In Episode 5 of The ESG Update, Jeff Gitterman, Co-Founding Partner of Gitterman Wealth Management, joins the conversation to discuss how climate change presents unique risks to investment portfolios.

Transcript

Dan Carreno, Change Finance:
Welcome to the ESG Update presented by Change Finance. I'm your host, Dan Carreno. I'm the head of Business Development at Change Finance, and 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. Joining the podcast this week is Jeff Gitterman. He's the founder of Gitterman Wealth Management. Jeff, how are you?

Jeff Gitterman, Gitterman Wealth Management:
Great, Dan, how are you?

Dan Carreno, Change Finance:
Great, thanks for being on again. For those who are not familiar with Jeff, he's a pioneer and a thought leader in the world of sustainable investing. I've been following him for a long time, and I've had the opportunity to hear Jeff speak a couple of times recently about some of the work that his firm has been doing in developing their SMART (Sustainability Metrics Applied to Risk Tolerance)® Investing Services. That risk mitigation message is really powerful, and this is something that financial professionals should definitely be aware of. So, we're going to talk all about that, but first and as usual, we're going to cover a couple of current events in the world of ESG investing.  The first article this week comes from Advisor Perspectives, and it is titled "New Challenges to the Merits of ESG Investing." This is a summary of a study that was published earlier this year in the Journal of Portfolio Management. That study was called the "Sustainability Conundrum." The study lays out some criticisms of ESG data and ESG investing.  I thought it was important for us to talk about this because we don't want to create an echo chamber here where all we talk about every week are the articles that praise ESG. So, this is a bit of the other side of the coin. The report argues that ESG data on companies can be quite inconsistent from one rating agency to the next. That can generate a large dispersion of results. The researchers, to illustrate this point, went to 24 different asset management firms, where there were portfolio management teams managing both ESG portfolios and traditional portfolios. What they found in studying these 24 different PM teams was that in 13 of the 24 cases, the managers exhibited better returns in their traditional portfolios, not the ESG ones. They use that as an argument to say that this feeds an ongoing debate about ESG and performance. I have some opinions, but Jeff, I imagine that you do as well. So, what do you think?

Jeff Gitterman, Gitterman Wealth Management:
You know, Dan, I've been a huge proponent that ESG shouldn't be viewed necessarily as an alpha driver. I think a lot of people are pushing that concept, that ESG is going to miraculously give you better returns.  I think that is a misnomer. If we look at all the different ways that ESG data is used, the bulk of it is being used in passive funds where you're comparing a benchmark index to its duplicate with ESG restrictions put on it. What that means is that they're using one data provider, they're screening out the bottom 25% of ESG performers in every sector of the market. Or they're underweighting and not even screening them out. They're then overweighting the top 10 to 25% of scores in each sector. You get a couple of misses there.  You get more capital driving to the better ESG scoring companies. So, for a short period of time, you'll get outperformance. But in any system where you have a scoring methodology, eventually, the other companies figure out what they have to do to improve their scores. Then, if you've underweighted the bottom scores, you've gotten all your alpha out of owning the top scores. Then you're going to underperform in the next period of time because you're missing the companies that are improving. With active managers, you and I both know that there are too many reasons why a manager performs well. And at the end of the day, 90% of it is sector weighting and 10% is stock selection. If a PM is managing two funds that are identical and just screening one for ESG, usually those funds wind up lining up over time. It's very difficult to de-select and pick over two funds that you're managing. I've always argued that there would be lawsuits because if you excluded a bond because of the ESG risk and it blew up in your non-ESG fund, and you had the data saying that it was a risk, why did you own it? ESG data is really a risk mitigator. I question how they looked at the data. I don't think it's a driver of alpha. I think of using ESG like your GPS. If you see something come up on your GPS that says there's traffic, you take a different route. That doesn't mean you're going to get to your destination any quicker, but it does mean you're going to avoid some potential pain.  I think we're looking at ESG sometimes in the wrong light. We're looking at it as this panacea, and it's just a lot more data. And there's no reason not to incorporate more data into your security selection process. ESG could outperform over long periods of time because if you're buying companies that are performing more sustainably over the long-term, that should pay off, but in short-term windows, even one to three year periods of time, there's no accounting for sector bias or tons of other reasons why you get outperformance.

Dan Carreno, Change Finance:
One of my initial thoughts was that it's important to conduct these studies and to have as much perspective out there as possible, but looking at 24 portfolio management teams just didn't compute for me.  That seems like such an incredibly small sample. Some of the studies that we've talked about before on this podcast, for example, Morgan Stanley's study looked at over 10,000 different mutual fund portfolios. A meta-analysis that we've referenced numerous times looked at a culmination of 2,000 individual studies, each one of those looking at data sets of hundreds or even thousands. Looking at 24 portfolio management teams, I felt as though it wasn't telling me all that much. The next article we're going to dive into this week comes from Pensions and Investments. It is titled "Norway's Wealth Fund Wants More Detail on Firm's Low-Carbon Strategies." The manager of the approximately $1.2 trillion Norwegian sovereign wealth fund is asking the companies that it invests in to produce additional data about how they plan to adapt to the transition to a low-carbon economy. Specifically, they are asking for scenario analysis for two degrees of warming, and they want companies to be very transparent about the assumptions that they use. As a side note, it also mentioned that the Norwegian sovereign wealth fund has recently exited three companies due to "unacceptable risk for violation of human rights." The reason I wanted to chat with you, Jeff, about this article is because this seems to indicate that some of the largest, most influential investors on the planet are starting to price in climate risk. This is something I've heard you speak about a few times. What are your thoughts, and what can you tell us about the capital markets and climate risk?

Jeff Gitterman, Gitterman Wealth Management:
This is very similar to what Larry Fink said at the beginning of the year. If you're not providing scenario analysis based on TCFD disclosures of a two-degree warming scenario, then we're going to be looking to not own those companies. Now, it's an interesting thing for BlackRock to say that because they're also the largest shareholder in Exxon. I don't know if you call that talking out of both sides of your mouth, but it's an admission to the marketplace that climate risk is the biggest risk that the capital markets are facing. Certainly in Europe, where they are probably ten years ahead of us, there has been adherence to TCFD since 2018.

Dan Carreno, Change Finance:
Can I stop you for one second for those that may not be familiar with that acronym? Can you explain TCFD please?

Jeff Gitterman, Gitterman Wealth Management:
It's the Task Force on Climate-Related Financial Disclosures. It's looking at the scenario of a warming planet, and what are the risks to physical assets, especially stranded assets of fossil fuel companies that potentially will never be brought to market because we have to move towards renewables.  So, the marketplace is getting there. Even in the US, with Larry Fink and his comments, and State Street’s, and Wellington, and Vanguard. There is an admission for the first time about physical risk and transition risk.  The two are a little different. Transition risk is moving to alternative energy sources.  What happens in an economy where we put a price on carbon emissions, or we start suing companies that are producing too much carbon? Versus physical risks, where we're dealing with the effects of more floods or droughts or extreme weather. Those two things are both risks of climate change, but they're looked at a bit separately. When they're talking about scenario analysis, they're saying we want to see that you're evaluating the companies that you own. Let's say you own a bank like JP Morgan that has huge exposure to fossil fuel companies and huge exposure to commercial, shoreline development. If you price in a two-degree warming scenario, what happens to all those assets? That's the scenario risk analysis that they're asking companies to do. It's what Larry Fink is going to ask people to do. It's what a lot of big asset managers are doing. What it means to the average RIA or investor is that the pricing of climate change is coming. There's been this understanding that I don't have to worry about climate change, because everything I read says it's 2050 or 2100 where the seas start rising. But when you write a 30-year bond, you're analyzing 2050. Even if that's the first time we are going to see any of these damages, 2020 is the year you have to start analyzing that risk. We all know about the California fires. I can make a long list here. If we just look at the last two weeks, we had the hottest temperature on earth recorded. We broke about 16 temperature records in California. This weekend, more acres burned in California than ever. 2 million acres already. 1.8 million was the prior record in 2018. Australia almost burned to the ground as an entire continent. So, we were seeing the effects of physical climate risk right now. And because of that, the markets are realizing they have to price it in.

Dan Carreno, Change Finance:
I know that this is something your firm has thought a lot about. Could you talk about how you have approached this issue and how you think about mitigating this risk and developing solutions?

Jeff Gitterman, Gitterman Wealth Management:
Solutions. That's an interesting question because a lot of people ask me what our portfolios do to stop climate change. When I started researching all of this back in 2014, I started out as this huge climate mitigation fan. I said we have to do whatever we can to mitigate climate change. And about three years in, I thought we have to move from climate mitigation to climate adaptation. Because what you have to understand about climate change is that all the buildup of CO2 in the atmosphere creates a warm, wet blanket over the planet, and the heat can't escape at night. Usually, our planet warms up during the day, and then the heat releases at night. When there's too much CO2 in the air, that heat starts warming the oceans. Then it starts warming the land and the air as well. That accumulation began in 1880 when we started polluting more and more, and it's ramped up tremendously since 1950. Similar to Moore's law, it's a vertical spike of growth. That's what a CO2 emission chart looks like. So, in the next 20 years, changes to the climate are baked in. There's nothing we can do about it, unfortunately. We can do something about 21 years out, and we can slow things down. Maybe we can avoid four degrees of warming and stop at two degrees. So, if that warming is already baked in, what does that mean to the assets that I own?  If you're an investor, it's easiest to think in terms of municipal bonds, mortgages, and real estate, because that is just an easy physical risk assumption. If it floods a lot over here, this real estate is worth less than that real estate where it doesn't flood so much. That's not even sea level rise. That's just flooding from more rains. Houston is a perfect example. Houston was deluged in the last storm. I think they had 28 inches of rain and three days. What I began to understand was that there were data providers for this just like there's ESG data. These data providers were doing what's called geospatial analysis. They were analyzing down to the 40 square feet, and producing metrics for risk areas in every scenario of flooding extreme heat, extreme weather, and droughts due to changes in temperature. That's TCFD adherence. If we get to two degrees, there are areas where I don't want to own real estate. I could show you data out of risQ. They have data on every single municipal bond cusip in America. If you need to build a municipal bond portfolio, you want to look at what's called value at risk or VAR. For example, I can look at a Tampa hospital bond, and know that Tampa bonds have about a 94% value at risk. If I can find a similar bond in Maine or Colorado or Rochester, New York that has a similar maturity and similar coupon, and it has an 8% value at risk, what do I want to own? Now, if you don't believe in climate change, you could choose to stick your head in the sand and ignore this data. But what happened in the last 18 months is that the rating agencies, Moody's, S&P, and Fitch, they bought these geospatial analysis companies, and they didn't buy them to bury the data. They bought them to use the data. Moody's has come out publicly and said that they're going to start weighing this data. You're going to start seeing a penalty for high risk in physical assets and municipal bonds, mortgages, and real estate priced into the market over the next 12 to 18 months. Right now, it's free to de-risk your portfolio from those assets. It doesn't cost anything more to own that Rochester bond instead of that Tampa bond. But that's about to change.

Dan Carreno, Change Finance:
Could you talk a little bit more about the next 12 to 18 months? If that Tampa bond has 95% assets at risk, what kind of discount would that bond actually end up trading at 18 months from now? Obviously, this is a speculative question, and we can't know, but do you have any sense of just how much of that risk is going to be priced in?

Jeff Gitterman, Gitterman Wealth Management:
About a week ago on CNBC, there was an article saying that every house in America is about to get a flood score. Not some areas or some regions, but every single house in America. It means you can go to this website, you can put in your address, and you can get a flood score. Let's say that a flood score of one is the best, and ten is the worst. Say you're looking in a neighborhood and you've got one house that's a flood score of one and one that's a flood score of 10 because of elevation. Is that going to matter to what you bid or don't bid on that house? Spencer Glendon, he is one of the best speakers on physical climate risk and the capital markets. He ran Wellington's quant department for 20 something years, and now just speaks pro bono on physical climate risks. He said that when everybody's asking when is it too late, when everyone in Miami is saying, when do you think I might have to sell my house? Well, then it's too late to sell your house. There's no buyer left for your house. Then the bigger problem is that insurance companies are looking at all this data.  Most people don't understand when you buy a house, and you sign a 30-year mortgage, there's a clause in that mortgage that says that you have to carry insurance on that house for the whole 30 years, or you're in default on your mortgage. Well, the insurance company isn't held to that mortgage. They're not a party to that mortgage. So, if 20 years from now into your 30-year mortgage, that insurance company decides it's too risky to be in that area, what do you do? This is happening now in Northern California. They're already seeing insurance companies pull out because the fire risk has become too great.

Dan Carreno, Change Finance:
You mentioned every home in America getting the flood score. As a resident of Colorado, where we think about fire far more so than floods, is it going to be something similar in terms of fire risk?

Jeff Gitterman, Gitterman Wealth Management:
427 has data on everything. They have data on flood, fire, drought, extreme heat. So, you can get that data on any of the risks of physical climate.

Dan Carreno, Change Finance:
It sounds like we are going to see a significant realignment of capital markets based upon everything that you've been talking about. If you are a financial advisor or an individual investor, and you think that this is something you want to get on top of now, what is Gitterman doing? What solutions are you guys able to provide to both advisors and investors?

Jeff Gitterman, Gitterman Wealth Management:
When we started out doing this, we started asking our managers a lot more questions. We have a 33-page due diligence questionnaire that asked about their adherence to all of these types of measures, ESG as well as physical climate risk. Then we built and launched the first UMA, Unified Managed Account, that's a multi-manager portfolio that specifically looks at managers that are adhering to physical climate risks in their portfolios. It took me two years to build that product. Everyone's worried about their clients' focus on ESG. How do I build portfolios and models if each client has different values? We said let's build the best in class ESG and climate-focus portfolio without restricting any of those values or sectors that a client might feel adherence to, and then let's build it so that the client can restrict any values that they want. So, we built a best in class portfolio, and because it's individual stocks and bonds, the client can then come in, and they can check up to 12 different restrictions on their portfolio.

Dan Carreno, Change Finance:
Can you provide some examples of those restrictions?

Jeff Gitterman, Gitterman Wealth Management:
No tobacco, no guns, no alcohol, your typical restrictions, but then they can go even deeper. I have a call today at five o'clock because a client noticed there's a Russian-owned bank in their portfolio. It happens to be one of the biggest weightings in the emerging market index. It's in the emerging market fund. I think it's the first or second biggest weighting in the index, and it's scaled down a lot. Instead of a 5% weighting, it's a 1% weighting, but still, if they have a real problem with that, they can say I don't want this security in my portfolio. They can go all the way down to the security level. That way, the advisor is sitting in a place where we've built the best in class related to risks in the capital markets, but on your own values, you get to vote. I think it's the perfect combination of allowing the client to feel good about what they're doing and have a say in what they're doing, but still aligning with the best managers.

Dan Carreno, Change Finance:
I know that you guys brought this to market just recently. How has the adoption and the interest been so far?

Jeff Gitterman, Gitterman Wealth Management:
Really great. We already have about $25 million in the portfolio in just a few weeks and a bunch of meetings with large family offices and RIAs. So, it's been going extremely well, and it's brand new. We're in the middle of COVID, which is not the best time to launch a product and send your salespeople out into the marketplace. But that's fine.

Dan Carreno, Change Finance:
Congratulations on the new venture. That's exciting. It's a challenging time, but we're all just working through it. We're running out of time here so let me wrap up remind all listeners that any of the articles, resources, anything that we mentioned during the podcast, can be found in our podcast library at www.change-finance.com under the INSIGHTS tab. Within the podcast transcript, you will find all of those links. If you have questions or feedback for us, you can always get in touch with us through the website. Jeff, if listeners want more information about the services and tools that your firm can offer, where should they go?

Jeff Gitterman, Gitterman Wealth Management:
You can go to https://gittermanwealth.com/ to get information about our outsourced CIO programs and the products that we have created in the marketplace for ESG and climate risk. If you want general information, we host a TV show at FinTech.tv called The Impact. It's lots of shows with managers and private equity and venture all around ESG and sustainability and climate risk. September 21st to the 25th we're hosting climate week. We'll have tons of content that whole week about climate risk and guests like Mark Carney and Tom Steyer. So definitely tune in.

Dan Carreno, Change Finance:
Excellent. I appreciate you mentioning that as well. Jeff, I appreciate you being on today and sharing your insights and thank you to all those that tuned in. We will be back soon with another episode of The ESG Update. Have a great day.