The Evolution and Controversies of ESG Investing

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00:04 - 00:37

Hello everybody. And welcome to The Pulse, where we cover trends in the economy, markets, and asset allocation for long term investors. I'm Matt Palazzolo, senior investment strategist at Bernstein. And today I'm happy to be joined by my colleague and good friend Travis Allen, who's our national director of Purpose Driven Strategies. You've all likely heard of ESG or environmental, social and governance investing, or as we sometimes refer to it, responsible investing. And Travis is one of our leading minds on all things purpose driven. So, Travis, welcome back to the show.

00:37 - 00:38

Thank you. It's good to be back.

00:39 - 00:56

So, purpose driven or ESG or responsible investing really appears in the news cash almost every day. So, Travis, what do you think accounts for this rapid growth, this adoption, this appreciation for this type of investing all of a sudden?

00:57 - 01:31

Well, the first and I think main driver of why ESG is in the news so much is because an increasing number of investors, people who are our clients are asking, requesting and then more and more cases demanding that environmental, social and governance issues be considered in the way that their portfolios are being managed. And so that's the main driver, is that there's a huge amount of growth in demand for investment portfolios to move in this direction.

01:31 - 01:58

Part of that is being driven by the fact that the people who make up the investor community is changing, right? More and more of the investors are younger and focus on environmental, social and governance issues in their lives at work or outside of work. And they view their investment portfolios as an extension of what they care about in their private lives.

01:58 - 02:27

The other thing that I think is also driving it in terms of being in the news is that it has grown rapidly and naturally. When something grows rapidly, there's going to be more and more criticism and more and more media attention to environmental, social and governance, investing in all its many, many forms, because obviously it's something that's on people's minds and as I said, increasingly important to people.

02:27 - 02:28

It certainly is controversial.

02:28 - 02:49

I'm going to get to that in a second. But before I do, it sounds like you're saying that the investor base has grown, it has widened out. That seems to be not just institutional investors who suddenly want responsible investing as part of their portfolios. It's also the high net worth or even just individual investors of all types. Is that fair?

02:49 - 02:51

That's yeah, that's totally fair.

02:51 - 03:04

And I guess I'm wrongly referring to this as a suddenly saying it's not responsible. Investing has been growing for quite some time. Right. It's had iterations, but this has been a long time coming in this fear.

03:04 - 03:35

That's right. You know, thinking about the social or environmental ramifications of your investments is not new. You can go all the way back to prior to the Civil War and religious institutions who decided they wanted to divest anything that, you know, touched on slavery from their portfolios all the way up to the 1980s, where portfolio managers under a lot of public pressure, divested from South Africa in a move to combat apartheid in South Africa. So, it's not something that's new.

03:35 - 04:19

I think what is new is that today we have a much more sophisticated set of tools that we can use in order to focus portfolios, attention on environmental, social and governance issues. And it's much less about divestment and punishment of companies and much more about how you promote positive ESG behaviors from companies and reinforce those behaviors through measurement. So there has been a big transition away from what historically has been thought of as socially responsible in the old SRK days towards a movement that's more focused on ESG as a broader set of characteristics that you can use to evaluate companies.

04:19 - 04:44

Let's just go a little bit further on that point. Travis, you make a great point. Maybe I'm oversimplifying, but responsible investing in the olden days was more about exclusions, meaning I'm not going to own X, I will own Y. But now it's evolved to know a broader set of tools in this toolkit. How are we doing Responsible investing, purpose driven investing here at AllianceBernstein?

04:44 - 05:26

Yeah, so that's a great question. I get that question all the time. And I think when people ask, they expect me to say X percent of our portfolios focused on ESG, which if you just flip that around, means that there's a huge percentage of the portfolio that's not focused on ESG. Now, the way we think about Purpose Driven. Investing and responsible investing in ESG and all of those the different titles at the firm really falls into three categories. The first, which you know, again, to me personally, but also I think to the firm, is something that we view as being very, very important to the future of the firm. And the culture of the firm is that we think about environmental, social and governance issues as it pertains to how we behave.

05:26 - 05:51

Right. Things like reducing our own carbon footprint, focusing on diversity, equity, and inclusion at the firm, making sure we have the proper level of governance and diversity views on our board of directors. And so, there is that level that I think is important, but that's normally not what clients are talking about. We're very excited about those changes and the progress we're making, but that's generally not client’s what clients are asking about.

05:51 - 06:23

The second way that we think about it is through what's called ESG integration. So environmental, social and governance issues are important to companies. Whether you are an ESG portfolio manager or not. You want to understand what risks are right now being under-reported or underrepresented in the way that people are viewing companies. And the way I often think about it is there's a term that gets used a lot with ESG integration focused on material, financial information, right? That this information is material.

06:23 - 07:07

But here's the thing, is that people will often say, well, you know, I don't think about diversity, equity, and inclusion as being material or the environmental footprint of a company as being material. And my response to that is that if companies ignore those risks for long enough and they like them to fester, eventually they absolutely will become financial material because they'll be sued for whatever that bad action is, or they'll lose significant amounts of brand value for ignoring that risk. And that absolutely is financial material. And so, you really can't go into a C-suite today where you don't have senior executives think about these issues both as risks but also opportunities. So, it's natural for investors to also think about them as well.

07:07 - 07:44

The last piece, Matt, is that there is a segment of investment strategies that we have designed that focus on environmental, social and governance issues at a much higher level of intensity. In terms of designing the portfolio, what do you earn in own in the portfolio and why? And the way I think about these strategies is essentially they have the similar financial objectives as traditional strategies that may do ESG integration, but they also have specific ESG goals, environmental, social and governance goals. In the way that you can evaluate those goals is that those strategies also provide some measurement.

07:44 - 08:33

So, for example, a strategy that we describe as being purpose driven or more broadly, I think oftentimes people call these ESG focused strategies may report on returns and risk like every other strategy, but also report on the carbon footprint of the portfolio, the waste efficiency and water efficiency of the portfolio, diversity at the company, gender pay equity, all of these issues, if they're important and relevant to how the investment manager is actually making the decisions for the portfolio should also be a part of the way that you measure the success. So that's what separates purpose driven from the traditional strategies that may involved ESG integration, is that investors, I think, deserve to get some ESG returns because that's part of the way they're going to measure the success or failure of the investment strategy in their portfolios.

08:33 - 09:05

Okay. You alluded to some of these controversies around responsible purpose driven investing. It's been in the news of late over the last few weeks, certainly a lot of critics of purpose driven investing, those that talk about, quote unquote, shareholder or stakeholder capitalism of woke boardrooms. I'd love to hear your thoughts on all this. Travis Certainly as it relates to the news over the last few weeks and the pushback amongst, you know, meaningful entities against this movement.

09:06 - 09:56

Yeah, I think that alongside the growing demand for ESG, there's been this growing backlash, and the backlash is as varied as there are ESG approaches. But primarily the backlash is that the ESG investing is trying to push political or social values onto people and and doing so at the cost of less attractive financial returns. And here's what I would say is that it's really, important to distinguish between ESG integration and ESG focused strategies. And then once you get into ESG focused strategies, exactly what the strategy is trying to accomplish, how they're accomplishing that and how they measure it.

09:56 - 10:36

The reason why I say that is that there has been a lot of articles that focus on, you know, large providers of index products. That criticize them for being sort of woke capitalism. And the vast majority of these guys I'm not defending these companies. I have no interest in defending these companies. But the vast majority of what they do is ESG integration and engagement. And in fact, if you run a really, really large company that provides big index products like S&P 500 index funds, by definition, you're buying everything, right? You're actually not making decisions that are driven by ESG.

10:36 - 11:31

Now, within your corporate behavior, you may decide we want to reduce our carbon footprint and talk to companies about why they should do the same. But they are not changing the amount in just by the way that they approach building their business around indexing, changing access to capital for fossil fuel companies, for example. So, I think there has been sort of a confusing set of criticisms that, you know, these companies are trying to impose values when if you actually talk to people who are running these businesses, they're the ones that are focused on these issues as well. It's not like there is a large CEO of a company out there who believes that they can ignore the carbon footprint of their portfolio, how they use their resources, or how much water they're wasting in their manufacturing process or bottling process. And so, I think a lot of the criticism has been sort of misguided and misplaced.

11:31 - 12:13

Now, if you wanted to criticize ESG focused strategies or purpose driven strategies, that's totally fine, right? Because those strategies do have a point of view. But remember, those strategies are much smaller segment of what people more broadly think about as ESG. And no one's being forced to invest that way. Right. Even within our investment platform, we have a lot of clients who invest in traditional strategies that do ESG integration. And then we have a segment of clients who have said to us that I am asking you to make ESG a part of the way that I'll evaluate the success in the portfolio, and then they move in that direction so no one's being forced. Is my point to invest in these more ESG intensive strategies? That's a choice.

12:14 - 12:37

You know, ESG integration is just table stakes at this point, right? Vast majority of asset managers think that understanding these ESG risks and opportunities are important to the way that you evaluate companies. So, it's not that it's, you know, totally without any merit. But I think a lot of it is really conflating ESG integration and ESG focused strategies.

12:37 - 12:58

Which I was just a little bit further on this on this controversy topic. I think it goes broader than what we were talking about. You know, it gets into policy, implementing policy at the political level. What effect does that have? How impactful can the policy changes or implementations be given where markets and where investing is today?

12:58 - 13:32

Well, look, ultimately it's the people who vote in those states that will determine, you know, how policy around ESG plays out. The only thing that I would say is that a lot of the criticism has been really focused, I think, incorrectly. And, you know, companies that that, again, are not pushing the envelope in terms of ESG focus or impact or sustainability but are simply adopting best practices as it pertains to considering environmental, social and governance risk.

13:32 - 14:10

And, you know, many of those companies are really, big providers of index products. And, you know, you can't pretend like these things don't potentially have a cost. You know, so, for example, you know, there are a few companies that are the largest provider of big cheap index products, and they can offer index products at basically no cost because they are so big. And it would be a cost if you said to the pension plans of all these states that they can't invest in the biggest, cheapest index products, if that made sense for their portfolio and maybe it's only a few basis points, but a few basis points on, you know, a large pension plan, it's not immaterial.

14:11 - 14:37

And so, I would just say that, you know, there's going to be a lot more sort of in the news. And there are obviously political points that can be won and lost in focusing on this. But it's important for the folks listening to understand the difference between ESG integration, ESG focused, and maybe we even talk about impact in a little bit and how those things have very, very different levels of ESG intensity to them.

14:38 - 14:53

Okay. Before we talk about impacts, I want to talk about greenwashing. That's another common criticism of ESG investing. So, if just for the benefit of our listeners, can you just explain what greenwashing is and how you view it in the markets today?

14:54 - 15:47

Yeah, Greenwashing is essentially, you know, marketing or representing an investment strategy or particular investment as being green. Or ESG friendly when it's not right. It's essentially misleading investors into believing that something has strong ESG characteristics when it does not. And I think that the focus around greenwashing is not so much that people should say this is a good find or this is a bad fund and so on. I think the focus should be that if an investment manager says that they're doing something in terms of ESG, that they be able to very clearly and transparently represent what they're doing right to potential investors and then follow through by measuring and being transparent about the outcomes and how they're making those decisions.

15:48 - 16:19

Right. If an investment product has no ESG influence to their investment process, then I'm not going to grade them on ESG, right? I mean, it's not fair to them because they're not considering it in their investment process. But if an investment product puts in its label that it's a green equity fund, then it is very reasonable to say, well, how exactly are you moving this towards being green or greener? And how can I measure that as an outsider to evaluate whether or not the strategy is truly green?

16:20 - 16:51

And so I think greenwashing is important because there has been a lot of it in the past. I think with greater levels of transparency and clarity on the way that ESG affects the investment process and then some requirements around measurement and reporting. We can go a long ways towards, you know, combating greenwashing. And the S.E.C. and European regulators have already started to move in that direction, requiring greater levels of disclosure and transparency around what, quote unquote, ESG products are actually delivering.

16:51 - 17:20

Mm hmm. Let's take the other side of the coin. Travis. So not that, you know, greenwashing. Perpetuating that your portfolio, your investments are responsible or sustainable. The other side of the coin, I guess, would be some issue like a bond issue, let's call it a green bond, where the proceeds of the raising capital through that bond are not really for the benefit of the environment or something like that. Can maybe give us an example of that and provide your thoughts on that whole impact.

17:20 - 18:15

Yeah, the green bond labeling process is not a panacea. I think it's still really incumbent upon portfolio managers and investors to really understand what justifies this bond being labeled as green. I've come across some really great green bonds, right, focused on increasing the percentage of power that's being delivered from renewable energy. Very clear in terms of its positive use of those proceeds. And then there have been other green bonds that are, you know, tied to natural gas. And that and that's more subjective, right? Some people will say they're comfortable with that as a green bond and others will say that still relying on fossil fuels and you have to think about methane emissions and so on. But there could be a green bond with natural gas at its heart. You know, there have also been green bonds for things like, you know, parking garages.

18:15 - 18:25

I was going to say the same thing. I remember you guys told me that story a couple of years ago about a parking lot that was built in some town. And so, yeah, that's not really helpful to the environment as it's done.

18:25 - 19:08

I mean, it's helpful that they installed solar, and they use the latest technology. And in trying to keep the carbon footprint of that parking garage down as much as possible. But of course, we would much prefer if you're focused on this from an ESD standpoint, that you spend that money on mass transit, right. Even providing shuttle service in order to avoid more and more cars being on the road and not to mention all the concrete it takes to build a big parking structure. Again, no one should just take the labels at face value. Right. Saying something as a green bond gives you, I think, permission for deeper inquiry, but doesn't guarantee that it's going to meet with your individual definition of what is green and what is it?

19:09 - 19:17

Travis Let's move to impact. We have just a couple of minutes left. What is impact? How do you define it and how is it occurring today?

19:18 - 20:03

Yeah, so impact, I think has three elements to it. First, it has to be intentional, right? Intentionality is very important. It must be measurable, and it must have some additionality. And you probably notice that I haven't been describing equity strategies or bond strategies as impact. There can be some strategies that are impact focused, but impact is easier to produce in the private markets. You can do some things and we've done some things in in Muni bond land where we focus on lower socioeconomic, urban, and rural communities and focus specifically on bond issues that address, you know, social inequalities or environmental inequalities. But it's much easier in the private markets.

20:03 - 20:25

To focus on impact, right? Investing in a company that's creating and building out the delivery of a technology that's going to change the economics in some way around environmental or social equity. You can really have impact in that area by aiding in the growth of those companies and perhaps even helping to advise those companies on the best path forward.

20:25 - 20:49

So, impact if you think about ESG as being a spectrum. I would say that there are some things that are really low ESG intensity, like, you know, big passive ESG index products. Nothing wrong with those. But the truth is they can be accused of overselling. They are a modest improvement in ESG characteristics for the portfolio versus a traditional index.

20:49 - 21:45

Then you have really focused ESG strategies that are stock and bond strategies that can move the needle more in terms of improving the behaviors, characteristics of the portfolio. You have really specific strategies like clean energy funds that, again, are more focused on sustainability and have a higher level of intensity. And I think all the way out at the highest level of ESG intensity is impact. And it's really important for people to know that ESG investing is not a monolith. If you have strategies that go all the way across that spectrum and it's important for investors to ask the hard questions, right? Where does this fall in terms of its ESG intensity? How do you think about the relationship between risk return and the ESG focus or impact focus of the strategy? So that spectrum idea, I think, has been really helpful to me and making sure I'm doing the deep dive and really asking questions to see what ESG strategies are really all about.

21:46 - 22:39

Yeah, I think that's a fantastic point, Travis, And it's nuanced. I think about it not in terms of a spectrum as you were walking through it, but really is a menu, meaning it's a menu for the investor to determine what do they want to own? Do they want to own only the good actors or the companies that are publicly traded that that are the best performing as it relates to ESG? Do they want to own the companies that are improving? So they're at some place and they want to get to a better place. Do they want to own something that has an impact where the portfolio manager is actually in there having an impact and not monolithic to your point and not one size fits all? Certainly. So some of this responsibility really does come down to the investor, determine what is it that they want and then who can provide it. What are you excited about in this space? Like, where where are we going to be ten years from now? And what's the most exciting part of that journey?

22:40 - 23:10

The most exciting part for me is that there is so much innovation happening in the broader ESG investment product landscape that there are more and more people who are coming to this work and coming up with creative ways to create investment strategies that, you know, can can maximize certain ESG characteristics or provide impact on specific issues.

23:10 - 23:47

I think the most exciting thing is that there will be a time in the future where clients can look at their portfolios and just like you look at a portfolio and you see that the stock component and the bond component and the alternatives and you have a nice pie chart. I think clients will also be able to look at their portfolios and say, you know, this is my sort of broad ESG part of my portfolio by sustainable part of my portfolio, by impact, part of my portfolio, and not in any way sacrifice types of risks and returns that you would expect from a traditional asset allocation that included, you know, stocks and bonds and alternatives.

23:48 - 24:38

I think that that's really exciting because it will allow us to get beyond this conversation that's happening right now that is oftentimes like ESG is all good and ESG is all bad and get get into the nuance of it and say, you know, here's how ESG can help this part of my portfolio. Here's how ESG can be integrated into my municipal bonds. Here's how I can think about impact in terms of private equity and venture capital. I think I'm really excited about the fact that we're moving towards a time where we have better set of tools than we've ever had before. More transparency and clarity on what managers are actually doing than we've had before, and much, much better measurement than we've had before. And that's excites me because I think it's going to allow those investors who decide that this is important to them to move into this area with a lot more confidence than they've been able to do it in the past.

24:38 - 25:04

Travis, I want to move on. I want to talk to you about I want to play a little bit of devil's advocate here. If we were to just look at performance for purpose driven equity strategies in 2022, they haven't performed as well as let's just call them non purpose driven strategies. What's been the reason for that? And then your thoughts on does that then turn some investors against. Purpose driven investing.

25:04 - 25:57

Yeah. And I just for the audience, want to make it clear that when we say purpose driven is the term we use internally for what? Again, more broadly, people think about as ESG focused strategies that have a high level, higher level of intensity and some requirement to provide measurement. Yeah, it's been a difficult year for purpose driven strategies, and a lot of it started in the first quarter. Actually, the bulk of the difficulties in terms of performance is from the first quarter. The first quarter was one of those times in history where you had one or a small number of stocks in the investment universe outperformed everything else by a really, really wide margin. And in the first quarter, for reasons that are probably going to be really obvious to everybody, listing energy companies primarily first and foremost, outperformed everything else by a lot.

25:57 - 26:27

And to the extent that ESG focused strategies or our purpose driven strategies tend to have significant underweight or no exposure at all to energy companies, that was a headwind from a performance standpoint, but also defense and mining companies did well. And so, we had this coming together of most of the things that again, a lot of things that ESG managers are very unlikely to hold in their portfolios do very, very well. And that cause there to be, you know, some challenges in terms of performance.

26:28 - 27:14

The way that I talk to people about this is that I don't think that anybody should make the decision on whether they want to focus their portfolio on ESG based on what happened in the first quarter of 2022. Right. They should be evaluating these strategies over the same time frame that they evaluate traditional strategies, right. Over full market cycles. And if you look at how ESG strategies have performed and our purpose driven strategies have performed over full market cycles, returns and risks have been very similar to our traditional investment strategies. And that's by design, right? It's by design. We're trying to set up a case where investors can make the decision based on their values, but not chasing returns, but also not accepting that returns are going to have to be concessionary.

27:14 - 27:52

One of the real pushbacks today and one of the reasons why I think there's been so much attention in the media is that energy companies have performed really well. But that hasn't been the case for most of the last decade. We've done the work. And so, if you had built a portfolio with no energy in it over the last ten years, it would have done quite well, both from a return and risk standpoint. I'm not advocating that. I'm not saying that you should just rely on exclusions. I'm just saying that over short periods of time there can be headwinds and tailwinds to ESG investing based on things like whether they have any exposure to energy when energy's outperforming everything else by a massive amount.

27:53 - 28:09

So, Travis, I want to be clear on what your view is. Are you saying that investors that are interested in purpose driven investing do not have or ESG focused investing, do not have to sacrifice returns to marry their values with their investments?

28:09 - 29:04

What I can say is that investors should expect the same returns and risk as they would from any traditional active manager approach. And ultimately, what drives whether a manager over the long term, what drives, whether the manager is successful or not will be what we always pay attention to will be the quality of the people making the decisions, the quality of their research, the repeatability of their process. In that way, evaluating ESG strategies should look very, very similar to evaluating non ESG strategies. My only caution is that just like with other active strategies, you shouldn't make the decision based on, you know, one quarter or one year. You should look at how the manager has performed over the long term. And I think ESG strategies have done just as well as traditional strategies over the long term versus traditional benchmarks.

29:05 - 29:27

Travis Some of our clients are legal fiduciaries to a trust or some charitable organization or some other entity, and one concern that they have is whether they, as that legal fiduciary can invest in purpose driven, ESG focused strategies. So, what should they know about purpose driven investing from a fiduciary standpoint?

29:28 - 30:04

Yeah, it's a big issue today because obviously, as the adoption of ESG grows, you're more likely to find folks on the board that you may be serving on who have moved in that direction and are encouraging the organization to move in that direction. And maybe that's the right decision. But here's what I would say, and we just sort of talked about it, is that trustees should take the same approach, same fiduciary level of oversight for ESG focused strategies that they do for traditional actively. Managed strategies.

30:04 - 30:58

Right. So, if we're talking about an equity portfolio, what are the things that the finishers will care about? They'll care about the returns, don’t care about the expenses or cost associated with the investment, the investment management team, the stability of that team. And so those questions are all relevant to evaluating ESG focused strategies. The only difference is that you then add on top of that that as a fiduciary, you really need to understand what is the ESG approach, right? How are they integrating that approach into the investment portfolio and what tools will we have to measure the ESG success or failure alongside the traditional risk and returns? And so, it's important for folks that are on charitable boards to realize that they can meet their fiduciary obligations by observing the same best practices that they have historically.

30:59 - 31:34

The only caveat I would add is that, of course, charitable organizations also have a charitable mission, right, or some social mission that they're trying to achieve. And it is possible for a committee to say, yes, we understand that we may be deviating from best practices or maybe this strategy hasn't had the highest returns. If we compare them to benchmarks historically, but if the strategy is very much aligned with the mission of the organization as a fiduciary, you can also justify including it into a portfolio.

31:34 - 32:02

And the last thing I would say is that, of course, if you document these things, it makes it much more comfortable for a fiduciary to move in that direction. Right. So, if the investment policy statement says that the organization prefers, you know, environmental, social and governance investments or specific issues that they focus on because it's tied back to the organization's mission, then again, it gives you a little more confidence and comfort as a fiduciary moving in this direction.

32:02 - 32:09

Good advice. Travis I wanted to thank you for joining us today on The Pulse Week. We appreciate your insights and your perspective.

32:09 - 32:21

It's my pleasure. It's always good to talk to you. And again, hopefully I'll be able to come back in the future and talk about some of those big advancements that I'm anticipating are just around the corner.

32:22 - 32:26

We're looking forward to it. And so, to all of you out there that were listening, thanks for joining us today.

32:26 - 33:07

We hope you enjoyed this conversation with Travis and learned even more about the current state of purpose driven investing. And we'll make sure to link to Travis's whitepaper for fiduciary use from him and his team. And you can also check out his On Purpose podcast, which Travis has been hosting for the last several years. As always, we'll continue to monitor the economy in the markets for you and to share our latest views and insights here on the Pulse. And if you've enjoyed our podcast, please subscribe in radius on Apple Podcasts or Google Play, Spotify, wherever you listen to podcasts and email us with your thoughts or questions or feedback to insights at Bernstein dot com and be sure to find us on Instagram and on Twitter at Bernstein. Until next time, thanks and be well.