. So, in order to answer that question, we have to do our research. We have to talk to the company, understand its plans in terms of how it intends to use bond proceeds, its cash flow forecast, and any potential threats to its business model that we might see over a three-year or a five-year period. And more information we understand we have of a company, the better we can actually price in those risks which may impact it, and those risks might extend to its cash flow position, but also it may be risk of M&A activity, which can be negative for bond spreads, and conversely is quite positive for shareholders, but we have a very different view. And also, it's also about understanding is there a risk of perhaps an LBO, leveraged buyout, at the company, which again, would be quite negative for the corporate debt instruments.
Joshua Kendall: So, all of these risk factors are something we pay close attention to, and another one of those risk factors is ESG. And as I mentioned in the beginning, ESG is another one of those risk factors that we are very much concerned with understanding. The more we can understand about a company's ability to manage those ESG risks specifically, and the more confidence we can have they are not likely to be material for its creditworthiness.
Joshua Kendall: So, in order to achieve that, we have a research process, which we call an integrated ESG process, and the way that works is we access ESG information. We do internal thematic research. We look at external research providers, and we provide all this information for our credit analysts to review. It's not the responsibility of an ESG team, but the credit team, the credit analysts job to understand this information, review it, quantify it, and make decisions on whether this risk is material or the timeframe in which this risk may materialize, and whether we can quantify this risk in terms of financial information. And we can call this ESG evaluation because it's done alongside the financial analysis and the analysis of the bond instruments as well.
Joshua Kendall: And if you do the analysis together in all these three components, so the ESG, the valuation of the bond, and the business through financial assessment as well, then you have a better understanding on a company's ability to manage its risk, and you have confidence that it's a suitable investment in a fixed-income portfolio. And that is our responsibility to clients, to ensure that we do all of this exercise to ensure we are confident that when we add it to a portfolio, we know it's going to perform.
Remy Blaire: And while we're on this topic of trends in ESG investing, Guillaume, as well as, Josh, you have highlighted what we're seeing in terms of gaps in terms of wealth as well as generations. So, Max, I want to bring the discussion back to you. What are some of the gaps that you're seeing in ESG investing other than just generational or wealth-based?
Max Messervy: Right. Well, the generational piece is important, and just to put some numbers on what Josh had mentioned before, some market observers have calculated really that there's about a $30 trillion-dollar wealth transfer that's about to occur from baby boomers to both GenX and to millennials. And what we've found, we did some research earlier this year with the World Business Council for Sustainable Development or WBCSD, which is a membership organization comprised of about over 200 different member companies and other institutions, and they hired us and partnered with us to develop what we call the Aligning Retirement Assets Initiative. It's basically a series of two different toolkits as we described them to help demystify the process of incorporating sustainable investment options into corporate retirement plans for plan sponsors, and this is both on the DB, defined benefit, pension plan side, and the DC, defined contribution, side as well. And, it was written in a global context. We also did a U.S.-specific version as well because the regulatory context is different here under ERISA.
Max Messervy: And what we found in that research, though, is that first of all this research was driven by the interests of plan participants asking their plan sponsor, their employers or plan sponsors, to offer them more sustainable options, so that drove the development of this project in the first place. But doing a meta-analysis of different studies that have looked at trends and sustainable investment attitudes, the majority of people surveyed actually did express an interest in investing more sustainably within their retirement plans, but millennials and women by 12% and 15% respectively, were more interested than the general populace.
Max Messervy: So, when you combine those kinds of trends indicated, those attitudes indicated in those surveys with this generational wealth transfer we're going to see, basically, we think that the investment industry as a whole really has to start advancing its processes to get their hands around this challenge and opportunity, frankly, around creating credible, ESG-oriented products that will appeal to these savers and investors of the future.
Remy Blaire: And I think that wealth transfer topic is a very important one, whether it comes to ESG investing or any other type of investing. And, while we're talking about trends, we can't have this discussion without talking about technology and how it's changed the way that we invest, whether it comes to innovation or how we get our information or misinformation for that matter.
Remy Blaire: Now, Guillaume, what do you think about the innovations that we're seeing, and can you explain to us what the term, creative destruction, means?
Guillaume Mascotto: Yeah, yeah. Well, that's originally an economics term from Schumpeter, a very famous economist, and basically what he means is as you are innovating, you know you are indeed making progress. But as a result of progress, you are chipping away from traditional business models, and sometimes it could have negative reverberations on society, right? So, a good example of that would be many, many, many years ago you had a lot of folks who were employed to light the candles in the streets, right? So, those folks had money, and, of course, they were employed. But as we invented electricity, these jobs are no longerrelevant, if you will.
Guillaume Mascotto: So, it's the same thing in other sectors. As you increase your level of technological innovations, you will indeed become more efficient. You will indeed be able to solve problems, but at the same time, of course, you will be leaving behind some other elements of that business model that might not be as innovative. And so, that's really what we mean by creative destruction.
Guillaume Mascotto: The reason why it really matters for ESG is those sectors that are highly exposed to innovation, if the companies in which you invest that operate in that sector are not keeping up with innovation, they don't invest in their competitive edge, around research and development, for example, then they might be exposing their investors to potential risks. So, it's important that asset managers understand that level of innovation and how it might impact business models and therefore choose the companies that are well poised, right, to capture growth opportunities associated with that innovation.
Guillaume Mascotto: I think a great example of that is definitely the energy sector. More and more renewable energy, of course, power storage, are chipping away the traditional, conventional energy model, right, as you move towards this BTU transition in the world energy markets towards lower carbon-ran economies. So, therefore, the companies that are not looking at these trends, they're not investing appropriately in these trends in order to stay competitive might actually expose the investors to potential risk, right? So, that's very important. But that's more in this sort of picking investments, right, picking stocks, picking bonds.
Guillaume Mascotto: I would say, though, that creative destruction also plays a role in asset management. So, the asset managers who are not keeping track with a lot of things that's going on in artificial intelligence, for example, a lot of things that's going on in terms of just the sort of computation of all kinds of different, or digitalization of all kinds of different ways of processing data, might be left behind as the financial markets continue to grow. And so, for us, we think that the next big step will be to how to use that technological innovation in a way to enhance an investment process in order to process more and more data, right, to QA that data and use it effectively in making decisions while at the same time keeping a human touch, of course, on it. You don't want to completely forgo a portfolio manager's ability to understand this data, to process it, and to make relevant and, of course, value-adding investment decisions for clients.
Remy Blaire: And, Guillaume, you did a wonderful job of explaining to us why this was relevant in ESG investing, and earlier, you mentioned SDG. So, can you tell us a little bit about the framework for the United Nations and whether you think this is a great framework or too ambitious?
Guillaume Mascotto: Wow. That's a good question. So, the first thing we have to say is when we talk about the UnitedNations Sustainable Development Goals, the confusion sometimes that we get is, "Oh, so that's impact investing." So, it is impact investing, but let's be clear that you don't necessarily need to adopt the SDGs in order to yield positive impact, right? SDGs is a framework of impact investing, is a framework by which investors could potentially align their portfolios with companies that yield positive impact.
Guillaume Mascotto: So we, of course, welcome the fact that now you have that framework that seems to gain consensus, so again, you're sort of contributing to solving this issue of not-one-size-fits-all approach that you see in ESG. Different investors adopt different frameworks, and the corporates themselves are very confused, too, because there's the GRI, there's the IR report, there's now the SDG, and they're all like, "Oh, my God. Which one do we have to adopt?" Right? So, the fact that the SDG framework is starting to gain a lot of purchase among the investment community is a welcoming sign for us.
Guillaume Mascotto: However, what we do want to make sure that investors understand is there is a need also to avoid impact washing, which basically is buying a company that might do a lot in terms of corporate social responsibility through philanthropic activities, through even their own employees. They might be doing a lot for them, but their actual business is just incompatible with impact. Or in other words, if you have an impact portfolio, you can technically as per the framework justify buying a tobacco company or buying even a coal mining company because they might do great, right, for gender diversity, right? They might invest a lot in the communities in which they operate across the world, right? They may actually justify that through their coal operations they are bringing electricity to remote communities who otherwise will not have access to that.
Guillaume Mascotto: Same thing with maybe forestry. Forestry is generating a lot of negative externalities with manufacturing pulp and paper, but the pulp has actually been proven to be quite useful in terms of hygiene needs, right, in the emerging markets. Paper has been associated with a higher level of literacy outcome for young kids who want to learn, right?
Guillaume Mascotto: You could justify having these companies, right, because they are sort of using their corporate social responsibility programs as a way to tilt towards one or more of these SDG goals, but in our opinion, that's a little bit of a risk, right? Clients are expecting that the companies actually have core assets, so services and products that actually contribute to one or more of those SDG goals and that you can indeed, as we discussed earlier, quantify what is the impact achieved or what is the projected impact, right?
Guillaume Mascotto: So in other words, re-injecting again, right, the fundamentals back into the equation, so understanding the business, and also being able to avoid this washing that we fear might be something that you'll see as more and more investors adopt that framework.
Remy Blaire: And one thing that is for certain is that none of this is black and white.
Guillaume Mascotto: Of course not.
Remy Blaire: And I think that's a very important topic, so that leads me to my last discussion point, which is building an ESG portfolio. So, Josh, based on what you've seen in this space, what's the mark of any investment manager that actually takes ESG risks seriously?
Joshua Kendall: There's going to be a number of ways in which an institutional client can look at a manager and think that actually they're doing a good job, and I probably would focus on a number of areas. The first is: to what extent is the process that they're describing unique to that asset class? Now, there's a lot of excellent work being done by a lot of fund managers out there, but I need the clients to think about whether the asset manager has a process which is consistent across all their different asset classes that a manager may be responsible for, or do they tailor their approach depending on the individual asset class?
Joshua Kendall: Now, Insight's in a fortunate position, and because we're fixed-income focused, it means that our activities and the work that we do focuses on these issues. So, the challenges that exist in the fixed-income space, we're able to tackle more effectively because everyone from the senior management downwards right down to the analysts are focusing on the solutions that we need to drive ESG integration within the asset class. So, the first one is the differences between the fixed-income approach and maybe other asset classes, and what are the nuances there?
Joshua Kendall: A second approach is probably going to be about the innovation and the process itself for a fund manager. To what extent do they just use a third-party research provider, and that's it? Or, is there something additional to that? We would emphasize that for a more sophisticated manager, you should expect a greater level of ESG integration. If you are a small fund manager and you don't have the resources, then it's realistic to expect a lower standard.
Joshua Kendall: However, for a large manager like Insight, we would expect that our clients have a higher expectation for us in how we operate, so to do this, we operate a number of models ourselves to guide our research process. So, we have our own corporate ESG valuation process. We have our own process to evaluate the impact of individual companies, plus we have our own ratings for countries. So, countries and sovereigns is the new area that people are focusing on. We have had our own proprietary sovereign ESG score for a while now, plus separately, a climate risk score for fixed income, which we believe is the first in the market, that we've launched two years ago. So, this type of innovation is really critical to identify how seriously a fund manager takes ESG and integrates it into their process.
Joshua Kendall: Another is governance and accountability, and I think this applies for all firms out there. To what extent is their senior management buy-in to support the ESG efforts within the fund management organization and the ESG team in particular? How much are they empowered to do their work and ensure that they reach the standards and the policies that they set? And at Insight, we have a number of governance frameworks. For example, we have three bodies that focus on ESG, plus we report to the Insight board on an annual basis. So, this level of accountability ensures that the senior echelons at Insight are familiar with what's taking place and ensure that we are held accountable for our actions as, and I had mentioned before, accountability and transparency is really important, and that's probably the final piece.
Joshua Kendall: So, number four will be transparency to clients. How much can you get transparency on your fund that is meeting your ESG objectives, and are we able to deliver that to our clients? We believe that we do that for our clients by giving them access to ESG reporting, and we believe that that level of transparency ensures that we are held to account.
Remy Blaire: And there are financial professionals as well as managers watching this, so I think it's very helpful to see the differences in terms of how ESG investing is managed at different firms. Now, now that we've gotten your perspective, Guillaume, I want to get your perspective regarding fiduciary responsibilities. Can you tell me whether or not you can align these responsibilities within objectives of an organization from this ESG perspective?
Guillaume Mascotto: Yeah, of course. I mean, at American Century, when we hear the word ESG, it's not that it makes us laugh a little bit, but we've been doing this since 1994. We are owned by the Stowers Institute for Medical Research through which we distribute 40% of our annual dividends, and it's a world-class medical research institute dedicated to finding cures for cancer and other gene-based diseases. So, for us, this aspect of responsible investment, this aspect of giving back and generating an impact for our clients, regardless of products, whether they're ESG integrated or not has always been core to our DNA.
Guillaume Mascotto: And so, when it comes to fiduciary duty, the relationship between ESG and maximizing long-term asset-adjusted returns, for us is just natural, right? We've signed the UNPRI quite late because we were already thinking that, yes, indeed, it matters to look at these extra financial issues, factor them into the investment in order to ensure that the portfolios of your clients are sheltered, right, from unintended risks stemming from these ESG issues or sometimes capture upside potential associated with ESG that otherwise might not be incorporated in the traditional financial analysis.
Guillaume Mascotto: And so, yes, it is fully aligned, in our opinion. That's why when we've designed our ESG integration framework, we've done it in a way that it is aligned with our fundamental research process. In other words, aligned with how we manage money, and therefore, aligned with our fiduciary duty.
Guillaume Mascotto: We would also emphasize, going back a little bit to the SDG framework and coming back to what do those issues mean, if we all agree, right, here on the table that ESG can, right, result in material financial impacts, right, to companies, to countries, to various degrees, right, over time, right? And that it is the responsibility of investment managers to have a process to incorporate those issues into the investment process, then we can say that by default, right, it needs to be aligned with fiduciary dutybecause not incorporating that would then be a breach of fiduciary duty, right? However, again, emphasizing the solutions component of an ESG program is very important.
Guillaume Mascotto: A little bit before that, I've mentioned how it's important to have the capabilities, right, to create solutions for clients according to different ESG approaches. That is also part of fiduciary duty. In other words, if you have existing clients in a portfolio, and all of a sudden you are imposing a certain value or you're making judgments on their behalf, right, they might not be 100% aligned with that, right? So, it's important to still be very client centric, right, evolve in a way that you see how the investment management industry evolves, which includes trends like the millennials, right? It includes also technological innovation so that you can stay competitive, but at the same time, some clients are not interested necessarily in you changing the way you manage their money. So, it's very important to consider that aspect of fiduciary duty as well.
Guillaume Mascotto: But at the same time, if you are quick at making judgments on behalf of your client and you're changing too fast the way you invest and you're not very transparent and clear to your clients as to how this adds value to the investment, then you might, in other words, scare them away, right? So, that is also part of fiduciary duty, right? If you are an asset manager, you're there to service clients regardless of their investment values, regardless of where they are in the world.
Remy Blaire: Well, now that we've gotten the management perspective, Max, I do want to get your perspective. Now, how do you think that sustainable investment approaches should be adopted when it comes to ESG?
Max Messervy: Sure. Well, I should just say that Mercer has been working in the responsible investing space. Since 2004, we've had a specialist team dedicated to working in this space. We're now up to 17 full-time professionals around the world dedicated to addressing responsible investing topics which we define as socially responsible investing ESG integration and impact investing, so all encompassing. And it's interesting, right, just reflecting on Guillaume's comments from the manager's perspective. The way that we have developed over hundreds of client engagements our kind of approach to responsible investing for clients is really what we call the responsible investment or RI pathway that we just released last year, and it's a crystallization of the experience that we've gained over many of those client engagements.
Max Messervy: And so, it's a four-part process. It starts as beliefs, policy, process, and portfolio. And so, it's an interesting process because you really start with what are the clients beliefs, and the way that we tend to assess what those beliefs are is go to say the investment committee members, fiduciaries, and issue an anonymized survey to each of them that they can then ask us, or once we've educated them, we'll then provide them questions that they can respond to about do they believe that looking at these non-traditional financial and material factors is actually a worthwhile practice for their particular institution. What are their beliefs about specific issues that they'd like to maybe screen out of their portfolio or reduce their exposure to, or would they like to tilt their portfolio towards themes that they prefer? So, it really depends on the mission of the organization if there is one, and obviously, this is very reflective of our endowments and foundations clients in a lot of ways.
Max Messervy: The second piece, though, is to really integrate those beliefs, once they've been crystallized amongst the key fiduciary members or investment community members, into the investment policy statement. And so, this makes clear here are our expectations and our guidelines that we expect our investment managers to abide by when we make our manager selection processes, and here's what we expect from the in terms of reporting and disclosure about how they're actually taking the ESG factors into account on our behalf. Then, process is integrating that, those guidelines, into the manager selection process, should there be a manager search, that the thing gets undertaken, and again, clearly defining in that search, "What do we expect of managers? What do we expect you to provide to us in terms of the products and services you're going to be offering in response?"
Max Messervy: And then, finally, the portfolio piece is really monitoring and reporting out about, again, how these material factors are being taken into account by managers, gathering from them monitoring reports so that you ensure that they're actually abiding by the guidelines you've set out in your investment policy statement. And so, just through all this engagement with clients, we've found that starting with those beliefs is really a way, a useful way to clarify amongst those key decision-makers, and frankly, to also clarify for stakeholders who may be involved, your employees, your other stakeholders of your foundation, for example, whom you are responsible to, what you're going to do, and how you intend to integrate these ESG factors across your investment portfolio.
Remy Blaire: And, gentlemen, I think we've been able to cover a lot of ground on a very complicated topic, so before I let you go, I'd like to hear your take regarding what's next for ESG. And, as a side note, one point that I did want to bring up to all of you is that social media has become a platform for public companies to take a stand on any of their beliefs, whether it's E, S, or Google. Whenever we see something happening in the public sphere, we might have a company responding on social media, whether they're taking a stance on gun control, equal pay, or even climate change. So, if I could just very quickly get your take on how that plays into this type of investing, I'd like to know your thoughts.
Joshua Kendall: So, I think there's a general change happening in society which is historically we've been relatively distant from many of these issues which society has been confronting, but now I believe everybody has to pull their weight to tackle and think about these issues. Climate change is the more obvious one because it's so topical, and the threats are real and happening now. So, it's not surprising that companies are realizing that if they want to have a client base in the future or customers in the future, they need to be seen as an active citizen and a citizen that actually cares about these issues. So, the fact that they are using social media to reach out to typically younger people to demonstrate who they are and their principles, I think that's definitely encouraging. And the more we can see from companies what they think about these issues, the more I believe that will filter through internally within some of these institutions so they actually build the products and create the solutions that society needs.
Joshua Kendall: Because if we're talking about the energy transition as we've spoken about today, well, we've only just started that journey really. If we're to reach some of these 2030 or 2050 targets to hit a two-degree world, well, we need everybody to join in and be part of that opportunity. It can't just be a responsibility of a few asset owners or a few companies. Everybody has to be involved, and the more that companies are aware of their responsibilities, the more I believe that we're likely to meet some of those challenges head on. So, I think it's certainly very encouraging that social media is included as part of what companies are doing, but it really is just the tip of the iceberg. A lot more has to be done if we are to do this.
Guillaume Mascotto: I mean, yes, I agree on the social media side, but I think the question is what we think about social media and what we think will be perhaps coming forward. So, on the social media front, our observation is that now investors have access to information about their portfolios in real time. Before that, it wasn't really the case, right? So now, there's going to be, in our opinion, a growing level of expectations on the part of investors to ensure that if there is a headline risk, such as what we heard a few months ago, whether on a data privacy or even in some case in a fake accounts level or natural disasters, investors are now going to see this on their phones and especially the millennials.
Guillaume Mascotto: And so, we think that it's going to be very important for managers to indeed have a process by which they can ensure that they buy the right stocks or bonds that have the appropriate risk management processes to prevent or companies from being involved in those controversies. Or, if they are involved in the controversy, that they have the right processes to remediate that controversiesand ensure that it doesn't happen again. So, that's the first thing on social media.
Guillaume Mascotto: I do want to answer the question on what's next, right? We believe that what's going to happen is more and more investors are going to look at ESG, and they're going to understand that it matters. I mean, after the argument that it's a fad no longer applies. But, you've mentioned 31 trillion in the U.N. That's about 34% of global AUM last year, right? About 80 trillion total AUM, so that's, yeah, approximately 34%. So, it's no longer a fad.
Guillaume Mascotto: However, we think that there's a lot of companies out there that, of course, by the nature of their sector involvement, might be penalized. Oil companies are just penalized by nature because they're oil companies, right? But, one needs to look at the macro level, right. So, at the macro level, climate change, indeed, a very important global issue, right, that affects different sectors. At the sector level, indeed, companies that are asset-intensive like energy, right, are exposed to potential financial risk associated, right, with climate change. But at the issuer level, some of these companies might be doing the right thing. Some of them might completely be discontinuing away, right, operations that are carbon-intensive and reinventing themselves into something that's more renewable energy focused.
Guillaume Mascotto: I mean, I think Ørsted, DONG Energy, the former DONG Energy is a great example. This is a company that was a pure play oil and gas company, and that said, "No." So, they completely exited that business and started to become a pure play renewable energy player. An exclusionary approach that would have penalized the company outright for sector involvement would have potentially missed out on this upside potential, right, of investing in a company that's now becoming a leader in renewable energy.
Guillaume Mascotto: So, we think that you're going to see more and more investors not necessarily wanting to exclude or not necessarily wanting to judge companies just as a function of their sector involvement but really expect the managers to open the black box and understand what is this company doing right now, how is it managing its issues over the medium and long term, and do we have confidence that this company is well poised, right, to ride that wave, right, and continue to generate strong return on capital for clients.
Max Messervy: And I would just add to all of this. I think my take will be slightly different given that as a consultancy, we really look at managers and what they, how they perceive these underlying risks. So, when it comes to social media, so you don't say, "We'd like to understand how an investment manager would perceive social media related risks or headline risk for their underlying holdings." How do they engage with companies when there is an issue that comes up? How do they then mitigate those ESG-related risks that come up as a result of, again, negative social media, maybe it's positive?
Max Messervy: And then, even furthermore, from a data perspective, are there ways to look through that data from machine learning or some other methodology to really see are the Tweets going one way, or are they going a different way for this particular company? Does that indicate greater risk or less risk? So, I think that there's data insights to be uncovered there as well that we hear about from some managers.
Max Messervy: I would just say, though, on a broader or larger kind of thematic though, we believe broadly that more disclosure, more transparency is generally a better thing for the market as a whole. So, to the extent that now social media is offering more avenues for engagement, and again, more data points for managers to take into account in making those investments, we think that that's generally a positive thing.
Guillaume Mascotto: I would actually echo on something interesting here is we also welcome more transparency as asset managers, but we think that if there's more transparency and more disclosure, it would need to be audited in a way that now we can actually use that and make investment decisions on behalf of our clients. So, auditing that data I think is also something interesting to look at in the next couple years.
Remy Blaire: Well, I think it's very helpful to have the different perspectives from managers as well as consultants, and I think one thing is clear, that nothing is black and white. And even when it comes to social media, communication is so important from the companies as well as by the audience as well.
Remy Blaire: So, gentlemen, thank you so much for joining me today. It was a fruitful discussion. Thank you so much for your insights.
Remy Blaire: And thank you for watching. I was joined by Joshua Kendall, Senior ESG Analyst at Insight Investment, Guillaume Mascotto, Vice President and Head of ESG and Investment Stewardship at American Century Investments, and Max Messervy, Senior Investment Consultant at Mercer. From our studios in New York City, I'm Remy Blaire for Asset TV.