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Episode 16: Covid-19 Implications and ESG Funds with Jon Hale

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In this episode we are joined by Jon Hale, Head of Sustainable Investing Research for Morningstar in a discussion on how COVID-19 has impacted ESG funds, and how Morningstar goes about assessing and examining this type of investing.

In this episode:

  • How ESG will change and adapt in a post-COVID world

  • Ways that Morningstar assesses ESG funds

  • Where the ESG marketplace is going in the coming decade

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Jon Hale: This crisis I think absolutely convinces them that they're on the right track as investors with their emphasis on companies that are better attuned to the needs of all their stakeholders, companies that are doing the right thing today by their employees and their customers and clients, their suppliers, the communities they do business in are the kinds of companies that are going to do better over the long run because they're focused on the right things, and they're not just narrowly focused on efficiency and maximizing profits for shareholders.

Michael Torrance: Welcome to "Sustainability Leaders". I'm Michael Torrance, Chief Sustainability Officer with BMO Financial Group. On this show, we will talk with leading sustainability practitioners from the corporate, investor, academic and NGO communities to explore how this rapidly evolving field of sustainability is impacting global investment, business practices and our world.

Disclaimer: The views expressed here are those of the participants and not those of Bank of Montreal, its affiliates or subsidiaries.

Manju Seal: I'm Manju Seal. We have with us today, Jon Hale, who is Morningstar's head of sustainability research. In that role, he directs their research into the environmental, social and governance investing practices of mutual funds and exchange-traded funds. An incisive analyst and writer, Hale authors the biweekly "Sustainability Matters" column on, which is widely read. He's regularly quoted by the media on ESG matters and speaks often on sustainable investing at industry conferences and other events. So, good afternoon, Jon. We are delighted to have you with us today.

Jon Hale: Well, thank you, Manju. This is nice to be here. Thanks for having me.

Manju Seal: Given that we are all thinking about the impact of coronavirus currently and it is foremost on everyone's mind, what are you seeing from your perspective?

Jon Hale: You know, ESG portfolio managers, of course, are investors first, and like everyone, I think they are concerned about the tremendous uncertainty surrounding both the containment of the virus and how long it could take to get a vaccine because that's all connected to consumer demand, and people have to be able to interact and to get their jobs back before they can spend money again. And I think the difference with ESG-oriented investors and PMs that I've talked to is that this crisis I think absolutely convinces them that they're on the right track as investors, and so, you know, I think this crisis and its aftermath is going to shed some light on who really is a good corporate citizen and who isn't, and I think we had already been seeing rising expectations for corporate behavior before the crisis. I think it's just going to continue in the aftermath, and so that's sort of what I'm hearing from ESG-oriented PMs and investors in the past month or so.

Manju Seal: When we think about the coronavirus and the kind of impact it had on financial markets given the time period of, say, January through March, have you done some analysis to be able to say these are the kind of funds that have done better than others or is that too short a time period to say we really can make a full assessment now, and let's see when the dust settles?

Jon Hale: Well, we will have to see when the dust settles, I think, to make a fuller assessment. But in the first quarter, the sustainable funds that I follow in my universe. These are open-end and exchange-traded funds, you know, available to US investors. There're about 311 of them currently, you know, in my database, and 200 and some odd of those are equity funds. They did outperform during March and during the first quarter on the whole, and I think it's interesting for, I think, for at least one key reason. I mean, on the one hand, you've got to say, "Well, they're equity funds, right, so they lost a lot of money in the first quarter just like any other equity fund," but I think the fact that so many of them did outperform helps demonstrate their ... The fact that investing with an ESG focus is something that can do well in all types of market environments because these funds were performing pretty well on average prior to the pandemic, but many of them had not been through a market like this, and not that many of them were around during the financial crisis. We've had a tremendous number of new launches in the past 5 years or so, so this was really the first test, and, you know, given the fact that there's, you know, kind of a long-standing myth out there that sustainable funds, the SRI funds that kind of preceded them underperformed. The fact that they were able to outperform during the first quarter, I think, was notable, and I think it will continue during the downturn, and just to give you a sense for the outperformance for the quarter, 70 percent of sustainable equity funds finished in the top half of their respective Morningstar peer groups, which are based on, you know, the area of the market a fund invests in, so US, non-US, large cap, small cap, et cetera, and so these peer groups contain both sustainable funds and conventional funds, and so sustainable funds were decisively overrepresented in the top halves of their respective peer groups, and even to put a little finer point on it, 44 percent of the sustainable equity funds finished in the top quartile of their peer group while only 11 percent finished in the bottom quartile of their peer group, so quite an imbalance. I mean, you know, like I said, on average, you would just expect it to be 25 percent of funds finishing in each quartile, so I thought that was notable, and so, you know, the question arises, "Well, why? Why did ESG do well?" and I think it's because high-ESG-rated companies tend to be less exposed to systematic risks, and certainly the onset of a pandemic, you know, very suddenly it’s an example of that. Why are they less exposed to systematic risks? Well, because I think being well prepared to address ESG issues is a great indicator that a company is managing risk with the thoroughness that is increasingly expected not only by shareholders but by other stakeholders as well, so it's not just a narrow focus on financial risk. It's on, you know, larger substantive issues, and companies that have done a good job of that, you know, tend to be the kinds of companies that are more resilient.

Manju Seal: So for our listeners, I think it would also be helpful to understand at this point, when you go through your analysis, and you've built this universe that you look at, how do you select these funds? What is the process for your analysis for sustainable investment funds?

Jon Hale: The thing to start out with to be clear about is that there is no sort of single template or approach for a sustainable fund. I think there is a perception in the broader fund industry that, or at least there has been a perception, maybe it's changing now, in the broader fund industry that ESG funds are all, you know, if not alike, then very similar. I mean, you know, I think for, like, investment intermediaries, whether it's financial advisors or, you know, folks that run platforms and due-diligence teams and things like that, they've tended to think that, "Well, when we evaluate ESG funds, we just do it on the same basis as we evaluate any other funds because they're all doing the same thing," kind of like a style focus. Like, "Okay, we're assuming most growth funds are doing something very similar, so let's just move on to looking at, you know, how well they're performing and what their risk-adjusted performance record looks like," and those sorts of things, so that's on the one hand, and then on the other hand, I think within the more focused, you know, field of sustainable investing for people who are working on it and thinking about it every day, I think there's a tendency to make it more complex than it is, so I was sort of shooting for a middle ground with my taxonomy that I've written about and described, really trying to keep it simple, but at the same time, trying to convey that all sustainable funds are not the same, so I have four categories of funds. The first one is I call diversified ESG-focused funds. These are funds for which, you know, ESG is a central focus of their security selection and portfolio construction. They may use some outright exclusions. Almost all of them use ESG ratings and analysis though in an integrated fashion to select securities and many, but not all of them, have pretty active engagement efforts by the way, which I think are extremely important, and if they're actively managed funds, you know, they also tend to have style tilts of some sort, growth, value, although what I'm noticing is that most actively managed ESG-focused funds employ a sort of quality growth style, so that's ESG-focused. Next, we have what I call diversified impact/thematic funds. These are funds that, you know, pursue specific themes, could be low carbon or gender equity or a variety of others, or these funds could be sort of really focused on only selecting securities that have some sort of measurable impact without maybe a specific reference to a limited number of themes, except a lot of them are now using the UN sustainable development goals as a framework for their impact assessments if not their impact focus, so some of them are just sort of saying, "We're subjecting our portfolio to an impact assessment. We kind of expect, you know, that we're investing in companies that have positive impacts, or at least their positives outweigh the negatives." Others are really using things like the SDGs to help them focus around certain themes, so many of these funds actually also look a lot like ESG-focused funds, but, you know, they've really added just in the last couple of years in most cases that has added impact dimension, and one thing that they do ... Well, virtually all of the impact funds also engage as shareholders, but they're all publishing impact reports that really attempt to, you know, describe and measure their impact for shareholders, so I think it's really important for transparency for them to do that. Third, there are sustainable sector funds out there. We know, you know, there's no standard recognized sustainable sector, but these funds are typically, you know, they're not well diversified across sectors, and so they look sort of like traditional sector funds, but they're focused on things like renewable energy, environmental products and solutions and services, climate-related solutions, green real estate. You know, there's several of those types of funds out there, and then finally, and I want to be clear about this one. There is this other group of funds that I don't designate as full-fledged sustainable funds. These are what I call ESG consideration funds. These are otherwise conventional funds that now include some level of literally consideration of ESG factors in their process but don't have an out-and-out ESG or impact focus, so that's kind of the basics. Like, think of sustainable funds kind of as an umbrella term consisting of ESG-focused, impact/thematic and sustainable sector funds, and then sort of outside of the, you know, full-fledged sustainable funds rubric sit these ESG consideration funds.

Manju Seal: So the ESG consideration funds, when you think about those plus the sustainable various types of funds you just talked about, the ESG-focused, impact/thematic and sustainable sector, do you find that this taxonomy that you all have adopted is quite different than often that is referred to in the industry that GSIA puts out there, right, and so I'm curious what sort of led you all to go down this path of simplifying it a lot more than what GSIA or the Global Sustainable Investment Review puts out, so it would be good to understand what are the differences and what took you down this path.

Jon Hale: So when I put this together, I sort of considered using those rubrics as a way to do it, but what I found is that when you're thinking about funds, that the breakdown was, I thought, a little too granular to truly get a sense of, you know, what a fund was doing. Like, there's always a list that says there's ESG integration funds, and then there's positive screening, and there's negative screening, so I guess what I noticed about the funds is that a lot of them do use a variety of those approaches. It's not just one single approach, so a lot of ESG-focused funds have exclusions. Some of them have quite a few negative exclusions. Others might have one or two. Some of them have none, but it's not really ... You know, it doesn't really, in my mind, detract away from the fact that ESG is really the focus of this particular strategy. Similarly, there's often a list that, you know, other taxonomies are just, you know, descriptions of different approaches to ESG. We'll list ESG integration and positive screening. Well, positive screening sort of refers to, you know, using ESG ratings or analyses of some sort and focusing on the leaders, the sustainability leaders where integration kind of implies that, you know, ESG is sort of fully integrated in the analyst's or the portfolio manager's mind at every level of decision. I think in practice, it's pretty hard to separate those two things out. In fact, when we first actually sent a questionnaire two summers ago to a number of funds in the US that we knew were focused on ESG, and we used those kinds of ... those options and asked them to just, like, check the box, and what we were getting back was just ... It was hard to even untangle because almost everyone selected ESG integration. Many said ESG integration, positive screening. Many said, you know, all three, but then when we tried to talk to them about, like, what and why they chose what they chose, we didn't find a lot of consistency, so those that said ESG integration only, you know, upon questioning would tell us, "Well, yeah, we also basically use some version of positive screening," and, "Oh, yeah, we do have a couple of, you know, basic negative screens," so anyway, I felt like some of those rubrics that sort of said, "Here are different approaches to ESG," I think they're useful and accurate in that sense, but to characterize funds as though they would only have one of those focuses, I didn't think was, like, you know, the actual reality when we looked into these funds, that most ESG-focused funds do, you know, make use of several of those types of approaches.

Manju Seal: Yeah. That make a lot of sense, so I'm wondering for our listeners out there, would you have some steps how to think about this? How does one plow through ESG data given that also a lot of what's happening in the industry today is integrating ESG data is a task that some of the bigger money managers or asset managers can undertake, so how does one go about this if you are a smaller boutique shop or a hedge fund, and you want to make this part of your analysis?

Jon Hale: A couple of things I guess I would say to that, my recommendation would be to not rely on ESG data providers to be who educates you about ESG and how you want to approach it, so I think what I've seen happen over the years is that, recent years, especially when more conventional asset managers want to, you know, want to start, like, doing ESG, so to speak, is they don't really have that, a clear sense of direction, and, you know, they start talking to ESG data providers, and that's who's educating them about ESG, and it becomes kind of a strange, you know, fit there. I mean, I think it's much better, and there's so much more information available today that it's better, I think, to figure out as an asset manager what kind of data you need to execute your strategy, your ESG strategy, and then to seek a match with the data providers that you think come closest to that, so that's one thing. I think the other thing is that there's a tremendous amount of ESG information embedded in what you get from data providers today. You know, obviously it's not just the top line ESG rating of a company, and so I guess part of my first point is that you might see, when you're thinking about, what are the material ESG issues that we think we, you know, want to assess, you know, sector-by-sector, industry-by-industry? Who's got that information? Who comes closest to being able to provide that information for us? And so there's some ... There are these broader providers out there, and then there are a number of more niche providers that they're also, you know, they're bringing in all kinds of big data and new data, and, you know, there's geospatial mapping going on to look at climate, physical climate risks and things like that, so there's so ... It's an avalanche of data, so I guess that's the other reason why I would say, like, focus on how are we conceiving of ESG? How do we want to execute in our strategy? And then, you know, go out and find data that's appropriate to that because otherwise you could find yourself just, you know, in a morass of so much data that we have out there, and it's hard to make sense of it all.

Manju Seal: I can't agree more with you, but for these products to become really main stream such that, you know, most 401(k)s can offer it, or often I'll meet folks outside of the industry who is very interested and keen in directly participating in these funds so that, you know, let's say the universe quadruples by 2030, and maybe we have ... Or more than quadruples, and we have $1 trillion worth of such funds out there. What needs to happen in your mind for us to get there?

Jon Hale: Yeah. It's a great question. I think about it both in terms of institutional investors and individual investors or maybe individual and smaller institutional, but I think big institutional investors, they have to overcome this hurdle that, I mean, for lack of a better term, is their sort of fiduciary hurdle that says, "You know, well, we can only take ESG so far." We have to ... You know, we get that ... You know, it's ESG analysis can be important in an investment process and kind of an everyday basis, but, you know, these bigger picture kinds of issues like thinking about systemic impacts over the long-term. We need more institutional investors to embrace that idea. Now a lot of them are. A lot of them are saying, "You know, we're willing to be sort of passive investor," and a lot of them are, you know, large passive investors. That means we are going to be investing in all these companies, virtually the entire market in perpetuity, so we have an interest in helping see to it that the kinds of systematic issues that are out there that could be addressed by the companies we invest in get addressed, and so I think more big institutions are doing that, but at the same time, with the actual investments, they're ... they feel like, "Oh, we're hamstrung by this idea of if we underperform a market-based portfolio, somehow, you know, we're in trouble, or we're not living up to our fiduciary duty," and so I think it's hindering their investments in more directly in impactful solutions, so that's the institutional side, so, you know, it could be helped by governmental, like, public policy that clarifies fiduciary duty probably almost more than anything. For individuals, and, you know, I don't discount individuals in the impact at all because collectively, you know, there's a lot of money that comes from individual investors. I think there's been several pinch points that have kept that ... You know, there's a tremendous amount of interest from individual investors in the concept of sustainable investing. They don't necessarily know how to do it or exactly even what it means, so one pinch point is financial intermediaries who need to get more up to speed on being able to talk about and educate investors about what it means and how to do it, and, you know, it's kind of one of the points that I was making regarding my taxonomy, but I've seen, you know, more and more advisors are getting up to speed on ESG. I get a lot more, you know, a lot more opportunities to talk to a lot more advisors today than 5 years ago for sure, and even when I'm in front of what I would call a conventional advisor group, you know, at a conference or, you know, in a setting where this is not an ESG-focused group, but a broader group, and I'll say, you know, how many of you are, you know, interested in this at all? How many of you have done this in the past? There's a lot more hands that go up now than there were just 5 years ago, so that pinch point may be being alleviated a little bit. I know a lot of sort of investment platform level, the platforms that these advisors, you know, select from. Certainly there's ESG initiatives going on virtually everywhere here in the states among large advisory firms to get the appropriate number and ESG options out there as well as education, so that pinch point I think is being alleviated. I think even more basic, there's, you know, until fairly recently been a lack of actual fund options. That pinch point has been alleviated a bit in the last 5 years. Like I said earlier, I have 311 funds right now in my list of sustainable funds in the US. Quite a few, you know, but it's not 7,000, so I don't ... You know, it's hard to kind of say how big the universe needs to me, but to me it's gotten to where it's getting to be to the point where, you know, there's plenty of choices out there to choose from. There's still a lot of young track records out there, and like I also said earlier, there's perhaps some mismatch between the options and what investors really want, but that's improving. I think the performance, any performance concerns have been largely alleviated. I don't really hear too many folks saying that there's any kind of, like, fundamental problem with ESG performance that should keep someone who wants to invest that way away from doing that, so I think that's ... You know, and stuff like, you know, the first quarter of this year helps alleviate that issue, and then I guess finally there's ... You just got to understand too there's been quite a bit of inertia, you know, involved in investing, both for individuals and even for institutions as well. It just takes a while from the point where you become interested in sustainable investing to the point where you are really looking into it to the point, you know, where you actually have a chance to make the investment.

Manju Seal: When you're looking outside of the United States, what does that universe that look like for you in terms of what you track and capture?

Jon Hale: Yeah. Well, we're getting more up to speed on the rest of the world, but one of the things we're finding is that in Europe and the UK, there's a lot more funds that do this. It goes into the thousands, so there are a lot more opportunities for investors. It's a lot more ... It appears to be a lot more mainstream for both individual investors and institutions, so, you know, the news in Europe is good. The other thing is that performance patterns tend to be very similar, so those funds, you know, tend to be performing on average perfectly in line if not better than their conventional counterparts, so yeah, I mean, it's a positive story, definitely in Europe. Other areas are a little, you know, even slower probably than the US, whereas, say, in Australia there wasn't much activity to speak of 5 years ago. There's a fair amount now, and same goes for Canada, Asia, that it's mainly an institutional thing there, but, you know, the US is the biggest market. It's, like, I think the real key to really making this a truly big thing, but, man, we have so much room to grow in the US is the thing about it, and whether we'll get their remains to be seen.

Manju Seal: And how about green bond funds? Do you look at them much, or is that something that Morningstar tracks?

Jon Hale: Well, yes. Green bonds and green bond funds are interesting. You know, I'll also just say even beyond that, the whole fixed income side of this is actually pretty interesting. There's definitely a growing impact component to what I would call, you know, sustainable fixed income investing that, you know, you can, you know, in a more straightforward way in some ways than with stocks, you know, you can look at the actual use of proceeds of any bond and connect that with impact aims that you might have for a fund, so there are a lot of ESG fixed-income funds in the US that are doing that, and so they would include green bonds. They would also have some conventional bonds in their portfolios. Like, for their corporate sleeve, they would still use ESG information to evaluate companies, but there's quite a lot of focus on green bonds and other social bonds. You know, I think green bonds, it's a great way for companies to attract investors and potentially get better pricing for their bonds. You know, it's kind of plain and simple. It's a little bit of a different question over the long run whether that is going to result in good performance for green bond funds, you know, because green bonds could get overvalued, and so that's kind of I think an issue that's kind of hanging out there with green bond funds. I like to look for those, and most of them are doing this, that have some flexibility to kind of range a little bit outside of the green bond, you know, the pure green bond exposure just in case there's supply issues or pricing issues that, you know, they need to address on behalf of their fund, the shareholders, but, you know, it's a ... I think it's a great way for bond investors who are interested in sustainability and impact to invest because, you know, basically you can structure these funds to where on a credit quality and interest rate risk dimension, they can be pretty much the same as core bond funds, so you're getting similar exposure to those kinds of characteristics.

Manju Seal: So I'm just wondering as you look at the next 10 years or 20 years, what are some things that come to your mind in terms of what you would like to see, and what are some things that would enhance and facilitate the growth of this market and also allow us to see that there is a lot more trust and transparency because I think often we hear about the social washing, green washing concerns or not making enough returns perhaps? I think we've come a long way from that conversation now, but I still do come across that, so there are all these various concerns or attributes made towards this nascent growing market, so what is it that you would like to see?

Jon Hale: Yeah, so I think I would like to see reflected among investors the broader attitude of society towards what appropriate corporate behavior and corporate purpose should be, and by that I mean, you know, we've got a mismatch, or we've had a mismatch in that recently, and I think it's had negative effects on society and the planet, so, you know, if you look, there's a company called ... It's a non-profit called Just Capital that surveys Americans on their attitudes towards corporate America, and, you know, it's very clear from those surveys, and it's not a partisan thing. It's not ... You know, there's not a lot of regional variations. It's very clear that the expectations that people have for corporate America is to treat their stakeholders with the same level of care and respect based on performance metrics too as they do their shareholders. You know, we hear very often ... We've heard very often just really in the past 6 months or so a lot about this notion of stakeholder capitalism, and that, you know, we need to be moving in that direction, and perhaps we are moving in that direction, and so that's, you know, what I would like to see a decade from now is sustainable investors really evaluating companies that have made claims that said, "Yes, we agree. We want to be focused on our broader corporate purpose and on our stakeholders as much as on our shareholders." Are they doing it and holding their feet to the fire instead of the situation we have today, which is nowhere close to that, and I think related to that, the huge issue, obviously, of climate change is the idea that through sustainable investing, we've helped companies become part of the solution to mitigating climate change. You know, this idea that corporations that we invest in are, you know, such large, powerful, influential institutions, that they need to use that as a force for good to make global capitalism work better for more people and the planet, and so that's what I would like to see. I think it's going to take more investors being more adamant about that. I think it's going to take more corporate leaders who are willing to make that transition from shareholder primacy to the notion of stakeholder capitalism. I think we're going to need ... and I think we're going to need policy support for it. Just two examples of that, we need to amend ERISA, to clarify that ESG funds can and should be in 401(k) plans. It's ridiculous that that's not the case, and it's kind of a political football. Like, one administration will say, "Yes, that's appropriate," and then others ... The next one will say, "No." The SEC needs to preserve and protect shareholder democracy, not roll it back as it's trying to do as we speak today because shareholder engagement is exceedingly important in this move towards stakeholder capitalism, and I just think bottom line, and I've already heard this from a number of corporate executives that as they perceive their shareholder base as tilting more and more towards sustainable investing, it helps them transition to a, you know, broader, long-term focus on sustainable value, on their stakeholders, on being able to address issues like climate change, so that's kind of my vision of where I'd like to see things go in the next decade, and, you know, I'm hopeful that we'll get there.

Manju Seal: Definitely. Hopefully, yes, we will get there sooner rather than later, and given how far we have come in the last 10 years, I'm confident that we will continue to make some strides in the next 10 years. Thank you so much for your time, Jon. This was absolutely amazing to be able to spend our time with you today, and thank you for being our guest.

Jon Hale: Well, thank you so much, Manju, for having me.

Michael Torrance: Thanks for listening to "Sustainability Leaders. This podcast is presented by BMO Financial Group. To access all the resources we discussed in today's episode and to see our other podcasts, visit us at You can listen and subscribe free to our show on Apple Podcast or your favorite podcast provider, and we'll greatly appreciate a rating and review and any feedback that you might have. Our show and resources are produced with support from BMO's marketing team and Puddle Creative. Until next time, I'm Michael Torrance. Have a great week.

Disclaimer: The views expressed here are those of the participants and not those of Bank of Montreal, its affiliates or subsidiaries. This is not intended to serve as a complete analysis of every material fact regarding any company, industry, strategy or security. This presentation may contain forward-looking statements. Investors are cautioned not to place undue reliance on such statements as actual results could vary. This presentation is for general information purposes only and does not constitute investment, legal or tax advice and is not intended as an endorsement of any specific investment product or service. Individual investors should consult with an investment, tax and/or legal professional about their personal situation. Past performance is not indicative of future results.


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