Owning Responsibility for the Future
November 11, 2020
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Sean Kenney: Hi, I'm Sean Kenney, head of defined contribution for MFS. Sustainable investing has become an important topic in the investment industry. It's particularly true for plan sponsors that oversee participant-directed retirement programs as more and more participants, particularly younger ones, are looking for their investments to behave in sustainable and responsible ways. However, as we talk with clients on this issue, it's clear to us that there's a cloud of confusion around this topic. Contributing to that confusion are the naming conventions, implementation considerations, and even the regulatory environment that plan sponsors are operating within. Our goal today is to simplify this conversation and provide some considerations for plan sponsors to move forward.
Sean Kenney: To do that, I'm joined by two experts on this topic, our defined contribution strategist, Jessica Sclafani and Mike Cantara, head of our global client group and chairs our sustainable group here at MFS. I want to thank you both for joining me today.
Jessica S.: Sure.
Sean Kenney: As I just highlighted, we have a lot of confusion around this topic from naming conventions and other considerations. Mike, maybe as a starting point, I can ask you to start with MFS's definition of sustainable investing.
Mike Cantara: Yeah. I mean, you mention a lot of challenges. You could almost add the definition of sustainable investing to that list of challenges because there are many. But at MFS, we really think about investing for the longterm. So sustainability means identifying those material factors that actually are going to have an impact on a company's valuation over the longterm. There's many ways that we go about doing that, but we think historically about traditional financial analysis and marrying that to an idea and expectation of what's happening on an environmental, social and governance front as well.
Sean Kenney: Okay, great. It's a great starting point because we're going to talk about a lot today. To start that, Jessica, historically for defined contribution plans, this conversation has been more focused in the nonprofit sector. Why is sustainable investing become more common across all DC plans here in the United States?
Jessica S.: Sure, Sean. I'd agree with you it's interesting. Across my conversations with DC plan sponsors, sustainable investing is increasingly a topic of interest. Many plan sponsors want to understand what they might be missing when it comes to sustainable investing. Most commonly, it's the younger participants that are expressing interest in sustainable investing. This can be a loud voice given that today millennials represent the largest generational cohort in the US workforce. Looking at data from a 2017 Morgan Stanley survey of 1000 individuals, we see that 90% of millennials are either very interested or somewhat interested in pursuing sustainable investments if they were offered in their workplace retirement savings plan. What I'd say overall is that while plan sponsors do have a lot on their plate these days, we believe sustainable investing is a topic that warrants further conversation. Unlike most things in the D.C. Market, there is no silver bullet and there is no single right answer for every plan.
Sean Kenney: Yeah, that would make things much easier if there was. It's interesting, those stats are compelling because we've seen this younger generation get really active in the endowments of the colleges and universities that they've attended. So it's an interesting dynamic to see that same generation get active with their employers in the workforce. So I think it's a dynamic that we need to pay attention to. Mike, from a global perspective, you've been talking with our clients, plan sponsors around the world for many years on this topic, is there anything you might add from a non-US perspective?
Mike Cantara: Yeah, the trend continues. I think that's one of the things that we're certainly seeing in different regions of the world. In Europe, a lot of regulation is already been moving in this direction to increase transparency. When you think about Australia and the superannuation funds, there's been a lot of movement to integrate sustainable practices into that process. I think it's also indicative of more options available for investors. So we have seen the UN principles for responsible investing. The membership there both for asset owners and asset managers has significantly increased in the last five to seven years.
Mike Cantara: So there's certainly a lot more choice available, not only for consumers or investors, but also as managers, there's a lot more data available. I think there's two sides to that coin. Like lots of things, we need to be very disciplined about what we're doing and the things that we're paying attention to. So when we talk about sustainability, it really comes back to this idea around materiality. What is the impact that these decisions are going to have on the valuation of that company going forward? That is what's in the price today versus what may evolve over time. I think we want to make that distinction between valuation and values. I know we'll talk a little bit more about that as we go.
Sean Kenney: Yeah. It's really amazing how global this conversation is. It seems like outside the US, plan sponsors are a little bit further down the implementation road and it's certainly very regional. So, Jessica, in the US, where implementation is lower, but the appetite for it is very high, where might a plan sponsor start trying to incorporate some sustainability considerations into their plan?
Jessica S.: Sure. There are two methods by which plan sponsors can implement sustainable investing in the D.C. plan. The first method is offering participants access to ESG-themed funds on the plan menu or by offering participants access to a self-directed brokerage account. Either way, this represents a values-based approach to incorporating sustainable investing in the D.C. plan. The second method for plan sponsors to consider is for them to select asset managers that integrate ESG factors into their investment decision making process. This represents a materiality-based approach that is focused on assessing ESG factors in the due diligence process for a company or an issuer. The second approach is more holistic and would be applied to all of the funds that are offered on the plan investment menu as opposed to just one or two individual funds that would be added. Ultimately, we think about a values-based approach versus a materiality-based approach as akin to a product choice versus a process choice.
Sean Kenney: Yeah, that's a really simple framework to think about it. If we were to zoom in a little bit on the value-based approach or the ESG-theme fund approach, what might a plan sponsor consider as a starting point?
Jessica S.: Sure. A few things for plan sponsors to consider with a values-based approach include thinking about if the ESG-themed fund would appeal to all or at least a majority of their plan participants. As you can imagine, this can be difficult to achieve. That said, offering an ESG-themed fund can work nicely when the fund aligns with the company's core mission. For example, if you are a clean energy company and you offered a clean energy fund on the investment menu. Also, I'd say that some plan sponsors are leery of offering a specific ESG-themed fund as you can run the risk of a participant choosing to allocate 100% of their account balance to that single fund which could be inappropriate. Because of these considerations among others, some plans sponsors have ultimately decided to offer participants access to a self-directed brokerage account instead of going with the ESG-themed fund approach.
Sean Kenney: Okay. From a product perspective, that makes a lot of sense. As we move towards more of the process discussion, we talk about materiality. Mike, I know there's some academic research out there that points to materiality being an important input into a company. Can you share a little bit of detail about that?
Mike Cantara: Yes. I think it is an extremely important point. It gets back to this idea of process and really understanding what is the process built around. So materiality just means how relevant is that factor to that company's business, their financial returns, their success from a competitive standpoint. Harvard Business Review in 2015 published a study that I thought was really interesting on a couple of different fronts. One, it defines materiality in a industry relative way. So to think simply about it, the environmental impact of a transportation company is going to look different from a bank, and so... to take that as part of the consideration.
Mike Cantara: But when you put all that together and then look at the actual returns of those companies that paid attention to those areas that are really material to their business over the long term, they outperformed by over 6% annualized relative to the peer group. Just as importantly, I think, as the other side of that coin, if you pay attention to things that aren't going to drive your business going forward, then you're destroying capital. So I think it's also something for everybody to really consider when they're making these buying choices, whether it's an investment fund or anything else. Is it real? Is it critical to the process that's involved in that part of the business? So, really being able to make that distinction between, is this material, and how to define that on an ongoing basis?
Sean Kenney: Yeah, that's interesting. So it's really about companies knowing where their materiality is and investing resources around that and not wasting it on other non-material factors in their company.
Mike Cantara: Exactly. It has to be substantial to the business and I think that's really where we're making that distinction.
Sean Kenney: Yeah, that's a great distinction. Jessica, if you're a plan sponsor considering going down more the process route, what are some of the starting implications you might consider?
Jessica S.: A few things for plan sponsors to consider with an integrated or materiality-based approach is that it applies to all of the funds offered on the plan's investment menu as opposed to individual funds. An integrated approach also requires the plan sponsor to modify their investment policy statement to demonstrate that they are considering ESG factors in the investment decision making process. In our view, the values-based approach has some potential to create new problems for plan sponsors. Because of this, we view the more holistic and integrated approach as the more likely path forward for plan sponsors to take.
Sean Kenney: That's helpful. As we zoom in a little more on the process side of things, Mike, you chair our sustainable investment group and so you have a bit of a unique lens into how we think about ESG factors and sustainable investing in our investment process. A few times you made the point that ESG integration is really good longterm investment management. Can you give a little more detail around how you can integrate ESG factors into an investment process?
Mike Cantara: Yes. As we've talked about a number of times, we keep talking about materiality, but it's assessing the impact that those factors are going to have on the company's business and therefore the current price and what that may mean for the future current valuation versus future valuation. But it really is about knowing and understanding the companies, taking a long view and being disciplined about engaging with those companies, meaning, meeting with the board, meeting with the executive teams and truly understanding how are they addressing these issues that evolve.
Mike Cantara: One of the reasons I would put the emphasis on the integration of the process part of it is these issues change and as constituents change within the plan, the issues that they're focused on may change over time as well. So I think that's one of the things that we have to be aware of in selecting a product is, yes, products can evolve, but they're also meant to address specific issues where if you take a more holistic view and think about the process, I believe that's just more durable over the long term. So that's how we... and why we put the emphasis there.
Sean Kenney: Yeah. A simple way to think about that is that longterm investors are evaluating and analyzing these factors as a part of their research. But are investors just evaluating and investing along those dimensions or are longterm investors actually making... impacting change and affecting the responsibility of these companies in the market?
Mike Cantara: Yeah. It's an important distinction because there is really a spectrum of sustainable investment types. If we think about impact investing, which is certainly something that's gotten a lot of attention recently, both from institutional investors as well as individual investors, there is a more express intention there to have an impact on an environmental, social or governance issue. There is an explicitly stating sacrifice of returns, but I think there's a willingness to trade that off. On the traditional way that ESG has been implemented in plans is through a screening process and that is simply eliminating companies that violate a certain threshold of certain criteria.
Mike Cantara: So we think that that is too blunt of an instrument in many cases. So really thinking about an integrated approach where we can incorporate these decisions into the process in creating a robust governance structure that ensures the discipline of that process over the long term. So I think integration is what I just described and then you have other variations of that as well that are available to investors.
Sean Kenney: Okay. So what you're saying is from a product perspective, they tend to start from more of a screened universe and build a portfolio from a screened universe, whereas a process-oriented approach is typically looking at the entire universe and using ESG integration as a part of company research to build within the portfolio.
Mike Cantara: Yes. As you point out, they're really different starting points. Are we eliminating a whole group of companies before we start building the portfolio or do we want to integrate the entire universe as part of that process? I think that really requires a discipline and actively engaging with those companies to be able to make those determinations. That's really what the process emphasis is all about, is making sure that over the longterm that we are disciplined about applying that criteria to a consistent group of companies, which gives us the benefit of... with... while we're engaging with those companies to actually influence perhaps future direction, which is I think a big advantage over simply walking away or divesting from those companies. But that has to be made on a case by case basis.
Sean Kenney: Yeah. So what I'm hearing is that it's not just enough to be longterm, it's actually about being longterm and active in the research and engaging with companies to actually influence change and influence behavior.
Mike Cantara: Yes. I think one of the benefits of seeing how ESG has evolved in the last number of years is there's certainly been a proliferation of new data sources, new ways to measure, more transparency into what companies are doing. So again, I think it makes it very similar to what we have always thought of as the traditional financial metrics. We can now put some numbers around that. This is a math problem at the end of the day and being able to figure out what does that valuation look like despite all the emotional elements certainly that come into it as well.
Sean Kenney: Yeah. So that's a simple way for plan sponsors to think about this, is that, ESG and sustainable investing is really synonymous with active longterm investing, and I think that's what we're saying here. For the last few questions, I'd like to shift gears and look at things more from a regulatory industry perspective. Jessica, maybe I will start with you because the Department of Labor here in the United States has issued some recent bulletins around ESG investing, sustainable investing, and certainly plan sponsors and fiduciaries care about what the Department of Labor has to say. Is there anything that you might highlight for a plan sponsor?
Jessica S.: Sure. What we've seen over the past several years is that the guidance provided by the Department of Labor has consistently aligned with the political party occupying the White House. Under the Obama administration, the DOL guidance allowed that ESG factors could be considered alongside traditional financial factors when making investment choices. More recently, the Trump administration Department of Labor issued revised guidance stating in effect that plan fiduciaries should not overemphasize ESG factors when making investment choices. Overall, because of this dynamic where the Department of Labor's guidance has ebbed and flowed with the political tide, we believe an integrated approach that is focused on determining the financial materiality of ESG factors makes the most sense for plan sponsors. Also, as we know under ERISA, being able to point to a process is so important and with an integrated approach based on materiality, ESG factors become a part of the plan fiduciary's process.
Sean Kenney: Okay, that's helpful. Mike, I'm going to ask you a really big question. We started the conversation today motivated by the fact that younger employees participants are looking to align their investments with their personal values and beliefs. Now plan sponsors are reacting to that and looking at this topic more closely. But when you look at this from a global perspective and you look at the investment management industry more globally, how do you see the industry evolving or changing now that the world's becoming a little more focused on the need for sustainability?
Mike Cantara: Well, I mentioned earlier that there's been some regulatory changes and so there's part of it that's coming out of Europe and other places. Again, it goes to this idea of transparency. So the implications, I believe, for the investment industry is that there's more information, more data available on environmental, social and governance factors which now gives us the ability to incorporate those into traditional financial analysis. The tricky part is figuring out again, what's material, what's the information we should be paying attention to and that gives us signals that are truly long term and not get caught up in the news flow which is something that we always try to resist against. So it's that really focus on longterm. But I think more and more investors as they commit to sustainable investing are getting more demanding on evidencing, how are you going about doing that? I think that's really one of the big changes that will continue in the future.
Sean Kenney: Yeah, it's a great point because more transparency means we can communicate better and understand it better. So that should help the conversation as well.
Mike Cantara: Really does. Yeah.
Sean Kenney: At the beginning of this discussion, we talked about our goal of really simplifying this conversation for plan sponsors. So if I were to ask you both for one or two takeaways that a plan sponsor could take action on leaving this conversation, what would those one or two things be? Mike, I'll start with you.
Mike Cantara: I think to me it comes back to this idea of focusing on the longterm and so really understanding the discipline that a manager is bringing to that process and challenging the manager to provide the evidence of how that is affecting portfolio decisions either through proxy voting or through buy and sell decisions in equity or fixed income portfolio.
Sean Kenney: That's great. Jessica, your thoughts.
Jessica S.: Sure. I'd point to two things. The first of which is, we really encourage plan sponsors to think about sustainable investing as a governance issue, not a product issue. Secondly, we view participant communications as key to a plan sponsor's success in implementing sustainable investing. You may even see some plan sponsors consider creating participant communications that explain the plan's approach to offering access to these types of investments.
Sean Kenney: Okay. Well, this is a really complex topic, but an important one and so I want to thank you both for not only simplifying it but giving us some frameworks and actions that plan sponsors can take as they go forward. Thank you both.
Sean Kenney: At MFS, our purpose is to create longterm value for our clients by investing their assets responsibly. Responsibility to us means being disciplined on taking the longterm view, maintaining a commitment to analyzing and actively engaging with the companies we invest in and a constant focus on seeking to understand risk from all angles. I hope you found this conversation helpful today and to learn more about MFS and how we add value for our clients, go to mfs.com/sustainability.
The views expressed in this video are those of the speakers and are subject to change at any time. These views do not necessarily reflect the views of MFS or others in the MFS organization, and should not be relied upon as investment advice, as securities recommendations, or as an indication of trading intent on behalf of any MFS investment product.
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