ESG Integration with MSCI

Linda Rogers: [00:00:00] My name is Linda Rogers, and this is Investing Forward.

Linda Rogers: [00:00:38] Hi! This is Linda Rogers coming to you from Atsugi, Japan. I'm the owner of Planning Within Reach. While I'm based in San Diego, I'm a military spouse and my husband was recently stationed in Atsugi during the covid-19 pandemic. I have not been able to explore this beautiful country yet, but we're all safe and healthy, and I hope you are, too. This podcast is designed to educate investors on how to invest for an environmental and social return, in addition to a financial return. We are in the midst of the covid-19 pandemic. Millions have lost their jobs, companies are struggling to adapt and survive, and we don't know when or how this is going to end. That being said, now is not the time to put our head in the sand. Only once we fully understand a risk, can we capitalize on opportunities. Joining me today is Joe Pendergast from MSCI. We are chatting about ESG factors. ESG was in the news recently because many ESG indexes outperformed traditional indexes during the market correction. We can never put too much weight into short-term performance, and ESG is meant to be a long-term strategy, but still, this is a topic worth exploring and getting us started with this season. Be sure to stay tuned after the interview where I chat with my friend and fellow advisor, Jayson Owens from Bright Road Wealth Management in Anchorage, Alaska, to see how he is integrating ESG factors into his portfolios. So let's get started with Joe Pendergast from MSCI.

Linda Rogers: [00:02:01] Are you getting settled back home?

Joe Pendergast : [00:02:02] Yeah.

Linda Rogers: [00:02:03] (aside) When I first spoke with Joe, he was temporarily displaced as he was out of town when covid-19 started to explode in New York City, the city where he lives and works. He was able to hunker down in New Jersey with his parents and fiance and has since made his way back home to the city. Of course, things are still anything but normal there.

Linda Rogers: [00:02:21] Thank you again for joining me. Tell me about MSCI.

Joe Pendergast : [00:02:25] Yeah. So, thank you again for having me. So just to start about MSCI a little bit. So we're a firm that is really designed to serve investors, right. We serve investors by providing decision support tools. So what do those kind of things look like? Most investors are going to be familiar with us from our global indexes, many of which underlie ETFs and passive and actively managed funds. We also supply investors with analytics, data and research that allows them to better build portfolios for their end-clients. So think of us more or less as a supplier to the people who build portfolios for clients.

Linda Rogers: [00:03:04] Great. How did you end up working there?

Joe Pendergast : [00:03:06] Yeah. So I studied, in school I studied accounting and finance in school. That was at least over eight, nine years ago at this point. I always had an interest in understanding how businesses operate and work. And right after school I found Vanguard - I grew up in Philadelphia - so I found Vanguard and was there for seven years. I spent time in product roles, some time in business development roles and relationship management type roles, and then my fiancee and I decided to move to New York City. So I followed her up here, found MSCI shortly thereafter, and it was a very smooth transition.

Linda Rogers: [00:03:42] Nice. Well, could you start off our conversation by sharing what ESG factors are?

Joe Pendergast : [00:03:50] So at the highest level, we define ESG as really just the consideration of environmental, social and governance factors alongside financial factors when you're making investment decisions and within that process. So then you take those factors, and you know, it really kind of depends upon what your end investor objective would be. We identify three of them - so integration, values based investing and impact investing. We think first about integration. What that is is just taking into account ESG risk and opportunities with the intention of enhancing your long-term risk-adjusted returns. You're looking to outperform the market by integrating ESG factors. Values based investing, which is a lot of where ESG has kind of come from in the past, is the idea of investing in alignment with you or your organization's goals. So saying you wish to or wish to not invest within a specific industry or business activity. And then the final one would be impact. So it's just investing with the aim of supporting positive social or environmental beliefs. That one is I think a little bit harder for some investors to grasp, but it's probably the one when you're thinking about and speaking with investors the one that they would most wish to aspire to. Right. We see ESG across those three different objectives growing significantly. It's been around for quite some time. It goes back to the 1960s and really started with that values based aspect of excluding certain sectors or activities. And now it's as robust as really those other two. So ethical considerations in alignment with values remains a common motivation of many investors, but the field is rapidly growing and expanding beyond that.

Linda Rogers: [00:05:38] So these ESG factors can be everything from how prepared a company is for climate change, how well they handle data security, their executive pay structure. Do you look at the same factors for every company, or do you have a list of factors that are more important to a company depending on their industry?

Joe Pendergast : [00:05:56] This is again, a key area that we want to highlight when we talk about our our ESG rating process. It's really about 37 key issues across the ES&G pillar's that we look at when we're analyzing and rating firms. So it starts with governance. Governance, if you think about it is universally applicable, meaning every firm is more or less the same in the way they think about, or more or less the same, in that they have a board, they have structure around executive compensation, they implement and practice certain accounting practices. And with that, we rate every firm across that across those key issues. Where you get some differences in where our system is different is that in the environmental and social pillars, not all of those key issues are relevant for each firm in the industry. And what MSCI does is looks to evaluate which of those factors for each one of those industries is most relevant. So I said earlier, there's about thirty seven key issues. On average, it's about four to eight key issues within environmental and social pillars that are relevant for a specific industry. And the example, we have a number of examples that we like to give, but one to just kind of tangible is think of a firm like Coca-Cola in the soft drink soda industry. Right. They are more exposed to an issue in the environment such as water stress, whereas they are less exposed to an issue such as like toxic waste, for example. Within our model we overweight something like water stress, as well as another issue for them would be packaging and plastics and packaging that they use in the production of their products. So those are issues that we would overweight versus something, like I said, for toxic emissions or even like on the social pillar or something like an opportunity of access to finance. It's not relevant to a firm like Coca-Cola, but that might be relevant to a different industry.

Linda Rogers: [00:07:53] Yes, that makes sense. Do you also engage with companies, meaning are you in communication with them during the ratings process?

Joe Pendergast : [00:08:01] Yeah. So this is another kind of, I think differentiating factor for MSCI's ratings process. And this is like a really interesting balance I think across the industry. So at a high level, we do not consult with companies when we rate them. We, when we conclude our analysis, we then go and provide this information to the company before we go and publish it to our clients and investors. Really the intent of this is to give the company a chance to respond to some of our analysis with any perhaps missing data or and it has to be publicly available data. But any missing information that we didn't catch within our analysis. We just give them more or less a fair shot to see and do the rating before we provide it out to the public. I think more than like just trying to think about their rating or approve their rating or work with us to try to really kind of game the rating, in some ways, we think the biggest change within the industry has been how much information these companies are now willing to provide outside of just mandatory disclosures. Right. I think, I think ones that I've seen - I can't say this is our information, but I've seen it - I think over 10 years ago, something like 10% of the firms within the S&P 500 willingly provided more ESG information than what was mandatory or required to be disclosed. I think at this point, it's upwards of 80% of firms in the S&P 500.

Linda Rogers: [00:09:26] Yes, I've heard something similar. And there's no doubt that companies are facing increasing pressure to disclose more and more of this ESG data. So one of the headlines during the covid-19 crisis was that many ESG indices outperformed broader traditional indices. Did you see the same thing?

Joe Pendergast : [00:09:44] Yeah. So we did notice a similar dynamic. I think it's interesting in that the covid-19 outbreak, while it's, you know, obviously occurred short term and limited in scope, we're still going through it right now. We're only looking at a few quarters or really one quarter of information, four months of information at this point. But it was the first really, you know, from an ESG perspective, the first real world test since 2008 of the resilience of companies with high ESG ratings. So we looked at performance and we just had a blog come out I think it was last week or this week. We looked at the performance of a variety of MSCI ESG indexes through March 31st, which was somewhat of the depths of the drawdown in the global markets. And we looked at a variety of these indexes and saw across different methodologies and across the global investable market, ESG proved really resilient. It outperformed parent indexes at least year-to-date. You know, it's not going to be the case in all markets going forward, but it was a very powerful reminder of some of the value and style factor tilt of ESG or what it does for a portfolio. The, you know, the one other note within that is that a common criticism of ESG tends to be how ESG strategies will allocate across sectors, notably within the energy sector. And given that energy has had challenging performance, and still has had challenging performance year-to-date, it's worth noting that a lot of these ESG indexes that we use are sector neutral, meaning they're not systematically just under-weighting energy or excluding energy stocks from the benchmark or from the, you know, from the universe. They're incorporating energy allocations in alignment to the market, meaning that any underperformance or overperformance as a result of excluding energy is just not the case.

Linda Rogers: [00:11:44] Great. And the dollar amount going into ESG strategies has grown dramatically. Any thoughts on why that's the case?

Joe Pendergast : [00:11:51] I think it's four things. So it's one, investors have kind of grown less tolerant of these types of risks as opposed to where they were in the past. If you look back to, and this is going back a ways, but like the Exxon Valdez oil spill off the coast of Alaska, it's over 20 years ago at this point. Back then, there was barely a dent in Exxon's stock price as a result of that incident. You can point to a number of different cases over the last few years where firms have had major corporate incidents and investors have reacted by, you know, obviously denting the share price quite a bit. A couple that come to mind would be Equifax - that was a big one. Volkswagen another. Just a series of these over the time that investors have basically become less tolerant of firms exposing themselves to this type of risk. And then with that, ESG has kind of developed a longer track record. We look at some of our indexes have been around for about twenty eight years. ESG indexes that is, and have shown outperformance versus the market. So ESG has just been around longer so its given investors more data and information to show its performance through time. And then a couple others - so large investors are allocating to ESG. We see this with large public pension plans and a number of global assets owners who've allocated to MSCI ESG indexes both on the equity and fixed income side. The growth there has been substantial. And then the one I guess I would really like to hone in on is that our ratings, and not just our ratings, but ESG ratings have substantially improved over time.

Joe Pendergast : [00:13:31] I think the one stat I would give there is that our coverage, this is again looking at MSCI, coverage of like the high yield index, which would be a global fixed income, has gone from something like in the range of like, say, 30 percent, maybe 10 years ago to upwards of seventy five percent at this point. So we're covering more and more firms with this ratings system, which tells you how robust the ratings approach has really become.

Linda Rogers: [00:13:57] Something that is often tracked is fund flows. It is essentially a way to follow where the money is going. What really surprised me was that in March, when things were really volatile in the stock market, the flows into traditional stocks dropped sharply, which you would expect. Investors get scared when things are volatile and stop saving or may exit the market. But that was not the case with the money going into ESG investments. The flows into ESG stock ETFs, for example, continued to rise steadily during the same time period. I don't think anyone can know definitively as to why that is the case, but I am curious if you have any thoughts on what drove that.

Joe Pendergast : [00:14:38] Yeah, I think, and this may not be from MSCI's perspective but a little bit from my perspective in terms of what we've kind of seen in both talking to clients and just kind of through a number of studies that are available right now of year-to-date flows. So, a couple of things, especially with the ESG. Last year was remarkable in terms of the growth of ESG. So, you know, MSCI saw its assets in ETFs using an ESG index basically triple over the course of 2019.

Joe Pendergast : [00:15:13] A lot of those investors are buy and hold investors, right. ESG tends to support long-term investment outcomes and not necessarily short-term sort of market exposures. So with that, there has been a number of studies really that these types of investors, right, buy and hold investors, I think like most notably of wealth managers are guiding clients through strong behavioral coaching, and that's probably most exemplified during a time of crisis like this. So I think what you see is a lot of wealth managers rebalancing back into equities. And with that, I think that was a chance, both from a tax loss harvesting perspective or an opportunity to move into something a little bit more systematic and potentially more resilient. And I think that's where ESG has kind of become an opportunity for investors.

Linda Rogers: [00:16:05] There are other rating providers that provide ESG ratings, such as S&P and FTSE. What makes MSCI different?

Joe Pendergast : [00:16:14] Yeah, we get this question all the time. So I think there's two things. It's material relevance. So as I mentioned before, with the key issues, MSCI is going to focus on what is materially relevant to firms within an industry. Right. We don't necessarily want to rate banks and other financial services companies on how well they're managing water stress. Right. It comes back to what is most financially relevant to investors. So that's accounted for within our ratings, within those key issues and within each industry. Then the other part would be where we're sourcing our data as substantially, or is rather different, than some of the other providers out there. If you think about the types of data that we get from companies, it really comes from three sources. It's going to be mandatory company disclosures, voluntary company disclosures, and then finally, where we get the majority of our data at this point, it comes from alternative data sources. It's important in our eyes not to just rely on what companies are saying, but try to take into account some of the actions behind just a lot of what they're going to be disclosing. And we think it helps investors avoid bias from what the companies are providing to us. So we want to account for that in our rating.

Linda Rogers: [00:17:33] Great. Anything else you want to share before I let you go?

Joe Pendergast : [00:17:36] Yeah. So I want to thank you for inviting me on today. This was wonderful. I think the thing I'd like to offer is at our website, MSCI.com, or alternatively you can go to ESG101.com. We have a great website just to learn more about ESG investing, learn a little bit more about MSCI, and just a little bit about the research that we put out there. And I'd love to make that available to you and your listeners here. And thank you for having me.

Linda Rogers: [00:18:05] Again, this is Joe Pendergast from MSCI. And I will have the links that he mentioned on the Investing Forward Podcast website. Next up, a conversation with my friend Jayson Owens from Bright Road Wealth Management in Anchorage, Alaska. Go ahead and introduce yourself.

Jayson Owens: [00:18:23] Hi, I'm Jayson Owens from Bright Road Wealth Management. We have offices in Anchorage and Tacoma, Washington, and work with clients actually all over the country, from DC to L.A., to the far north into the Arctic Circle. In my free time, I like to go out and play in the rivers and the mountains with my family and things like that. I still have a side job from my old days of outdoor venture guiding, which I did for years and years. And so I teach wilderness first aid classes for an organization called NOLS, which is the National Outdoor Leadership School. So I've actually flown all over the world to teach these two or three day wilderness first aid courses, which is super fun.

Linda Rogers: [00:19:05] Jason and I are in a mastermind group, which is essentially a study group with a cooler name, and we focus on impact investing. So you listened to the interview with Joe. Was there anything that stuck out to you?

Jayson Owens: [00:19:19] I was really surprised that their research - I can't remember exactly what he said, but it was essentially, oh, we don't ask the company about themselves. And I was like, that's genius. Of course, you wouldn't ask the company about themselves because they're just going to give you the shiny resumé, you know, and show you what you want to see. So I really was impressed that it's like that's not even part of their process to me. I also didn't realize that they were so, I guess, proactive, in the ESG space.

Linda Rogers: [00:19:50] Are you integrating ESG factors into your investment process right now?

Jayson Owens: [00:19:55] We are. You know, we're primarily a DFA shop, so we're using mostly DFA funds. And it's been really exciting.

Jayson Owens: [00:20:02] because DFA is coming out with more sustainable funds and ESG funds.

Linda Rogers: [00:20:08] For those who don't know, DFA stands for a Dimensional Fund Advisors. DFA is a private investment firm headquartered in Austin, Texas, and individual investors can access DFA funds through financial professionals, retirement plans, or certain 529 plans. Jason, are investors coming to you asking for ESG integration or impact investing?

Jayson Owens: [00:20:32] So 50 percent of my clients are pleasantly surprised when they come, when they hear, that we can tilt the portfolio towards sustainability and exclude the kind of companies that they want to exclude. They're excited about that. Maybe twenty five percent of my clients don't care either way and are not really that interested in hearing about it. And then the other 25 are scared that there's going to be some kind of underperformance to do what they want to do, you know, to to exclude the companies they want to exclude they're afraid that they're leaving retirement funds on the table and they're not gonna be able reach their goals. And so in that case, it's really just an education process, just as everything in our world is. Particularly about investments, because people have been miseducated so grossly.

Linda Rogers: [00:21:20] I would say that I am seeing a similar breakdown.

Linda Rogers: [00:21:23] Clients don't ask about it because they don't know about it or they have an old assumption that there will be a performance penalty. There was definitely an assumption in the past that socially responsible investing funds, which is another name - so we'll talk a lot about that on the podcast - is all these different names you might hear - but socially responsible investing funds would underperform the market. That has proven not to be the case. And thousands of research papers have come to the same conclusion. Portfolios that integrate ESG factors do not suffer when it comes to performance. Things that I have found that have really resonated with clients personally are the Exxon Valdez spill that Joe mentioned. For those who don't remember, Exxon Valdez had an oil spill in 1989 and there was virtually no effect on the stock price. Compare that to the BP oil spill that happened in 2010 and BP's share price dropped 30%. Another example along those lines is that more CEOs were forced out for ethical lapses in 2018 than they were for poor financial performance. That just would not have happened 10 years ago, even though there was always unethical behavior, because the standards have just changed. There's more demand for transparency and accountability. And there's so many examples of factors like high employee turnover, poor data security, lack of an independent board of directors, the list goes on - that affect stock performance, but they were once considered to be unmeasurable or just not tracked consistently. So ESG integration is filling that gap by just helping investors measure and systemize things that traditional financial analysis doesn't always capture.

Jayson Owens: [00:23:03] Yeah, well, I will say that I'm very excited about the MSCI ETFs because we have a lot of hourly clients that we want to give them a sustainable portfolio and we can't because there's not enough out there in the ETF space and they can't get DFA on their own. So it's we want those we want those sustainable ETFs. We don't feel right now that we can build a great portfolio exclusively with with sustainable ETFs. So we're excited to see what they bring to the table for sure.

Linda Rogers: [00:23:35] Actually, that is a great point. I'm glad you mentioned that because I know for the ESG integrated portfolios for my clients, there are two to three traditional funds in the portfolio because I could not find a suitable ESG replacement for RIETs, for example, so that's real estate investment trusts, there are some interesting REITs with an impact focus, but not with the same risk return profile for what I needed, or they have a very high minimum such as one hundred thousand dollars, or they require the investor to be something called an accredited investor. So these are things that we will touch on in more detail on the podcast, but you make a great point. And with that we are at our time. So, Jason, is there anything else that you want to share before I let you go?

Jayson Owens: [00:24:19] Yeah, I think obviously our website, BrightRoadWealth.com is a great place to look. It's kind of boring and says a lot of things that websites say. So if you want to see something more interesting, I post a lot more interesting things on my LinkedIn page, Jayson Owens CFP, the Facebook page professional page where I post a lot, maybe a little more risky, interesting things than I post on my LinkedIn page. But yeah. And you can, you can register for our webinar on our website. There's an events button and you can just register for that. The webinar coming up on May 26th is called "Life After Retirement". And so it's the third in our series of sort of retirement prep. We previously talked about how everyone focuses on the day. It's like getting married, right? It's like the day.

Jayson Owens: [00:25:12] But really what you needed to know about getting married is how to handle everything after that day. Like, the wedding is not you didn't really need to be prepped for that. It was like a party, right?

Jayson Owens: [00:25:22] So so that's what this session is going to be about. It's like, what does it look like to go from being a frugal saver your whole life to becoming a spender? And how is that?

Jayson Owens: [00:25:33] You know, how do you cope with that? Because that's a thing people don't think about. They just think, what will I do with my free time? And then they have in their mind a hobby that lasts like three months, you know, and then they have this whole other life that they haven't figured out and they haven't laid out a plan for. So that's we're gonna be talking about.

Jayson Owens: [00:25:49] What are the things that you didn't think about coming to this retirement thing and the finish line is really just the beginning.

Linda Rogers: [00:25:58] Absolutely. Thanks for sharing your perspective and hopefully you will be on again soon. You can find Jayson's information and the other links mentioned today at InvestingForwardPodcast.com. My name is Linda Rogers. You were listening to Investing Forward. If you liked what you heard, leave us a rating, subscribe, and stay tuned for next time.

Linda Rogers: [00:26:57] Linda Rogers is the owner of Planning Within Reach, a Registered Investment Advisor. Planning Within Reach produces the podcast and makes it available on its website and through other distribution channels. Linda Rogers and any guests on the podcast are providing their own views and opinions and are not necessarily the views and opinions of Planning Within Reach. Nothing on the podcast should be construed as a solicitation or offer or recommendation to buy or sell any security. Investment advisory services are only provided to investors who become Planning Within Reach clients pursuant to a written Investment Management Agreement. Clients of Planning Within Reach may hold positions in securities discussed in this podcast. Past performance is no guarantee of future results. All investments involve risk and may lose money. The Investing Forward Podcast is for informational purposes only and should not be relied on for any investment decisions. Consult with a financial advisor, accountant, attorney, or conduct your own due diligence.