The ESG Update Episode 18: The First Annual ESG Trends Report
If you’re interested in the most prominent trends happening in the ESG advisor community, listen in to this special edition of The ESG Update! We welcome Victor Orozco of Bair Financial Planning to join us as we officially release the findings of the Change Finance ESG Asset Allocation Trends Report.
Transcript
This transcript has been edited for clarity.
Dan Carreno, Change Finance:
Welcome to the ESG update presented by Change Finance. I'm Dan Carreno.
Brittany Damico, Change Finance:
And I'm Brittany Damico
Dan Carreno, Change Finance:
Brittany and I manage the business development efforts at Change Finance. We are an ETF provider dedicated to environmental, social and governance investing. Our mission is to help investors align their portfolios with their values without sacrificing returns, Brittany, how's it going today?
Brittany Damico, Change Finance:
It's going good. Going good. I'm excited that it's starting to get a little bit warmer here in Seattle.
Dan Carreno, Change Finance:
This week we are dedicating the entire episode to reviewing Change Finance’s new ESG Asset Allocation Trends Report. To help us with that Victor Orozco is going to be joining us. Victor is a managing partner at Bair Financial Planning, he sits on the investment strategy committee for The Wealth Consulting Group, and he co-manages their High Impact Portfolios there. Victor, how's it going?
Victor Orozco, Bair Financial Planning:
It's going well.
Dan Carreno, Change Finance:
Okay, great. Well, Victor, thanks so much for being here and we're just going to dive right in to our ESG Asset Allocation Trends Report. I know that's a bit of a mouthful, but by way of background Change Finance our analysts here did a bit of research on some of the prominent trends that are occurring in terms of building portfolios for investors and aligning those with environmental, social and governance principles. What we did is actually relied on a whole database of proprietary Portfolio Impact Analyses. These are reports that we run on behalf of financial advisors to allow them to show to their clients how their portfolios may or may not align with their values. It was a rich database of information, and we thought that it would be very useful for other investors to hear about the macro high-level trends that are occurring. So just to set the stage in terms of the sample data here – number one, the analysis that we are able to perform is only relevant to equities. So you won't be hearing any information about trends on fixed income and on the bond side of the spectrum. Also, all of the analysis that we did was specific to ESG oriented portfolios. We did not include any analyses on more traditional asset allocations. After doing all that, we ultimately came up with the sample set of 55 different ESG funds and ETFs that are really the most popular products that are being utilized by advisors and investors out there and they are coming from 27 different asset managers.
So the first finding was that despite the proliferation of ETFs in the marketplace, investors that have more of a dedication to environmental, social, and governance investing still seem to have a preference for mutual funds. In our analysis, 60.3% of the products that fell into the sample were mutual funds versus 39.7% being ETFs, which we largely attribute to the mutual fund companies that fell into the sample, being those companies that tend to be more dedicated to this style of investing. These are companies like Calvert companies like Parnassus Pax. Victor, I'd be curious to hear your feedback and if that's what you would have expected?
Victor Orozco, Bair Financial Planning:
I would, but then I also think you're getting a new wave of a sustainable investing advisor that is looking for maybe more tax efficiency and all other characteristics that may come with the ETF market. Maybe they want to be a little bit closer to an index, right? They don't want a big tracking error and it's kind of a good, better, best way to approach this. Maybe not all advisors, all shareholders want the advocacy components that may come with this space. They just want to have an initial screen and start from there. But I think the solutions are going to represent the advisors that come to market.
Dan Carreno, Change Finance:
Yeah, that's great feedback. Of course, I think one of the other things that factors into that is fees, right? We looked at the weighted average portfolio expense ratio across all the different portfolios that fell into the sample. Again, keep in mind, these are all ESG oriented portfolios and the weighted average came out at 56 basis points. So not a lot of sticker shock there. I think it's kind of eroding that perception, that “ESG, ah, yeah, it's great, but it's really expensive”. I don't think that's really going to shock a lot of people and frankly it probably would have been lower if not for just a couple of funds that tended to be a bit more prominent within the sample that really elevated that expense ratio. So suffice to say that if one wanted to come in much lower than that 56 basis points, it’s certainly possible. What do you think of that, Vic?
Victor Orozco, Bair Financial Planning:
With that, when we’ve seen what we've seen in the last few years there are a lot of the capital gain distributions. The phantom cap gains that get distributed to shareholders have been pretty high over the last couple of years as well. So even to amplify the tax efficiency side of it and the fee side of it from taxable accounts, I think that's definitely a big part there. When it comes to the expense side of it and the economy’s scale as we grow this base, rather it's new investors or some of the larger fund names repurposing old funds and slapping a sustainable investment mandate or ESG label on it – now has mass scale of assets in the old fund that they repurposed that they could actually have that pricing power, right? So I think it's all getting achieved and moving the right way, maybe for different reasons. Ultimately, hopefully it passes onto the shareholder where it could be a cost-effective. I know with our fund partners out there, there's a lot of hard work from a qualitative standpoint of engagement, shareholder resolution filing that there’s a lot of sweat equity earning that expense ratio as well. So we have to also respect the work that comes with that, that you would not get in a non-ESG, more of a traditional kind of fund.
Brittany Damico, Change Finance:
Absolutely. We also were pulling some prominent trends. What we found were that 25.8% of advisors are using global funds in lieu of international and emerging markets. We also found that approximately half, 48.4%, of allocations were foregoing growth and value allocations in favor of blend products. We also found that a vast majority at 80% of the allocations incorporated some form of thematic fund into their allocation, which is not surprising in the ESG space. And when we broke down those thematic trends, what we found were that 55.6% of the allocations were invested in some form of climate or clean tech, that 15% we're investing into gender lens, 14.8% were investing in water. And 3.7% were investing in vegan-oriented products.
Victor Orozco, Bair Financial Planning:
Yeah. So a lot to cover there. I think from the allocation and style trends you had mentioned from a global standpoint, we know most advisors like the easiness of the Morningstar style puzzle pieces. The large cap, the developed, the EEM, and global sometimes tends to trip up strategic allocation committees. Even though you can just do the math and say most of the time, it's pretty 50 / 50, and you just do the math that way. I can see how there's definitely a big lopsidedness in this when it comes to global versus a la carte Morningstar style pieces. Growth and value, I think this space has very limited choice when it comes to overweighting a particular style, right? They tend to be core and more even balanced. I think this might just be a reflection of what's exists in the marketplace. And hopefully now with the short-term run-up we've seen on the value, small cap, mid cap size, maybe that will be an opportunity to increase some more opportunities in the marketplace for more solutions. By the time they come out, maybe it's too late and we have a reversion again, but ultimately I think it's all a reflection of what's available in the marketplace. As more advisors adopt this style or more clients come to market with this, then having those strategic over-weights and tilt of funds may be requested from the bottom up to the fund partner. So maybe there's more movement to be had there.
Thematic funds, they're the fun ones. There's obviously a lot more themes that need to be addressed in the marketplace when it comes to social justice, right? That's one of the big, big issues that have always existed, but in regard to make it an investible solution and top of mind, there's more work to be done. I think others, you said, veganism making it to the list - I don't know how many other themes exist in the space outside of the ones that are currently listed. I think it's also a by-product for what exists in the marketplace, and hopefully we can build more robust options out there that address that. Essentially the fund partners in this space all include these types of concepts in these lenses, right? So in a way they're kind of all addressing these issues.
Dan Carreno, Change Finance:
The next data points here revolved around fossil fuel free funds and portfolios. By way of disclosure here, the definition of fossil fuel free that is being implemented is companies that own, process, extract, or burn fossil fuels for electricity generation. So a little bit more of an encompassing definition, but within that framework only 20% of the sampled funds and ETFs could be considered fossil fuel free and since, of course, a relatively small portion of the funds and ETFs are meeting that definition, it becomes that much more difficult to actually build a comprehensive asset allocation. So only 6.4% of the portfolios that we looked at could have been considered comprehensively fossil fuel free. We believe that this is number one, a way that certain advisors continue to differentiate themselves in the marketplace. It's certainly something that a lot of investors are not seeing in many other areas. And two, it's also interesting to see that at this stage, it's also possible to do it. There is enough fund infrastructure, if you will, to be able to build these allocations since of course 6.4% of the portfolios did meet that standard.
Brittany Damico, Change Finance:
And moving into our next data point was looking at the percent of allocations that were engaged in some form of shareholder advocacy and a little bit of a disclosure here in terms of the analysis that we had to do. So as we looked at the 27 different asset managers, one hundred percent of them engage in some form of shareholder advocacy, but we went and did a little bit deeper dive and pulled a qualitative analysis to see to what extent that they were engaging in a meaningful and impactful advocacy or engagement. We did that by reviewing their websites, looking to see if they had dedicated teams for engagement, how transparent the data was, and how relevant and up to date it was. After the analysis, what we came up with was that 63% of the asset managers were engaging in some form of meaningful, impactful shareholder advocacy. That number is quite reflective of what we saw earlier with that ratio of mutual funds versus ETFs being at 60% mutual funds, 40% ETFs. So it shows that percentage of mutual fund companies might be the majority here that had been engaging in that advocacy work. But as more of these ESG ETFs are coming along into the stage and, and breaking into that space, we're seeing that 60% may grow a little bit. Victor, I'd love to hear your opinion on that.
Victor Orozco, Bair Financial Planning:
As much as that pie is going to be broken out between funds and ETFs solutions, this would probably be a mirror image of that. But hopefully for the movement and progression in the space, it doesn't have to be that way, right? As ETFs come on board, I think advisors and shareholders start to educate themselves where a big part of this is voting with your dollars, right? That's the phrase that's used a lot with the marketing and the PR with this at The Wealth Consulting Group. We have two different versions of our High Impact Portfolios. Each one looks at funds and ETFs only. It's kind of for this reason of a good, better, best, and aligning with what's ideal for your practice and your clients. Hopefully as more these solutions come out, we progress on voting and being active owners, right? Or PRI number two, right? Active ownership, it's a biggie. That ‘they’ understand, they being the ETF issuers, that there's also the 360 component to the sheet. You have to finish up on the qualitative side when it comes showing up to vote.
Dan Carreno, Change Finance:
I would say, anecdotally, this has become probably the most prominent question that we get at Change Finance. Of course, everybody can say, I can see your performance. I can see what your ESG metrics looks like but tell me what you're doing in terms of proxy voting in terms of engaging companies in the portfolio. It's just interesting to see how important this facet has become to investors. I expect that it'll only continue to grow in importance in the coming years.
Victor Orozco, Bair Financial Planning:
Yeah. I think as advisors try to understand this space to figure out where you want to be on the spectrum, this may be important to them or not. I think as a community, we can't necessarily look down or poo poo the solutions that may not engage from that standpoint. I think we need to help educate advisors about the differences between ESG solutions. Not only is it fees and tax efficiencies, but it could be the quality of the things that come with the solution. I think there's more education that needs to be had there because the ETF space is what's talked about in the media the most, because they're the biggest and the loudest, but not being the most authentic (see through that, how you may) but I think that's a big thing that's missing from reporting. An education standpoint is what comes with the different solutions as well. It's not just necessarily higher fees. I think once we have a better understanding around that, hopefully better dialogue and responses can come with.
Dan Carreno, Change Finance:
Yeah, I totally agree on the education piece. It's funny how many folks I talked to that seem to have a perception that ETFs cannot engage in shareholder advocacy the same way as a mutual fund. We always have to say, Nope, you know, we can and we do here at Change Finance. It's just that some other companies are choosing maybe not to put the same emphasis on it. I think the education component is so important.
Just to wrap up here finally, the last couple of data points that we have around ESG and relative returns. We looked specifically at the 43 funds and ETFs from the sample that fell into core asset classes, and excluded the more thematic products here and just looked at them and how their performance compared to a common benchmark for their peer group, going back over one and three-year periods. And what we found is that over the last year, 79.1% of the funds and ETFs outperformed their benchmark, and going back over three years, 78% outperformed their benchmark.
Brittany Damico, Change Finance:
Yeah. I think this is really great data. I think the takeaway from this is that if you have been investing in ESG over the past few years, you've been having a really great experience.
Dan Carreno, Change Finance:
Then when we actually look at this from an asset class standpoint, what we found is that in pretty much every asset class, large cap blend, developed international, emerging markets, really strong performance, very good investment options available to investors and advisors with the exception, unfortunately, of small and mid cap. So for whatever reason, over the last year, only 16.7% of the small and mid cap ESG products that fell into the sample outperformed their benchmark. And over the last three years, it was only 40%. So Victor, any thoughts as to why there's, there's kind of a weak spot there?
Victor Orozco, Bair Financial Planning:
It really kind of jumps out at you. I think really it's the space in the sectors is exposed to that SMID Russell 2000 world, right? The financials, the energies, of the world that typically, from an exclusionary type of concept, tend to be the no-no areas for some of these active managers to go. You can actually see it's more of a coin flip on the ETF side where you're tracking error is a little bit lower because you're hugging an index. You're really just getting rid of the bottom quartile of companies, but you're still having sector representation. This shows, in that space where style and sector drifts, you can see the devoid there. We're seeing that run up currently, right in those spaces predominantly in 2021 year to date, those have been some shiny spots of the market. So very interesting to see the X energy discussion come back a little bit. Could it be a short-term term pop in over a longer term decline? We will see, but it's definitely really focusing that narrative and that story when it comes to that space there specifically, you can see it shows pretty, pretty brightly.
Dan Carreno, Change Finance:
Excellent. Well, Brittany, Victor really appreciate your thoughts and your perspectives on the analysis. We'll start wrapping it up there for the episode, but before we do, it's time for Around the Campfire.
*Wolf Howl & Fire Crackle*
So, spring is in the air, you just mentioned it, Brittany. It’s starting to get a little bit warmer there up in Washington. When you go out and you start pitching the tent, sitting around the campfire with friends and family and colleagues, what are you going to be talking about this week?
Brittany Damico, Change Finance:
So earlier this week, I was reading an article in the New York Times and it was called ‘What's good for the ocean may also be good for business’. It was focused on these small businesses that were working in aquaculture, fishing technology, transportation, and increasing biodiversity. I felt so much inspiration while I was reading it and one of my thoughts went back to this Trends Report and the small/mid cap space. They're lagging in terms of allocations and options there so I was thinking about how could build an ETF that was about ocean regenerative practices.
Dan Carreno, Change Finance:
That's so cool. We're definitely going to link to that article on the transcript. I want to read that. Victor, how about you? What are you going to be chatting about the next time you're around a campfire,
Victor Orozco, Bair Financial Planning:
Not as prestigious or academic as most people. I honestly, I don't read a lot outside of our industry kind of stuff. So really my outside reading tends to be board books and rhyming books because having two young girls under three, if it's more than five pages and it doesn't rhyme, I don't read it. So The Colors of Us and ABC What She Can Be - those are my things. One thing I did see earlier today was a quote that I think, when we do have those conversations, something to have a mindful thought around is – you could be talking to someone who is trying their best not to fall apart. So whatever you do today, do it with kindness in your heart. I think we've been so in our own bubble, literally for so long that it's hard to reach back out to people and say, ‘how are you?’ versus looking at your own personal problems like all the struggles we have around homeschooling not seeing family. I think we have to unlearn that and realize that we've all gone through a lot of crap and remembered how to humanize again and see how people are doing what they've experienced and what kind of life they've lived over the last year. I think when you do have those conversations, keep that in mind. I think is a good perspective to lead into more outward than inward.
Dan Carreno, Change Finance:
That's a tough act to follow. I can't believe I have to go after that. My Around the Campfire chat is not nearly as profound as Victor’s, but with spring coming and things get a little bit warmer, one of the things that I really like to do is grilling and frankly, these days I don't really eat that much meat anymore but when we do, we wanted to find something that we could eat that we didn't feel like was going to be damaging the planet and the process. We got wind of a regenerative Buffalo farm in South Dakota, which is called the Wild Idea Buffalo Company. There they are raising herds of Buffalo and they're using the Buffalo to actually restore healthy grassland ecosystems, which are super important for biodiversity for sequestering carbon.
It's working so well because bison are actually what are supposed to be in North America. These ranchers in South Dakota are doing this amazing thing in terms restoring the bison to the ecosystem, to the grasslands and actually doing it in a way that there's some sort of business there for them so that they can make livings and provide jobs in the area. So we really try to support Wild Idea Buffalo Company when the summertime comes around and we do a little bit of grilling, and I hope other people will check them out too.
Brittany Damico, Change Finance:
Awesome.
Victor Orozco, Bair Financial Planning:
Thank you.
Dan Carreno, Change Finance:
Excellent. We'll wrap it up there. Victor, thank you again for coming on and sharing your insights with us today. If anyone listening wants to see a copy of the ESG Asset Allocation Trends Report that we reviewed today, please contact us through our website, which is www.change-finance.com. Thank you to those that are listening and we will be back soon with another episode of the ESG update.
Disclosures, Definitions, and Footnotes:
The information within this report was researched by Change Finance, PBC with the tools available to the Firm from Change Finance Portfolio Impact Analyses, As You Sow, and Morningstar.Various indexes were chosen that are generally recognized as indicators or representation of the stock market in general. Indices are typically not available for direct investment, are unmanaged and do not include fees or expenses. Some indices may also not reflect reinvestment of dividends.