ETF Expert Corner

Marie Dzanis Talks “Smart Beta”, FlexShares ESG ETFs

September 27th, 2016 by ETF Store Staff

Marie Dzanis, Head of Intermediary Distribution at Northern Trust, offers her perspective on “smart beta” and spotlights two recently launched FlexShares ETFs tilted towards companies scoring high in environmental, social, and governance (ESG) factors.



Transcript

You can listen to our interview with Marie Dzanis by using the above media player or enjoy a full transcription of the interview below.

Nate Geraci: We're actually spotlighting two ETFs this week. The FlexShares Stocks US ESG Impact Index Fund, ticker symbol ESG, and the FlexShares Stocks Global ESG Impact Index Fund, ticker ESGG. Joining us via phone from Chicago to discuss both of these ETFs is Marie Dzanis, Head of Intermediary Distribution at Northern Trust. Northern Trust oversees the FlexShares ETF business. Marie great having you back on the program.

Marie Dzanis: Great to be here, thank you.

Nate Geraci: Well Marie, before we get to these two ETFs, I know earlier this year FlexShares celebrated a five year anniversary and assets in FlexShares ETFs have now eclipsed $10 billion. It's clear FlexShares has been able to stand out in an increasingly competitive ETF marketplace. I'm just curious, what do you attribute this success to?

Marie Dzanis: A lot of good thoughtful hard work and one of the reasons why we are distinctive, instead of style boxes and asset classes we found a better way, a better way is to think about investment and that's in terms of outcomes. Our ETFs are actually strategic, long-term buy and hold investor centered products that is managed by Northern Trust just like you said, the fourth largest indexer and we leverage their expertise. What we found was is leveraging that expertise it didn't matter if you were a government, a sovereign debt, an individual affluent client, an individual person, you only want four outcomes for investing. You want to grow your assets which is capital appreciation, you want income to supplement your needs, you want risk management to control your exposure in a portfolio and you want liquidity, you want to get money when you need it. I still contend that to this day nobody ever called their financial advisor and said they don't like their standard deviation, but they do say I'm not able to fund my college or my child's college. These are outcomes that we seek to get with our ETFs and now we have 24 of them including the funds that we're going to spotlight today.

Nate Geraci: Marie as I know you're certainly aware, so called smart beta ETFs are all the rage right now. It seems like a new smart beta ETF launches every other day, but FlexShares has been in this space for a while, you are one of the more established names here. I'm just curious, one how do you define smart beta because this can be a confusing term for investors. Then two, what are your thoughts on some of the trends in this space?

Marie Dzanis: I don't like the term smart beta because beta itself is a factor and it's not smart or dumb. It's just what the industry calls it, but what smart beta implies it's typically a deviation from a traditional market cap index weighted benchmark. The challenge with this is across the universe of investment options it's inconsistently defined in the investment world. Each asset manager can have their own definition of what they want to alternatively weight verses an index. I could speak for us, what we seek to do is capitalize on empirical evidence, so if we're going to capture a premium we want to make sure it's consistent, it's academically based and it's sustainable. We do this in a rules based implementation that's actively designed, meaning that you take on active risk from a benchmark, but implemented in a passive rules-based ETF.

Nate Geraci: Marie, with all the new ETFs coming to market and especially given the growing complexity of some of these ETFs, I personally think the job for everyday investors has certainly become more difficult, there are a lot of choices out there. How do you think the average investor should go about sorting through all of these options?

Marie Dzanis: Let me give you three tips. Because there's not common language around what the industry does, like I said, every asset manager can define things differently, it makes the research or the due diligence around investments very important. It doesn't have to be scary, so I actually like to think of it like speed dating. If you want to have rules for picking a partner you'll do well. Number one, rule number one, clarify your own philosophy, who do you want to date? What are you trying to do? Are you trying to reduce risk, enhance returns? What outcome are you seeking? Are you looking for income? If you're looking for income and you get total return with moderate income, it's not a match. Next, every firm has a specialty and your goal is to find your perfect match. Number two, once you list out your potential partners you create your short list. For example, if you don't like white wine, that five page wine list got cut in half. If you are more conservative knock out asset managers that are known for taking aggressive risk and focus on those that have a pragmatic, thoughtful approach. Then you look at characteristics for their funds. Are they focused on growth, on value, what is the expense ratio? Bear in mind that it doesn't have to be the very cheapest if it's going to be exactly what you want for an outcome. You want someone who thinks like you do to date your money. The last step is perform the due diligence. This is the long dinner date with the shorter wine list. Your goal is to build long-term core holdings, so you need to ask some really tough questions. You need to ask things like how was the product created? Is it based on proven fundamentals or is it designed with new bells and whistles to attract investors? What are the risk constraints around those ideas and how do they manage them? How does the strategy effect the composition of my overall portfolio? In other words, how does the portfolio look now with my new family member? If you have a good understanding of these basic questions it doesn't have to be intimidating, but the goal is to find someone who thinks just like you do when you're identifying investments.

Nate Geraci: Again, we're visiting with Marie Dzanis, Head of Intermediary Distribution at Northern Trust. We're talking FlexShares ETFs. All right Marie, the two ETFs we're spotlighting today incorporate ESG factors and for our listeners ESG stands for environmental, social and governance. The idea here is to invest in a more socially conscious manner and perhaps improve returns. The first ETF is the FlexShares Stocks US ESG Impact Index Fund, ticker symbol ESG, great ticker by the way. Tell us how this ETF selects its holdings.

Marie Dzanis: For years investors thought out how to express their personal or corporate values with their investments, and traditionally there's been more an exclusionary strategy which means you don't include certain types of investments because you don't want them in a portfolio. Often this strategy compromises returns because we're Xing out very large companies with diverse global businesses. We have a different approach that is inclusionary or what we call integrated and that's the ESG portfolio. You're right E is for environmental, so you think about things that impact the environment and do these companies in this environment have metrics around it? S is for social like you said, looking at social policies, things like workplace environment and health issues. G for governance, this is things like responsibilities of the board. Are there assessment and rules in place? We have a core holding in the portfolio because it's inclusionary, it's going to include a lot more securities that what it is designed to do is give you risk adjusted returns that doesn't compromise the return. What we do is, as more and more companies disclose ESG data, meaning there's more and more companies reporting carbon footprints and child labor laws and women on boards, we view this as an opportunity to deliver what we do well with financial risk factors and combine it with ESG. You can get superior risk adjusted returns, that's the goal. ESG factors are classified as what they call KPI, key performance indicators and in our partnership with stocks, our index provider, we look at all available reported KPIs, figure out which ones will fit well with a risk adjusted return in the portfolio. There's many KPIs out there that are really positive for society but then the question becomes are they statistically significant at building better portfolios? Once we have an ESG score for all the companies we eliminate the bottom 50% and we keep the sectors in 5% range to the benchmark and the countries in the international portfolio to 1% range within the benchmark.

Nate Geraci: Marie, can you tell us just at a high level about some of the research in this area? I think intuitively it makes sense, I think companies who are trying to do the right things whether from an environmental perspective or diversity or whatever the case may be they probably have better management, they're certainly less likely to be sued and therefore I think you can make the case that they're more likely to outperform. What does the data say here?

Marie Dzanis: Exactly that thought, if you want to have the inclusion of more securities in your portfolio but you want to be careful of those that have policies that would be aligned with your goals, that's difficult to do until today. This inclusionary strategy allows for that. You can better capture the additional returns on some of these companies because they have well thought out standards, very high standards for each one of those E, S or G strategy.

Jason Lank: Marie, this is Jason Lank, I want to revisit a point you mentioned that smart beta is a term that's really not universally defined. Specifically for investors who are coming across these ETFs and these investment philosophies for the first time, it seems to be very challenging that different managers might define these terms differently and each person has their own take. How does the investor sort through that?

Marie Dzanis: That's a very fair question and that's why you need to ask questions of the asset manager. Why are they building these products? Is it more the hot stock, is it based on long standing research? Understand why those indexes were created because in some cases there are varying reasons, and for the more products that we have that are created it's important that we, as investors, understand what they're supposed to do when the market turns against or for the way it's supposed to go. The experience to the end investor is very important, so asking questions about how will this hold up during times of market duress, is there any research on that index itself, and again back to the point of empirical evidence, is it based off of something that's a cool trend right now or is it based off of something that is a long standing principle to capture a premium in the market? Those are good things to ask.

Jason Lank: For investors again, coming across these concepts for the first time you mentioned the term superior risk adjusted returns, so from a very high level it's not just about supporting a cause that you believe in whether it be environmental or governance, it's about making superior returns along with doing it. That sounds like a pretty good combination.

Marie Dzanis: Well that is the goal and we endeavor to have something that is going to be a core holding, it's not just a portion of a portfolio, it's not just an overlay. When you do and have an inclusive strategy like that it has to work well, those individual securities while stand-alone might be great, how they act together in concert is an important facet of how you assemble the portfolio.

Nate Geraci: Okay Marie, the other ETF we're spotlighting today is essentially your international version, it's the FlexShares Stocks Global ESG Impact Index Fund, ticker symbol ESGG, how are the holdings in this ETF selected?

Marie Dzanis: Identically the same way, the process is the same as the US one by looking at KPIs. The difference you'll see between the two portfolios is the country, there's a 1% ban. Right now there's about 55% in the US and then other countries are the balance of the portfolio, but we put tight constraints on them so that make sure that they don't have a lot of drift to the strategy. The ESGG has 657 holdings right now and the ESG, which is the US based has 245 but both give you the option to participate in the strategy of having exposure to that market.

Nate Geraci: Marie, should investors view these two ETFs as core holdings? Would these replace existing broad US and developed international stock holdings in an investor's portfolio?

Marie Dzanis: It would be a core because if you look for a stable, risk adjusted return type strategy that's what these funds endeavor to do. Instead of traditional thinking maybe to have just a small portion of your portfolio, this would be the main portion of your portfolio and you can actually feel good about the selections that you make.

Jason Lank: Marie, ESG is a domestic based ETF, ESGG is a global version. I noticed that approximately half the holdings are US as well. Is ESG a subset of the global or how much crossover is there?

Marie Dzanis: With overlap I'm actually not sure. They're going to have similar overlap based on the key performance indicators within the US portion because when you have a US portion that the KPIs as things like governance and women on boards they will absolutely have very similar rankings. The difference is there's a larger universe of stock from ESGG because it is a global portfolio and the US is going to be only 245 holdings comparatively.

Nate Geraci: All right Marie, we have just a few minutes left here. We had Morningstar's Ben Johnson on the program over the summer. We talked about some of the trends with socially conscious investing and he mentioned how he thought this was really being driven by millennials and women investors. Ben made the point that women decision makers now control over 40% of the nation's investible assets. I'm just curious, are you seeing some of the same trends?

Marie Dzanis: It's interesting because across different generations, of all the generations, millennials think differently. As we think about wealth transfer, a lot of the younger generations do like the idea of ESG and ESGG because they grew up with a global perspective, they want to impact. The younger generation wants to impact a lot of people and the way that I think about it is there's five different generations, they could all invest in one single philanthropic cause but for very different reasons. If you would say, for example, the heart association. The mature generation, the older generation might give to it because that charity has been in their family for years and years and the Smith family always gives. Baby boomers have more of an activist mindset and they might donate because the people their age are now looking at heart risk. Generation X are the skeptics. They might give to the very same charity because it's the best philanthropic group in their area that make good use of the funds. Then Gen Y is kind of emerging, they might do it because they think it's good karma, but Gen Z, the youngest of them all which is categorized inside of the millennials, they want to do something because they can impact the most people. They're thinking about how to change the world and having them enter not only being the recipients of wealth, we're going to have to think about the investing landscape to incorporate things that match with their values which has been a very, very exciting time for us.

Nate Geraci: No question and Marie we'll have to leave it there. As always we certainly appreciate your time. Thank you very much for joining us today.

Marie Dzanis: Thank you for having me, it was great talking with you both.

Nate Geraci: That was Marie Dzanis, Head of Intermediary Distribution at Northern Trust. You can learn all about the FlexShares ETF lineup by visiting FlexShares.com, that's FlexShares.com.