MASTERCLASS: Liability Driven Investing - October 2019
October 7, 2019
Tamara Laine: 00:00:04 Welcome to Asset TV, I'm Tamara Laine. Interest in ESG investing continues to gain momentum. As popularity grows, have performance outcomes met expectations? We will discuss how investors identify key metrics to incorporate into their analysis, plus are we missing a prime opportunity? To discuss all of this and more, I am joined by experts in the area ESG investing. Douglas Lopez, Principal Portfolio Manager at Aristotle Credit Partners, Mozaffar Khan, Senior Quantitative Analyst at Causeway Capital Management, Jessica Zarzycki, Green Bond and Short Duration Impact Bond Portfolio Manager at Nuveen, and Kevin Parker, CEO of Sustainable Insight Capital Management. This is Asset TV's ESG Masterclass.
Tamara Laine: 00:00:53 Welcome everyone to the Masterclass on ESG investing. Until recently, ESG investing has been seen by some as a trend, but now we're seeing it move into the mainstream as a valuable strategy. Mo, I want to start with you. Why do you think that this has gained momentum with investors?
Mozaffar Khan: 00:01:11 There's so much interest and excitement in ESG investing. There is broad and rich array of ESG issues and investors are increasingly recognizing and becoming aware that a lot of these issues affect firms, cash flows and discount rates. Firms themselves are taking a variety of actions undertaking a variety of used initiatives that have an economic impact on their business. They're doing this in a structured and systematic way. They're quantifying their objectives and setting targets. They're aligning those targets with executive compensation in many cases. They're quantifying and measuring their accomplishments. They're holding non-deal roadshows with investors to showcase their ESG accomplishments and publicly reporting in their annual Sustainability reports their accomplishments and ESG issues.
Mozaffar Khan: 00:02:01 These are the actions by firms. Consumers that decide which products to buy and how much to buy, policymakers who shape the regulatory environment within which firms operate. The actions of all these parties together collectively really suggest to investors that ESG issues have the potential to affect firms' return risk profile and therefore investors are paying increasing attention.
Tamara Laine: 00:02:27 Doug, I want to ask you now that we've talked about momentum, what are some actionable steps that investors can take when they're looking at their portfolio and their strategy?
Douglas Lopez: 00:02:36 That's a great question. The key with that, what we found in terms of actionable steps is really to, you have to do three things. You have to mine the data. One of the difficulties these days is the lack of some data in certain factors to do with environmental social governance issues, but there is a lot of data out there, so you have to make sure you're taking care of that. You can get that via subscription's with third-party vendors. You also have the ability to get some non-profit organizations that are tracking activities of different companies in different industries and a variety of other sources in terms of getting that information. The key is you start, is that we start really just mining the data that is available.
Douglas Lopez: 00:03:14 The second most important thing is really just to engage with the companies. Because of the lack of perfect data, what we'd find is that the ability to actually engage brings forth a lot of information that isn't disclosed from companies that perhaps don't know how to disclose it, don't have the staff to track data and report that into different databases, but it's really the engagement part. For us that's real important since we as investors spent a lot of time talking to management teams. We buy management teams, we don't buy balance sheets or income statements, so for us that dialogue is really the key part of the investment decision anyway, so we just integrate the ESG factors into that with these companies.
Douglas Lopez: 00:03:54 The final part, in terms of making an effective ESG strategy and putting it into place is really the fact that you have it fully ingratiated and integrated into the investment process. The data, action with the companies, then actually integrating it so that the data and all the work you're doing is actually fulfilling itself in terms of the holdings in your portfolio and you see those decisions actually reflected in the portfolio. There's a lot of work being done but you want to make sure that that's actually showing up in the holdings and you're showing clients why they're in the portfolios and why it makes sense and how's it really benefiting them and also fulfilling the mission that they want you to fulfill.
Tamara Laine: 00:04:33 I saw, Jessica, you nod your head on that as well. What do you think actionable steps are that investors can take?
Jessica Zarzycki: 00:04:39 Sure. Engagement is definitely extremely important. We work very closely when we meet with management teams making sure that not only what they're supplying but we're also asking for additional information from management teams and continuing that dialogue with the companies doing our own research. We are a fundamental credit shop, so ESG has always been a part of our implicit process. Now we've just made it more of an explicit process and really looking at the information that is provided to us. Then, it's not just the ESG but it's putting it all together and making sure that from a relative value perspective that it makes sense in the portfolios as well.
Tamara Laine: 00:05:22 Before we go too much further, Kevin, I was wondering if you could break down really the terminology of ESG specifically for investors. I know it's been changing, sometimes it's a catchall for impact investing and socially responsible investing, can you explain that for us?
Kevin Parker: 00:05:40 Yeah, sure. Just before I do, I would just add to the comments previously that one of the money in the bank issues around ESG is to avoid the bad actors. It's not only been proven in the academic research, but for a lot of market practitioners that have looked at this, the bad actors are absolutely underperforming and will continue to underperform. For folks that are obviously interested in the investment landscape, knowing who the bad actors are and not having those stocks in your portfolio is a pretty good start.
Kevin Parker: 00:06:17 As far as ESG goes, over the last ... I've been involved with this for 20 years now, I guess the old guy in the panel or the mature guy or the adult or whatever you want to say. Over the last five years, we've really seen more clarity come into the picture, and it's anything but clear. It's really kind of let a thousand flowers bloom. What I mean by that is the investors themselves are really driving their own definition of ESG, and to every single asset owner that means something unique, something different; really relating to their own personal views or the views of the organization whose assets they're responsible for.
Kevin Parker: 00:07:11 Really, when we talk about ESG, you have to talk about broad categories of ESG. I think at one end of the continuum you have firms that still have as their primary mission return and risk, and ESG is a contributor to that view. It's not primary. I wouldn't say it's secondary, but it's become, I think as Doug said, it's now integrated into the process, but still the primary driver for that particular asset owner is return and risk.
Kevin Parker: 00:07:50 Down the other end of the continuum falls, really, what we talk about is socially responsible investing. Folks who are looking to make an impact with their investment dollars and who are not putting return as the primary mission. They're putting impact as the primary mission. Still looking for a return but not having return as the primary driver of their decision process really having impact or perceived impact as the driver. On the one hand, you have the folks who are interested in risk, on the other hand you have folks that are interested in impact, and in between is really where the thousand flowers are depending on where you fall on that continuum.
Jessica Zarzycki: 00:08:40 I would just add to the last comment, as being a portfolio manager on some of our responsible investing accounts, we absolutely believe in the double bottom line investment returns and impact investment. We have several social responsible products where we do believe you get the returns as well as the impacts on investment. I think you're finding the balance that while people are looking for that impact they're also looking for return. I think we've seen a shift in the market in that way over the last couple of years.
Mozaffar Khan: 00:09:11 I think those are very important points. It's, I think, the starting point at Causeway, at least, is to be very clear on what ESG investing means to us. It means having a very clear definition of what ESG is and what our objectives are from ESG investing. We view ESG issues from a shareholder lens and from the lens of materiality in the sense that when we're looking at a broad array of ESG issues, we pay close attention to issues that are critical for corporate's business success and therefore a material for shareholder value. If they're not material for shareholder value, then they really don't fit in our information set.
Mozaffar Khan: 00:09:56 Our objective really is to ensure an appropriate risk-adjusted return for clients, and our research suggests that indeed there is the potential for risk-adjusted returns in alpha in ESG investing. In terms of materiality, what do we mean by that? In terms of defining which objectives in terms of defining what ESG means to us, it's actually a very detailed process. We've built frameworks. We’ve developed frameworks to identify which issues are material for us as investors. We've gone industry by industry and ESG issue by ESG issue to systematically filter out issues that are in-material for us as investors.
Mozaffar Khan: 00:10:36 To give you an example, if you take the ESG issue fuel management. You take a couple firms, you take one that is in the healthcare distribution business and the other is a healthcare provider. Both in the same sector, the healthcare distributor by its business model has a large distribution fleet and is a heavy consumer of fuel. Optimizing their routes and managing fuel is going to be good for the environment, but it's also good for their bottom line. It's a critical business success factor for them. A healthcare provider, on the other hand, is not a heavy consumer of fuel. If they were to undertake initiatives to manage fuel consumption, that they would really just be making a mountain out of a molehill. That is not a material issue for them.
Mozaffar Khan: 00:11:18 We've proceeded in this way, ESG issue by ESG issue and industry by industry to identify which issues are material for us as investors, which issues affect firm's bottom line and really are at the intersection of investor interests and other stakeholder’s interests, and those are the issues that we define as material ESG as ESG investing for us.
Kevin Parker: 00:11:38 Just to follow up on that, as a former board member at SASB, which is the Sustainable Accounting Standards Board. Our mission was to do exactly that which was to go industry by industry across all 77 industries and really codify with the various constituents in the investment world, the corporates, the buy side analyst, the sell side analyst, and others who had a stake in each of the industries in the material issues facing that industry. They really do vary industry by industry and company by company.
Kevin Parker: 00:12:19 The codification of those standards is now done and out and available, and that's a good place to start. I think what SASB has done is help also define the difference between what would be considered useful and valuable information from an investor relations standpoint. There's a lot of that data out there, so the information that appears in corporate sustainability reporting and annual reports and so forth, all good stuff. A lot of companies doing great stuff out there in their communities and so forth, but the difference for us as investors is what of those things that are going on really are material to a company's bottom line because ultimately that's going to determine the valuations and the appreciation and so forth of the underlying securities.
Tamara Laine: 00:13:17 I'm glad that you brought that up and actually all of you have brought up data and analysis and data sets and indicators. We are going to talk about that, but before we dive in, I want to take a broad look and ask you, Jessica, what's going on right now in the markets globally that may be affecting fixed income or the bond markets and ESG?
Jessica Zarzycki: 00:13:40 Sure. I think more globally, within the fixed income markets, we've really have seen a shift from most major central banks, starting with the Fed back in December. The Fed was raising rates every quarter for two years. They saw this pretty quick pivot into a more cautious Fed, and that really starting in December allowed your emerging markets, your high yield asset classes to outperform and continue to outperform. We, again, saw this with the ECB this March. They definitely caught the markets by surprise, and having a bit more of a diverse stance, and a lot of this is coming from a slowdown in global growth that we started seeing in the second half of 2018, uncertainties around trade-related issues, Brexit, and so everyone is taking a bit more cautious stance. I think if we start to see global growth bottom out and see some stabilization, it's still a very good market for your credit asset classes, your investment grades, your high-yields, your emerging markets.
Jessica Zarzycki: 00:14:46 If we see growth take a turn, another turns down, I think people will become a bit more cautious and this is where I think you start to see the interchange with ESG and people looking for in a more cautious environment. People are looking for the better-quality companies with potentially higher ESG ratings. That's where I think you start to see a better risk profile from these types of companies.
Tamara Laine: 00:15:12 We've looked at how ESG as an investment is gaining momentum, but there's still some debate whether including ESG indicators will affect performance. Doug, I want to ask you, is that misconception? Is that true? Is there alpha potential for ESG investments?
Douglas Lopez: 00:15:32 There definitely is. We're firm believers in the investments we make and becoming partners of the management teams, we're more intermediate to long-term investors focusing on the mission of the company, the management of the company, and how they manage the risk profile of the company. Within the credit space, bonds have asymmetric skew in terms of how they can perform. The can go up a little bit or they can go down a lot. Within bonds, especially within credit management, it's really about managing the risk in your portfolio. The way we look at it is that, if you look at ESG factors, they really complement traditional credit metrics. They do allow you to avoid the bad actors, which in the bond world if you take a couple of big hits with some companies that have fraud, have some big lawsuit that pops up from an environmental or a social reason, anything like that, that can really disrupt the performance flow of an account, the ability to generate often. It's hard to make that up in a bond portfolio.
Douglas Lopez: 00:16:31 Like I said, consistent performance is really about avoiding the risk. If you look at the factors of environmental, social and governance issues, these are all potentially risk to a company that really complement traditional credit work in looking at balance sheets and income statements and cash flows and things like that. We think they can generate, this is a great way to generate alpha, and I haven't even touched on the fact that if you look at the consumer demand these days, what consumers are doing, which is really where I think the push is coming towards the investment world, is that baby boomers as they get wealthier or older want to give something back, the millennials are really pushing for a lot of different agendas here, and they're really looking holistically at the companies that they get involved with in terms of the products they buy, and also, I think are going to be looking at companies in terms of the ones they invest in.
Douglas Lopez: 00:17:18 They're going to want to see managers that don't have bad actors on the list of holdings because they're going to want to feel a lot better about the portfolios and at the end of the day we think the profitability of those companies is going to be better because consumer demand is moving in that direction in terms of therapy companies that tend to perform well.
Tamara Laine: 00:17:35 Then the question, why are some of the reports not showing that, and Mo, I'm going to put you on the spot.
Mozaffar Khan: 00:17:40 I think these are some great points that Doug made. There is, our research at Causeway suggests that indeed there is alpha potential in ESG investing, and this is ... We've put a lot of work into going beyond off-the-shelf data and developing our own proprietary frameworks for measuring the firm's ESG performance, and going beyond some of the greenwashing that might occur. Kevin mentioned SASB, great organizations, done a lot of very useful work and we've certainly relied on some of their guidance on materiality. In addition to complementing that a Causeway, we have both fundamental investment expertise and quantitative investment expertise. We're able to also deploy the knowledge and expertise of our fundamental analysts in determining which issues are material and which are not.
Mozaffar Khan: 00:18:28 It really comes down to going beyond off-the-shelf data doing proprietary research with an understanding of which ESG issue is material. I described our approach to materiality for environmental and social issues. For governance issues, which are very important and where potentially a lot of the alpha potential is, we also developed a new proprietary corporate governance assessment framework and metric that is similar yet different. It's similar in the sense that we're also looking for material governance factors. It's different in the sense that instead of identifying variation across industries, we identified variation across countries in material governance factors. Why? Because some of the most important variation in the nature of the governance problem actually comes from cross-country variation.
Mozaffar Khan: 00:19:20 Just to give you a sense of that, in the US share ownership ... One of the big reasons that ownership, the governance problem varies globally, is differences in ownership structure. In the US, share ownership is generally highly dispersed and as investors we entrust our capital to firms and its really decision rights over the allocation of that capital are entrusted to firms, managers. Now, we know that managers can take a variety of actions. They might overinvest in some projects, they might be reluctant to discontinue pet projects, and so on, so that creates a conflict of interest between investors and managers. This gives rise to the governance problem.
Mozaffar Khan: 00:20:02 There are a lot of fairly well-developed governance mechanisms in place to mitigate these problems. We know that we can use high-quality auditors and boards of directors to monitor and to advise managerial actions. We can align managers with us through compensation contract design. At the end of the day, we can exercise our voting rights to ensure that our voice is heard. Globally, however, share ownership tends to be very concentrated, and generally this controlling shareholder who obtains control through very opaque structures such as cross shareholdings and stock pyramids, generally has a minority of the cash flow rights. What you have is this disjunction between cash flow rights and control rights.
Mozaffar Khan: 00:20:54 The standard governance problems that we worry about in the US, these incentive problems between shareholders and managers, they're actually superseded by problems, incentive conflicts between minority investors and a controlling shareholder globally. This gives rise to a whole different set of governance problems. We think about these issues systematically and incorporate them into a governance assessment framework. From that, we identify new corporate governance metrics. Using our quantitative investment expertise, we back test these new metrics and we find significant evidence of outperformance. It's actually along the entire spectrum. I noticed some discussion that you can avoid the weak performers, firms with weak corporate governance that are going to underperform.
Mozaffar Khan: 00:21:40 We actually find there's a relation between the entire spectrum of corporate governance strength and stock returns, so that firms with good corporate governance strength outperform firms with poor corporate governance strength, underperform.
Tamara Laine: 00:21:52 Also, obviously, we've identified that there is alpha potential. I want to now, are there any missed opportunities that investors should be looking at? Doug, what do you think?
Douglas Lopez: 00:22:02 I think, basically, the missed opportunities are maybe focusing a little bit too much on specific agenda items and not more of the fulfilled, well-rounded research in terms of the companies on ESG, because the risk and the return can come from really various factors across the entire spectrum there. Perhaps a lot of people are thinking today and some people's viewpoint of ESG is they're just looking at the environmental side, others are really focusing a little bit on social and governance.
Tamara Laine: 00:22:34 What of the fixed income?
Douglas Lopez: 00:22:35 Yeah. Within fixed income, though, one of the things is that you're not seeing a lot of specialized managers within the corporate credit space, which is something that we're talking about here today. Some people are focusing more on maybe green bonds or things like that that have a specific purpose, more direct investment, and not really investing in the managers that are taking into consideration all the issue factors with the corporate credits that they're putting in in their portfolio. We think, I think that's a missed opportunity.
Tamara Laine: 00:23:07 Jessica, what about performance outcomes are you seeing with ESG in the fixed income space?
Jessica Zarzycki: 00:23:13 Sure. We have several dedicated socially responsible investment funds. We actually view these funds as a core bond fund. We have it set up so that we're looking at really best in class, performers from a corporate perspective and then we're also adding impact investments into this fund. It really, its benchmarks against the US Ag, we're benchmark, our peers our core bond funds, and we've actually seen similar or better performance from our dedicated social choice bond funds. We also recently just launched a short duration. It's a very, very similar format, that it's ... we view it as a core short duration fund. it's benchmarked against peers where our goal is to outperform the peers, but we're really using that best in class ESG and impact investments to have a diversified portfolio looking at the relative value opportunities within that portfolio to really add the alpha and mitigate those risk.
Tamara Laine: 00:24:17 Kevin, what are you seeing the equity side of this?
Kevin Parker: 00:24:21 Right. The bad news is that outside of the bad actors that I mentioned before, the degree of differentiation between those really good actors, those kind of good actors, and maybe not so good actors but are not bad actors, hasn't really occurred yet. The good news is that the differentiation hasn't really occurred yet. I think that the governance aside and governance is a factor that's been around for a long time in positive correlations in equity world have been well-established. In terms of ESG and its totality where you might mix signals from social and environmental as well, you really don't yet see the kinds of differentiation. The market is not really differentiating the really great companies from the middling companies and that's an opportunity, I think. It's also something that investors need to be aware of going forward, because I think for all the reasons that everyone mentioned here whether it's client focus or the consumer focus or choosing companies based on their value system and so on, if we see evidence of that everywhere, that's all positive but it's yet to translate into share prices reflecting those differences in positive views.
Kevin Parker: 00:26:03 Very clear correlation and negative views, but in positive views it's not broadly in the market yet. I think that's the good news from an investor standpoint. I think picking managers that have a belief that that differentiation is going to occur I think is important for investors to keep mindful of. If you're not integrating ESG, there's no way you're going to be even vaguely familiar with those factors at work. You may not even be able to explain why there is a differentiation between and amongst these companies if you don't have your finger on the ESG pulse. I think this is to come, which is exciting for all of us that have integrated ESG into our approach. We see the signs there, the green shoots are there, but there's not the degree of differentiation that one might expect from rewarding the good actors.
Mozaffar Khan: 00:27:07 I think there are very exciting opportunities in the equity space in terms of, really, it takes you being able to deploy our skill as investors to identify the sources of heterogeneity among firms, because they all look quite similar if you're using standard metrics and standard lens. In particular, I mentioned governance for example, and there's been a lot of ... investors have been keenly interested in good corporate governance for a long time. This is our standard investment analysis. There is a very strong expectation that governance matters for stock returns. The problem is that it's just not backed up in the data. When you ... this is where we start.
Mozaffar Khan: 00:27:52 A host of academic studies going back decades now, there's been a lot of research in this space, and have really struggled to find any empirical evidence. You contrast that with the strong expectation that governance matters, and yet the empirical findings have just not been there. Academics have struggled. Our starting point, we looked at data from standard data providers and you use your governance scores and you look at their return predictability and there's just no relation. We were scratching our heads, are all of these investors wrong? Is all their effort misplaced?
Mozaffar Khan: 00:28:29 When we stepped back to think about the nature of the governance problem, one of those I mentioned differences in ownership structure, but there are other sources of variation. One is in the degree of shareholder orientation. In the US, for example, it's generally well-accepted that the purpose of the firm is to maximize shareholder value. This notion, this conception of the firm is not universally acknowledged. You take Japan, for example. They've come out ... one of the key pillars of [inaudible 00:28:59] is to improve corporate governance. Tokyo Stock Exchange came out with a revised code last June. The first principle, the first aspirational goal that's enumerated in that code is to ... [inaudible 00:29:16] Japanese companies to secure equal treatment for shareholders.
Mozaffar Khan: 00:29:20 It's telling when the best that we can do as investors is aspire to equal treatment of the stakeholders. You can see that in the returns and the performance of Japanese companies versus US companies. Japanese companies have much more of a stakeholder orientation versus a shareholder orientation. There are different degrees of shareholder protection embedded in a country's laws. We're able to systematically parse and exploit all these sources of heterogeneity to construct better measurement frameworks, and that's really key. Out of all of this, that's the opportunity. There's so much ... Everything seems so diffused and everything ... all firms seem so similar, yet when you step back and you think of it more deeply about these problems and you conduct some proprietary research and bring all of your investment knowledge to bear, we're able to separate the good from the poor and to take advantage to take of these opportunities.
Douglas Lopez: 00:30:18 I was just going to add. In terms of ... one of the things that gives us hope that you're going to see that differentiation in terms of doing the work and having a shelf in the performance is going to be the money. In our businesses, there are a lot of technicals, about the money following the ideas. As we see more money flowing into these strategies, you're going to start to see, the differentiation starts to be much more reflected in the valuations of whether it's equity prices or bond valuations, because investors as they go towards those and move towards those investments there's a certain amount of supply out there, and as the demand rises the technicals are going to shift and you're going to really start to see, I think, more dispersion in the performance.
Douglas Lopez: 00:30:54 I'm very confident that that's going to be happening as money starts to move more and more into ESG investments, but that's something to really pay attention to. It's not just so much the data getting better, the company is performing better, but having people realize that in having the money actually move into that to reinforce that and that really is going to cause more, I think, dispersion in our performance alpha generation.
Tamara Laine: 00:31:17 Mo, we're talking with you. Tell me about ESG corporate credit and why it makes sense.
Mozaffar Khan: 00:31:24 I think I mentioned earlier that when you look at corporate credit, it's asymmetric in terms of where the prices can go. We're not like stocks that can go 5, 10, 15, 20 times if is a great idea. We can go up maybe 5 maybe 10 points if it's really cheap. The bottom line is if the company, it doesn't work out and the company has restructuring, you can go down the line. Like I said, I've learned a long time ago that the way to outperform is to mitigate risk in the portfolio, get your yield, you carry your performance, but you want to mitigate the bad actors, the losers in the portfolio.
Mozaffar Khan: 00:31:54 Why make sense in terms of corporate credit, is that it fits perfectly in terms of giving us a different lens into the quality of management of these companies, the decisions they are making, how do they manage risk, because at the end of the day for all the good that ESG metrics in terms of showing the good that a company is doing in terms of being good stewards of the environment, their work population, the local communities, the governance of the company, beyond all that you if you're not managing those right, those are all risks that can hurt a company.
Mozaffar Khan: 00:32:23 You can have lawsuits, you can have massive employee turnover rate, you can have your fraud in terms of what's going on in the governance. The bottom line is that by integrating ESG in, we're getting a different lens, a different viewpoint, we're asking and engaging with questions that are non-traditional credit questions to the companies, and so you're putting management and IR guys on a little bit of a different footing that they're not used to answering, so perhaps you get more of non-canned answer from these guys. The beauty of that, I think, is just that having these conversation, integrating ESG, it's just is really a great dovetail in terms of investors in the credit space and in the equity space that are intermediate long-term investors. At Aristotle, all of our strategies whether it's credit or equities, they're all meant to be buying quality companies with quality management and quality businesses as a long-term investor, and this is a great metric in terms of helping us make those decisions we think.
Tamara Laine: 00:33:19 That's a really good segway because I want to dive into data and how we pick these indicators in order to measure how our ESG investors should strategize their portfolio. Jessica, I want to talk with you first. Tell me how do you pick your indicators and your metrics in order to pick your portfolio?
Jessica Zarzycki: 00:33:40 Sure. First, for our dedicated responsible investing strategies, we're really looking at the best in class names. This is really done by an industry standard and industry metrics, so we're really, I think this point was made earlier, we're really looking at the energy industry and what's driving energy industry and what are really the best in class metrics for this particular industry. We're taking each industry in doing that, individually, to come up with our universe of what we view for proprietary model as best in class. From within this universe, we're looking at relative value in making sure that the performance is going to be there. Then, in addition to that, we're going and looking at impact investments.
Jessica Zarzycki: 00:34:26 We could have a green bond, which isn't in our ESG universe, but is a company outside of it, but these the proceeds are going towards a positive environmental impact. We add these into the portfolio to help add the alpha to our performance. Then it's run as a standard fixed income portfolio. We're looking at asset allocations, we're looking at should we be investment-grade or high-yield based on how the market conditions are moving where we are positioned on [inaudible 00:34:56] curve in terms of duration? It's really run as a regular fixed income strategy, but we believe that the ESG criteria investing class really adds that alpha and helps reduce the risk.
Tamara Laine: 00:35:09 Kevin, I've added some more question for you. How do you choose your screening metrics to include in your ESG analysis?
Kevin Parker: 00:35:16 Right. Think of us a mix between or a cross between Money ball and CI. CI meaning being short for collective intelligence. In our database going back to the year 2000, we have collected information on 40,000 analysts over 20 million recommendations, 20 billion records. We cover 43 countries, all eleven sectors, 99.9% of MSCI world. We do that with six people, the cloud and the ton of compute power. It's really that combination of the collective intelligence of the world, mixed with a whole bunch of computers applied to figuring out where the value is.
Tamara Laine: 00:36:15 Mo, how should investors gauge a firm's ESG metrics?
Mozaffar Khan: 00:36:22 I think it's important to ... a variety of firms have developed their own what they refer to as materiality matrix. Essentially, they look at the array of ESG issues and they plot them on two dimensions. One is how important is this issue to stakeholders and the other is how critical is this for our business success. They pay attention, they're going to prioritize those issues in the top right quadrant, issues that are critical to their business success and they focus on this. I think it's important, it's critical for investors when they're reading sustainability reports, when they're part of non-deal roadshows with management to really identify what are ... and to ask management, what is your sense of ESG issues that are critical for your business success?
Mozaffar Khan: 00:37:15 What are your ... then, have you quantified your objectives with regard to these issues? Have you aligned your people with regards to these objectives? Are you quantifying and measuring your accomplishments, your movement toward these objectives? Finally, reporting on the MP3 and reporting on ultimately their effect on your bottom line, on your ability to return capital to shareholders. I think that's what, that perspective, again, it's materiality lens, it's materiality perspective, and that's what investors should focus on.
Tamara Laine: 00:37:49 It seems like it's almost goes back at that same concept we talked about each firm has a different focus and that's why you have to look at their mission and what they qualify ESG as.
Mozaffar Khan: 00:37:59 It's important for firms to be smart about this, and not all firms understand which issues are critical for their business success. There are some firms that will diffuse their efforts and invest in issues that might be relevant to some stakeholders, but really are not that important for their business success. This is a dilution of shareholder capital. The best firm is a firm that really perform well, are going to be those that are smart about identifying which issues matter to stakeholders which issues are good for the environment, good for my employees or social stakeholders and in terms of governance, but at the same time are relevant to my bottom line or critical for my business success.
Tamara Laine: 00:38:43 Doug, how can incorporating ESG metrics enhance traditional credit analysis?
Douglas Lopez: 00:38:50 Yeah. It touches on something we've already talked a little bit about, but it's really, like I said about risk management, looking at the factors, it really brings us through a series of decisions and information gathering that leads us to a much better conclusion in terms of the overall credit quality of the company. One thing we really see as a correlation between management teams that manage ESG metrics, some knowingly and some not knowingly, they just are doing it because they believe in treating their employees correctly and they believe in treating the environment properly. They don't report any data to any of the services because they don't have any staffing to do that.
Douglas Lopez: 00:39:30 By engaging that you can pull this out of them, but the bottom line is these types of companies are making good decisions in terms of how they run their businesses. How do you run a sustainable business? You have to do all these things right to have a sustainable business, we believe, and so at the same time we've seen a correlation between managers who manage these factors well and also managed their balance sheet well, the risk factors on their balance sheet.
Douglas Lopez: 00:39:56 A lot of managers that tend to be carefree about their leverage on the balance sheet tend to be carefree about a lot of things in their business, and are maybe looking at just the bottom line of money, they're not treating people well, they're polluting the environment, they have bad governance structures that compensate themselves primarily. You see correlations here in terms of the decision-making quality of a management team, so for us it really enhances the credit selection process by really reinforcing the overall quality of a management team.
Douglas Lopez: 00:40:24 Like I said, having these discussions with management teams leads to other observations that really help facilitate our decisions, and at the same time we've had a lot of management teams that want to re-engage back with us saying, "These are all great questions, we hear about ESG, but we really don't know what to do. How do we report this information? Nobody's ever told us that. Where's the little roadmap we have here on how to be good ESG companies?" What we've done is point them in the direction of firms like SASB in terms of giving them their number and saying, "You should talk to SASB, they can help you set up a structure in terms of how to report the data in a responsible way with the information that investors want to see." It's been a great give-and-take as a credit investor in terms of enhancing our process. As far as we're concerned, it's a win-win and it's really making better decisions in the portfolio.
Tamar Lane: 00:41:16 After listening to all of you, I feel like everybody has their own style and their own approach. I'm wondering, we'll leave this open to whoever wants to answer it. Do you believe that ESG metrics should follow a quantitative or qualitative approach?
Mozaffar Khan: 00:41:31 I have to take that, we got both. At Causeway, we have both fundamental investment expertise and quantitative investment expertise. Really, we find a fusion of the two approaches. We are able to use our quantitative capabilities to identify systematic factors. The advantage of quant is the breadth. We're able to look at a cross-section of thousands and thousands of stocks. Globally, we're global investors, and so we're looking 4000, 5000 stocks globally and we're able to systematically identify a parsimonious set of factors.
Mozaffar Khan: 00:42:05 If you got too many factors, you look at some of the leading data providers out there and you look at some of their metrics, they have over 100 underlying factors. That really limits transparency into the rationale. You have analysts and PMs struggling with why is a firm scored a certain way. We're able to systematically identify a parsimonious set of factors that are material for shareholder value. We can do this on the quant side and back test them across a universe of 42 countries, thousands of stocks in the cross-section over a long period, but yet we're able to go to our fundamental investment staff and use, draw on their more timely and in-depth knowledge of firms. For example, they might have information. They go out in site visits and they're able to tell us about ... my impression, that matters as well. We're able to meld and fuse the two to come up with better measurement frameworks and metrics.
Tamara Laine: 00:43:03 You believe they're both important.
Mozaffar Khan: 00:43:04 Exactly.
Douglas Lopez: 00:43:05 Yeah, I totally concur. You have to have both. Our world is too big to qualitatively dive in and try to assess on a qualitative basis different companies. You have to call down the investible universe in some way and data is the way to do that. It also helps you mine out different things you want to focus on in the portfolio and maybe source the companies that maybe performed better in one area or another. The data mining is extremely important, but we think at the end of the day, I think some firms stop at the data mining. We think without engagement, you can't truly be that ESG investor because it's really the conversation with management, how do you make an impact on a company?
Douglas Lopez: 00:43:43 You can buy their securities and they don't even know you did that, how does that change their behavior? By picking up the phone having a conversation with them, they know investors care. That's a big difference. I know some sustainability has a different large corporation that have told me that, "Doug, every time somebody calls and ask a question on ESG, calls IR, the IR guy calls me and I call the CFO or the CEO and at the same ... reinforces his job, this one friend of mine, I love it when people do that because that shows them how important I am and that investors really care.
Douglas Lopez: 00:44:17 You can, by making that one phone call, whether it changes their behavior or not, as that feeds back up into the senior management executives, they know that investors care, and if you get two or three or four, even five calls of that nature from different investors, be it bond or equity investors, they're going to actually have to come up with answers. In the process of coming up with answers, maybe they institute policies that they never had before. This is a different level of impact. It's not making direct investments into a project or something like that. This is having impact with the behavior of a management team, and you can do it just subtly having these phone calls and engaging them.
Tamara Laine: 00:44:52 Did you want to add on?
Jessica Zarzycki: 00:44:52 Yeah. I was going to say I hundred percent completely agree it's a mixture of both between the quantitative and qualitative. You need the quantitative to cover the wide universe, but it's really the quality of factors where I think you can start to see the alpha. If you have a shift change in management, the analyst is going to see that pretty quickly. If there are safety concerns, the analyst knows that credit so well that they're coming back immediately with a recommendation on the impacts. You see some of that in the emerging markets. You had the [inaudible 00:45:21] and other issues that are ... that you have to make that quick assessment and you really need that qualitative piece of the puzzle as well.
Tamara Laine: 00:45:31 You just mentioned the emerging markets. I did want to talk about ESG investing in different regions. Kevin, what are you seeing in the different regions right now? The US, Europe, Asia.
Kevin Parker: 00:45:42 I think it ties in with the previous question, which my answer would be it depends. If you're a small cap manager in the United States focused on small cap equities, and you're relying on quantitative analysis to lead you to the promised land, I think you're probably not going to get very far. All of us are involved in bigger businesses with a global view, international view and so forth, and once you go beyond a certain point then obviously the data and the compute power and so forth really begins to kick in. I think a lot depends on what your manager is actually doing. I would be, personally, wary of a small cap manager saying, "I'm a quant because the data richness is maybe there, may not be there.
Kevin Parker: 00:46:34 Emerging markets, I think Mo touched on it before. It's a whole different landscape when you go out of the United States in terms of governance and what's accepted and what is standard. It really does differ country by country. I think the more you go out of developed markets, the less standardization you get. The whole idea behind SASB, and by the way, SASB is the Sustainable Accounting Standards Board. We didn't define that before, we just left folks with the acronym. That's really the equivalent of FASB, which is the Financial Accounting Standards Board. Maybe people have not even heard of FASB but they basically promulgate all of the accounting rules and standards in the United States. It's an independent board separate from the government, as is SASB. Really, what SASB is looking to do is to get at materiality, just all what we've been talking about.
Kevin Parker: 00:47:45 Today, under the Supreme Court definition of immateriality, which is what investors tend to care most about. I think it's fair to say that the more you go away from developed markets where you have clear accounting standards, the more the data becomes problematic in terms of timeliness, in terms of accuracy and completeness, and so on and so forth. What you find is that the ability to do comparisons because you have these standards in place becomes more challenging. That's where ... if you look at the firms that were successful doing this, they tend to be very, very large firms with lots of assets, lots of feet on the street, lots of portfolio managers and analysts. It really becomes a more people intensive business, and so you need that kind of size and scale. Very difficult for a small manager to really run a big, global footprint with not a lot of people, because at some point the computer stop being effective, and it really becomes more people intensive focus.
Tamara Laine: 00:49:05 In turning the lens to emerging markets, how you gauge ESG with fixed income in emerging markets?
Jessica Zarzycki: 00:49:14 There's definitely challenges associated with emerging markets. We were just alluding to some of the challenges in terms of reporting. You could get an annual report eight months into the new year, and you only get one report. The timely information just isn't there. It is intensive. Our team actually travels to 20 or 30 countries per year to have feet on the ground, talking to officials, talking to businesses, talking to corporations to really get that insight, which I think is extremely important in emerging markets. We have seen steps forward. We saw J.P. Morgan come out with the first emerging markets ESG index. I'm really starting to rank the emerging markets in terms of governance on social and environmental, which I think is a big step forward. It also brings the conversation to officials and corporations which is important to the engagement piece of it.
Jessica Zarzycki: 00:50:12 We've really seen a pickup in engagement on both the investor side as well as a corporation side. Corporations asking us what do we need to do, what type of information do we need. It's really been a breath of fresh air because they want to do the right thing. They're just not quite sure what they wanted, what we want to see, and what information they need to provide. In some instances, I've actually found emerging markets, especially in the green bond space, are more willing to be like, "Here is all the information you need, here is more information than you need versus some of the US corporations." I think there's a lot of potential, if you look at the climate change and who's going to be impacted by climate change, it's really the emerging markets. You have to start to take that into consideration.
Mozaffar Khan: 00:51:05 On the equities side, we're equity investors and we're excited by the opportunities. When you think of ESG, in general, in emerging markets the average performance tends to be lower, but there's also greater dispersion. For us, that's what's exciting. There's so much more opportunity there to find value, to find the better performing firms. It's the dispersion that we really are interested in and that creates exciting opportunities for us.
Tamara Laine: 00:51:30 I want to talk about some actionable opportunities for investors. This is an open question. Are there any innovations that you're watching in responsible investing?
Douglas Lopez: 00:51:41 I think that just the fully integrated ESG approach doesn't sound like an innovation but that definitely is an innovation in this space, I think. A lot of, for years, I've had a lot of clients going back 20+ years that were really, it's more an SRI in terms of how you restricted your portfolio and tried to steer in the behavior and the types of investments that those investors wanted to have. I think the fact that now people are realizing that there are more important factors than just perhaps one of the three or the social or the environmental or one of the other ones, this fully comprehensive ESG approach to me is an innovation in the field in terms of how investors are taking these things into consideration and presenting that to clients.
Mozaffar Khan: 00:52:26 Absolutely. The integration piece is really critical because all of us research and at the end of the day the question becomes, how do you harness this alpha potential that we described and mentioned and integrate this in the investment process in order to benefit clients. The integration really has to be systematic as opposed to ad hoc. What we've done at Causeway is we've built tools, we've built apps that are installed on all analyst machines that allow them to really tap into these frameworks that we build systematically that allow them to uniformly apply these frameworks across analysts and across stock so that the process is repeatable, that allow them to do this with transparency, so there's insight into what's happening, and to really deploy all of this information to build a holistic picture of a firm, we don't apply mechanical cutoffs. There are no certain mechanical rules if it's below this score, above the score we're going to buy or self, but it's constantly monitored, it's integrated in our processes in a number of ways.
Mozaffar Khan: 00:53:32 That's really, I think, important for clients to focus on is, how is it integrated in your investment process. It can be on the equity side, for example. You could integrate this into your expected return models, which we have so we have a top-down governance factor that's integrated into the alpha model, one of our international strategies. You can also have this as a constraint in the optimization process. Again, that creates a tilt towards an alpha producing factor. You could have it as a monitored exposure. For all of our strategies across the firm, we have weekly emails that go out that track for all of our holdings, hundreds and thousands of holdings, the firm's performance on, for example, governance, and so we're able to, for example, make buy or sell decisions or sizing the position. It's constantly monitored.
Mozaffar Khan: 00:54:24 It's integrated into every investment memo. it goes into a scenario analysis that fundamental analysts conduct, and when they're building this picture of the firm in evaluating the investment case. A variety of ways systematic, not ad hoc, repeatable processes, transparent processes in which all of this is integrated into the investment process.
Kevin Parker: 00:54:48 I would say this is not ... I wouldn't use the word innovation, I would use the word evolution. The reason why I would point in that direction is because materiality is not a new concept. What is new is that the structure of the market in the market and what constitutes market capitalization of companies in equity world has changed dramatically. Thirty years ago, you would've had 80% of a company's value in the plant and equipment. You would've been able to walk around and touch the assets of the company, but we've entered into the information age some decades ago when now 80% of the market capitalization in the United States is in goodwill and intangibles.
Kevin Parker: 00:55:33 That gives rise to a whole different set of challenges for determining the valuation of companies, which can be impacted by reputational issues. We saw Facebook recently with $100 billion market cap drop in a single day. Absolutely unheard of if the vast majority of your company's value was in physical plant and equipment. As the nature of the market and the market capitalization has evolved, so are the tools evolving, so are the things that constitute materiality, and along with that requires a different way of looking at risks and returns than what we would've had 30 years ago, but it's not really an innovation, it's really an evolution of our economy and what makes up the value in our economy.
Tamara Laine: 00:56:34 Quickly because we're just about to wrap up, but I want to make sure that I get this question. Going forward, what's one key issue that you're watching that's going to affect ESG investors? Mo, I'll start with you.
Mozaffar Khan: 00:56:48 I think the exciting part is there are so many ESG issues that are important for investors, and being able to really identify which of these to be able to track their trends and have a sense of which ones are most important. That's going to vary by firm, that's going to vary by industry, but the exciting part is there are so many issues. There's so much that creates opportunity really.
Douglas Lopez: 00:57:11 I think full integration and engagement.
Jessica Zarzycki: 00:57:15 I think, for me, it's the trends, understanding the changes in corporations that we didn't really get into the details on plastics and what that means for the consumer companies and other issues like that where you have to see the changes in corporations' behavior and what that means for valuations in the fixed income market. I think there's going to be plenty of opportunities there and the opportunities to pick the winners through an ESG lens.
Kevin Parker: 00:57:43 ESG has left the station. It's happening, it's going to happen regardless of what else goes on in the world, but to me that's not the key issue. The key issue for me is the SEC, because the SEC decides on what's material and what's not material, and literally, with a wave of a wand, if the SEC tomorrow said ESG is material, then every player in the financial markets would need to conform and get in line and deliver what they're supposed to deliver, which today is happening but it's not happening unilaterally, it's not happening across the board, it's still fairly spotty and that needs to happen before ESG truly becomes mainstream and we don't have to talk about it anymore.
Tamara Laine: 00:58:31 We have covered so much today in this Masterclass, but before we go, is there anything that you think that investors should know in order to help them make their best portfolio? I'll start with you, Kevin.
Kevin Parker: 00:58:45 Yeah, I think ESG is happening. It's here, it's now, it's getting implemented across the board. You don't need to be an ESG manager to be integrating ESG. In fact, that's where, that's the misperception in the market. All of the incumbents from the largest players on down are integrating ESG into their portfolio construction process. The game's really been won and done, now it's really into the implementation phase.
Tamara Laine: 00:59:21 Jessica.
Jessica Zarzycki: 00:59:23 I completely agree. We integrate ESG at a firm wide level. It's not just the responsible investing funds, but it's also, every analyst is looking at ESG from a fundamental perspective. That continues to be important. Then, it just goes back to continue to look for performance and relative value in the space and using ESG as a tool. The one caveat I would say is ESG, if you're looking at one number to tell you how to make an investment, that's not the right way to make an investment. You should be using ESG as part of your investments practice.
Tamar Lane: 01:00:04 Doug.
Douglas Lopez: 01:00:04 Yeah. I go back to the holistic approach. Investors really need to understand that there's more to ESG investing than the environment or any other specific issue. It's really a comprehensive investment decision-making process. You really need to look as an investor at the companies that are doing that and really focus on that because it is very meaningful and it's really ... the train has left the station, it's already happening, the money is moving that way, it's a great time to get invest in.
Tamara Laine: 01:00:35 Mo, final thoughts.
Mozaffar Khan: 01:00:36 Yeah. At Causeway, we're really excited about the opportunities. When people think about ESG, they think about a lot of the bad actors. Really, for us, what's more important is not the average level, it's not the mean, but really the variance because it's the variance, the dispersion that creates these opportunities to find value for our investors and to really deploy a broader information set to build a holistic picture of the investment case. I think the other important point for investors to keep in mind is that firms that have fully integrated ESG considerations into their investment process are going to be better positioned to capture the opportunities to deliver higher risk-adjusted returns.
Tamara Laine: 01:01:18 Thank you so much for being here for our Masterclass in ESG Investing. Thank you for watching. Our experts today were Douglas Lopez, Principal Portfolio Manager at Aristotle Credit Partners, Mozaffar Khan, Senior Quantitative Analyst at Causeway Capital Management, Jessica Zarzycki, Green Bond and Short Duration Impact Bond Portfolio Manager at Nuveen, and Kevin Parker, CEO of Sustainable Insight Capital Management. From our studios in New York, I'm Tamara Laine and this has been Asset TV's ESG Masterclass.