ETF Expert Corner

Morningstar’s Ben Johnson on Intersection of Sustainable Investing & ETFs

July 26th, 2016 by ETF Store Staff

A growing area of investing is sustainable or socially responsible investing, where companies are screened based on environmental, social, and governance (ESG) factors.  Ben Johnson, Director of Global ETF Research at Morningstar, discusses his recent article on the topic, offering perspective on the intersection of sustainable investing and ETFs.



Transcript

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

Nate Geraci: The focus of our show today is on sustainable investing, and I'm now pleased to welcome to the program Ben Johnson, Director of Global ETF Research at Morningstar. Ben is also the Editor of the Morningstar ETF Investor Newsletter. He's a tremendous all-around resource in the ETF space, and Ben is now joining us via phone from Chicago. Ben, our pleasure to have you back on the program.

Ben: Thanks so much, Nate. I'm thrilled to be back.

Nate Geraci: Ben, you recently wrote a piece for the Morningstar ETF investor newsletter titled "ESG plus ETF equals BFF," which is a great title by the way, but the thrust of this article was on sustainable investing in ETFs and how they seem to be a perfect match for each other. First, why do you think sustainable investing is growing in interest? Why is this now going mainstream?

Ben: I think sustainable investing, broadly speaking, is growing in interest owing to some seismic shifts that we're seeing in terms of investor demographics. We're seeing greater representation ... and this will continue over the course of the next decades ... of women in investing, so by some estimates, women decision-makers now have control over 40% of the nation's investable assets, and millennials and Gen Xers, so younger investors. By some estimates, we're going to see some $30 trillion in investable assets pass from baby boomers to younger generations over the course of the next 20, 30, 40 years. The common thread amongst women investors and younger investors is that survey data show that they are far more likely to take into account factors related to sustainability when making their investment decisions.

Nate Geraci: As it relates to millennials, in your article you referenced a Morgan Stanley survey from last year that showed 84% of millennial investors are interested in sustainable investing. You know, if you combine that with the Schwab ETF survey from last year that showed ETFs accounted for a greater portion of millennials' portfolios than any other generation, you can see the potential here, combining sustainable investing and ETFs. What is it about ETFs that you think makes them a good fit for expressing social viewpoints?

Ben Johnson: You know, it's really a marriage of two relatively new ways of investing. On the one hand you have the incorporation of one or multiple sustainability-related elements that are baked into the investment strategy itself, which is really easy to do in an index format because these are rules-based strategies. If I want to screen certain things out by way of negative screens ... so kick say tobacco or alcohol, firearms, petrochemicals to the curb ... or I want to invest for impact, so I want to invest in those firms that have set out to actually improve upon their impact, be more inclusionary, have a better impact or a lesser impact on the environment, we can very readily bake those into an index methodology. Then we compare that or marry that with another relatively new innovation with respect to how we invest, which is the ETF chassis. This is just a way to deliver typically an index-based investment strategy to the end investors that is open architecture. It is sort of the Amazon Kindle to mutual funds' kind of local bookseller. It is open source, it is open architecture. It's available to anyone in an amount as low as a single share, typically at a very low fee, that has access to the exchange on which these things are traded.

Nate Geraci: Ben, we always talk about how ETFs have helped democratize investing, and when I think about sustainable investing, this used to be an area primarily reserved for wealthy individuals or institutional investors, maybe institutions that had specific mandates on what they could invest in. Can you tell us a little bit about the backstory here on sustainable investing, and maybe how the original roots of sustainable investing have now led to the creation of sustainable ETFs? I know you used a great example in your article of this SPDR Gender Diversity ETF.

Ben Johnson: I think by way of background, what you've seen historically is that its predominantly been a category that has been most relevant to institutions that might have different charters, different mandates, that are looking to incorporate certain sustainability elements, certain positive or negative screens, into their investment process. They've typically done this through separately-managed accounts, so that they can get very specific and very granular with the types of rules that govern that portfolio management process. What you've seen more recently is that you can marry these very specific strategies, and the example of the SPDR SSGA Gender Diversity ETF ... the ticker for that is SHE ... is an example whereby the California State Teachers Retirement System, so CalSTRS, has this broad diversity mandate. Specifically within that broad diversity mandate, they have a mandate to invest in a manner that promotes gender diversity within the upper echelons of publicly-traded U.S. corporations. They partnered with StateStreet to build an index that does exactly that, that gives a greater weighting to U.S. stocks that have greater representation of female members of boards as well as the C suite, and the resulting portfolio, while built specifically to fit the needs of CalSTRS, is now available to you and I on an ETF chassis that's listed and traded all day long on the New York Stock Exchange. Another example, to your point Nate, of the democratizing force that has been the rise of the ETF category.

Nate Geraci: Again, we're visiting with Ben Johnson, Director of Global ETF Research at Morningstar, and Editor of the Morningstar ETF Investor Newsletter. Ben, right now there really isn't any sort of agreed-upon criteria of what constitutes a sustainable investment, and so in response to that, I know Morningstar has developed a sustainability rating system which helps investors determine whether the investments they own reflect best sustainability practices. Can you tell us a little bit more about how this rating system works?

Ben Johnson: Earlier this year, we announced that, in partnership with a firm called Sustainalytics, that we would be launching the first-ever sustainability rating for funds. What Sustainalytics brings to bear in that partnership is very specific, very detailed data for individual stocks and even individual fixed-income issuers. We're able to partner their very detailed ESG scores for individual stocks with our wealth of portfolio data and roll those scores up into portfolio-level scores. We're able to look at the portfolios of funds and ETFs and assess overall how they score on a number of different ESG criteria, and send out to investors a signal of how they fare in this regard, whether they've got an ESG-specific mandate or not.

Jason Lank: Ben, this is Jason Lank. A follow-up on the Morningstar sustainability process, you do use information from Sustainalytics, but further in the process you polish that data with something called a portfolio controversy score. That caught my eye. What is that, and how does that apply?

Ben Johnson: The portfolio controversy score is sort of a trump card, if you will, so no matter how well the remainder of a portfolio might score, if there's one individual stock in there that has been doing something that's particularly egregious, what you see there is that that is not a slap on the wrist. It's something far more severe, so we want to be sure that there's not one bad apple that is potentially ruining the best of the bunch, as it were, with respect to our assessment of that overall portfolio. That's effectively sort of a last-minute override that could otherwise sort of scar what's, aside from one or perhaps a small handful of stocks, an otherwise high-scoring portfolio.

Nate Geraci: Ben, if I understand this rating system correctly, it certainly helps in identifying funds scoring high in ESG factors, but to be clear here, a fund scoring highly could still have exposure to companies involved in areas a particular investor may disagree with, right? This is not meant to tell you whether a fund completely avoids certain areas. Is that correct?

Ben Johnson: That's absolutely correct, and I think it's important to underscore that sustainability, that impact investing, is really very personal by definition. We all have our own different values. We're not ever going to be able to perfectly align our portfolios with those values necessarily, so it's important to be aware of the fact that these ratings, these scores, these issues, might not necessarily perfectly align with any individual investor's specific circumstances. These are meant to be not something that is viewed in isolation, but another complement to investors' existing tool kids.

Nate Geraci: You know, I think along with that, we should also be clear that the Morningstar sustainability ratings, these are portfolio-based, not performance-based. In other words, these ratings should not be used to gauge fund performance, correct?

Ben Johnson: That's absolutely correct, and I think there's been a lot of debate as to whether or not investing with sort of a sustainability overlay is either performance-positive, neutral or negative. What I can say is that what we've seen, especially of late in the ETF space, is that there is a lot going on by way of product development, in particular to marry sustainability views of the world with other criteria that we know have historically helped to generate better risk-adjusted returns over the long period of time. In mid-June we saw Columbia, for example, launch a suite of sustainability equity income ETFs, which marry sustainability screens with a dividend orientation. I would fully expect that we're going to see more of this in the future.

Nate Geraci: Can you offer us any additional insight on the performance of socially-conscious funds? We referenced some data from The Wall Street Journal earlier which I believe that they actually took from Morningstar, that did show some outperformance for sustainable funds over the trailing ten years, but I've seen other data showing the track record is much more mixed. Is there any insight you can offer on the performance or perhaps the risk profile of sustainable funds?

Ben Johnson: I would say that the performance has been mixed, just like the performance really for any funds have been mixed. What I would say is that, to the extent that sustainability criteria tend to introduce sort of a back-door tilt towards quality ... so towards firms which we at Morningstar would deem to have wide economic moats, so they're very profitable, their profitability is quite stable, they've got clean balance sheets, they've got entrenched competitive advantages ... that can be marginally positive with respect to their return and their risk profile. Again, what I would fully expect to see is that, with respect to product development, we'll see more and more of these factors, explicit factors, be they dividends or quality or value or low volatility, married with sustainability criteria in order to address some investors' prospective concerns over whether or not they're giving something up with respect to the return profile of the portfolio.

Nate Geraci: Again, we're visiting with Ben Johnson, Director of Global ETF Research at Morningstar, and Editor of the Morningstar ETF Investor Newsletter. Ben, as it relates to product development, and going back to ETFs, right now according to ETF.com, there are 23 ETFs classified as principles-based, and I believe ten of those have launched this year, and there are certainly more ETFs that could be considered for this category depending upon your criteria. How do you expect this area of ETFs to evolve over the next several years?

Ben Johnson: I think product development continues to march forward, so I'd mentioned in mid-June Columbia launched a lineup of ESG-oriented ETFs. iShares in late June added to their MSCI ESG-select lineup, and then just a few weeks ago, July 13, we saw Northern Trust Flexshares, partner with STOXX, an index provider, to launch their ESG Impact ETF. Many of these are new. Many of them are unproven, and in some cases the methodologies are really tough to pick apart. It gets a little bit black boxish, especially if you look at some of the criteria that they're employing to screen for these different ESG characteristics. I would fully expect that what investors will do will be to take a wait-and-see approach, that they'll wait a number of years to see how performance plays out, to see how adoption goes, and inevitably, just as is the case with any funds, you'll see a weeding out, a thinning of the herd further down the line, a company by more and more product development. Just given what we discussed at the onset, which is just the size and the trend within the investor base, so more and more people incorporating these sorts of screens into their investment philosophy, and that investable asset base growing with time as more money moves into the hands of female decision-makers, as more money moves into the hands of Gen Xers and millennials.

Jason Lank: Ben, in your piece from June you had a really neat example, and it was "Exhibit 2, the Good and the Ugly," and basically you gave ten ETFs that had high factors, ESG, and then ten what you called ugly that were low. What caught my eye on that was the Morningstar category of the funds that scored in the "ugly" category, and eight out of ten of them were from China. That was just an "aha," just one of those "huh" factors. As more and more investors use ESG factors to profile their portfolio, can they expect to see further "ahas" like that?

Ben Johnson: Yeah. It's interesting when you run those tables. I had quite a few "ahas" myself when I aligned the entire rated universe of ETFs. One of the "ahas" was actually at the top of the tables, amongst the goods, so the top-scoring ETF was actually the Global X FTSE Portugal 20 ETF, which I would expect that very few people tuned in right now have in their portfolios. It scored so high because, if you look at the makeup of its portfolio, it's got 40 percent of its portfolio in the top two holdings Its biggest holding is EDP, and EDP is effectively a utility, and it's the third-largest wind power owner/operator in the world. I think I'd put these examples forward as, you know, hey, this is an interesting curiosity, but it's also an example of why, as I said before, you should consider these ratings as a complement to your tool kit and by no means a substitute for deep-dive due diligence. I would not advise that anyone allocate any meaningful portion of their portfolio to a narrow Portuguese stock ETF.

Nate Geraci: Ben, we have just a few minutes left here, and you began to touch on this a bit earlier, but as we talked about sustainable ETFs growing over the next several years, I wanted to ask you a question that I've asked each of our guests the last few weeks on the program, and I know you have some thoughts on this because we actually referenced two of your articles when we first introduced this topic. The question has to do with whether ETF proliferation has gotten out of hand. I'm not sure if you saw the comments from Vanguard CEO Bill McNabb where he expressed concern about some of the new ETFs coming to market. I'm just curious, what are your thoughts on this?

Ben Johnson: I mean, in my mind, it's gotten to the point where it's absolutely silly, to the extent that we're seeing ETFs being launched on the basis of themes that might be trending on Twitter like robotics, like 3D printing, millennials, obesity, organic produce. You know, it's just evidence of the fact that all of the white space that's worth covering, that's relevant to investors, was covered off a long time ago, so we've got ... you know, going on, and we'll cross the 2,000 mark in terms of the number of exchange-traded products in the U.S. by year's end. If you line those up and you rank them by assets, the top 100 of those had three-quarters of the assets. We've got over $2.25 trillion of investors' money invested in ETFs now. Those top 100 are almost uniformly broad-based, market cap-weighted, very low-cost, very tax-efficient, as dull as watching grass grow and paint dry at the exact same time, and are in my mind exactly where the vast majority of investors' money should be. The risk as I see it is that all of this proliferation distracts investors from the most worthy investments on the ETF menu. It becomes a bit of a sideshow, and potentially runs the risk of tarnishing the ETF brand in the minds of people who are new to the category.

Nate Geraci: Ben, I think those are all absolutely valid points, but I guess a question I might ask is how do we square that with the mutual fund space? Because right now, there are 8,000 mutual funds out there, or 24,000 when you consider all the different share classes. I made the point that I feel like Bill McNabb should be focusing on whittling down the number of mutual funds in the different share classes before we say ETF proliferation has really gotten out of hand. I guess, what are your thoughts on that?

Ben Johnson: I think that's a movement that's already afoot, and I think regulation is only going to drive that further. I think share classes, the loads, 12B-1 fees, all of these artifacts of sort of the legacy of funds distribution, that's all going to get chipped away at. I think what you're seeing with respect to just strategies is that, you know, these quote/unquote innovators are choosing to bolt their strategies ... so these gimmicky strategies ... onto this new chassis, because it's just less costly for them to do so. To a certain extent they're benefiting from the halo effect that sort of exists around the ETF category, because as I described earlier, so many people equate ETFs with being very straightforward, very simple, very low cost. While going back ten, fifteen, twenty years ago you might have had the thought of bringing a robotics strategy or portfolio to market in a mutual fund chassis, today the chassis of choice is just an ETF. We saw internet funds in the late '90s. Today's internet funds aren't going to show up in a mutual fund, they're going to show up in an ETF.

Nate Geraci: Ben, we'll have to leave it there. As always, just an excellent perspective. We certainly appreciate you joining us today. Thank you.

Ben Johnson: Happy to be with you guys. Thanks again.

Nate Geraci: That was Ben Johnson, Director of Global ETF Research at Morningstar.