ESG: Investors Awakened
by P.E. KelleyMr. Kelley is managing editor of this magazine. Connect with him by email: [email protected]
It is hard to look at any event that occurred during 2020 without it being wholly subsumed by the sheer gravity of the year itself. Still, much did happen while we engaged that other shared experience. For Sustainable Investing, 2020 may in fact prove to be a turning point… when the ESG phenomenon became mainstream. According to research data from Northern Trust, ESG investment realized $51.1 billion net flow in 2020, more than doubling 2019’s $21.4 billion, and surpassing 2018’s $5.4 billion times ten.
So, while the pandemic and social unrest may have heightened investor awareness of the principles of ESG, there is still a dogged misperception that these funds must necessarily sacrifice performance. That notion is slowly ebbing, as investors realize that ESG no longer has to be a satellite holding, proving over the past decade that it can now be used as a core holding.
We spoke with Mike Hunstad, head of quantitative strategies for Northern Trust Asset Management, who asserted that that key to constructing an effective ESG portfolio requires an underwriting that looks not only at the commitment to the principles and objectives, but, just as critically, to the underlying management, including risk-control, diversification and the integration of quality.
ESG funds, he said, do not operate in a vacuum.
PEK: Is there a belief among investors that ESG investing somehow involves sacrificing performance? How do you dispel this notion?
MH: Actually, we see more and more investors embracing the idea that you don’t have to sacrifice performance to invest your ESG criteria. And it really all comes down to implementation, which has evolved from the exclusionary-based approaches of the past. We’ve seen an appreciable evolution of ESG investing in recent years, as investors now have access to better data, are less focused on exclusions, and are more engaged. We believe that ESG data is quite valuable in terms of highlighting risks and opportunities unseen in the financials of a company, and, if employed strategically alongside other known drivers of return, may improve the risk and return outcomes for a particular strategy.
PEK: Your research talks about ‘factors with alpha.’ What is the nature of your current ESG research?
MH: Our ESG research agenda is focused on two main priorities. First is the definition of ESG. We spend a lot of time thinking about the dimensions of ESG that are most relevant to corporate financial performance. This process involves looking at an extensive amount of data and organizing it in a manner consistent with the identified key dimensions. The second priority on our ESG research agenda relates to portfolio integration. ESG does not exist in a vacuum. As investors, we build an investment thesis involving not only ESG objectives, but other areas that are crucial to a company’s prospects overall. Another key and often underappreciated aspect of this work is risk control and diversification.
PEK: Within the universe of ESG companies, how do you distinguish high-quality commitment to the principles of ESG investing, as you have defined them: profitability, cash-flow and conservative balance sheets?
MH: The three dimensions of quality are foundational to our approach, and we begin by identifying them. First is management efficiency. Second is profitability. And third is cash flow.
Within management efficiency we look at measures of capital expenditure outlays, asset growth, and capital decisions. In other words, we focus on prudent balance sheet management and organic growth rather than growth through acquisition, the latter of which research shows are not rewarded over the long run. Within profitability, we look at measures of business profitability, operating efficiency, and operating improvement, which point us to companies with strong “return on” metrics, high margins, and high asset turnover. And last, but certainly not least, is cash flow where we look at both free cash flow and cash flow from operations. Building a portfolio that draws upon high ESG performers that are also high quality provides a more holistic view of what makes for a sustainable company.
PEK: What’s the best way to integrate quality into an ESG portfolio?
MH: We believe the most effective way to integrate quality into an ESG portfolio is by identifying the subset of companies that are not only high quality, but also that deliver from an ESG perspective. We focus our portfolio on that subset of stocks. However, risk management is crucial to our approach. We carefully control risk throughout our investment process to ensure we are delivering a portfolio of high quality and high ESG companies that avoids exposures our research shows are uncompensated, particularly sector biases. We aim to consistently meet the objectives of the portfolio surrounding quality and ESG characteristics, diversification, climate risk management, and ultimately, risk-adjusted portfolio returns.
PEK: What have you learned to date about recognizing, and ultimately choosing, quality ESG companies. What are some of the risk-profiles that help clarify the process of building profitable ESG portfolios?
MH: After designing and managing ESG portfolios for more than 30 years, we’ve learned that although there is not a “one-size-fits-all” ESG portfolio, there is a lot of common ground amongst ESG investors. Our fully integrated strategy maintains a well-defined process when constructing the portfolio. We incorporate exclusions, ESG ratings, controversies, as well as climate risk management. We continue to emphasize the role of risk management in the process because it can be quite easy to build a portfolio that is concentrated in individual industries and stocks, while having zero or limited exposure to other parts of the economy. Thus, it is important to identify companies in each industry that provide us with the best possible combination of quality and ESG, while considering risk and diversification.
PEK: Your research identifies the important role of sustainability in ESG investing, and that there are two dimensions of this: financial and non-financial. What distinguishes one from the other, and why are they important dimensions?
MH: We view financial and non-financial ESG considerations as very complementary to each other. A company is sustainable financially, broadly speaking, when it prudently deploys shareholder capital, earns a strong return on its capital, and is generating cash through its operations. Companies also foster non-financial sustainability when they adhere to corporate governance best practices, are committed to ensuring product safety, and prudently manage their impact on the environment. However, a company may look attractive from a financial perspective, but their ESG practices raise concerns, and vice versa. Our process seeks to capture companies that exhibit both dimensions, because we believe this approach captures a more holistic view of sustainability.
PEK: Can you discuss some of the real-world implications of incorporating ESG into the mindset of industries, and then into the mindset of investment portfolios? For example, how can companies heavily engaged in fossil fuels formulate a global-warming response and strategy?
MH: Real-world examples abound. Take, for example, traditional energy companies. In many cases, they are aware of the business case for a commitment to sustainability. As solar power and other renewable energy sources become increasingly cost effective and consumer appetite for these forms of energies increases, the business case to diversify fuel mix becomes clear. We expect companies to think about the ESG risks and opportunities that are impacting their businesses, and to provide relevant information to shareholders to allow them to evaluate whether a company is acting according to prudent ESG investing principles. The first step is recognizing climate change’s importance on business strategy and acting accordingly. As we construct portfolios, we are looking at the way companies are positioned to manage a transition to lower carbon emitting fuels and the extent to which they are positioning themselves to benefit from the opportunities of a low carbon economy. We are also focused on climate risk management as a cornerstone of our stewardship activities. We believe that serving as an active owner produces sustainable value over the long term, which leads to better outcomes for clients, shareholders and stakeholders.
PEK: There’s some industry research which implies that ESG and quality are the same thing or that it’s quality which improves performance, not ESG. Do you agree or see some overlap?
MH: Our research shows a modest positive correlation between quality and ESG metrics. This is a good thing. A positive correlation supports our thesis that quality and ESG are two sides of the same coin. However, the fact that the correlation is relatively low suggests a significant opportunity to have quality and ESG complement each other. In other words, looking within the universe of companies with high ESG ratings, there are high- and low-quality companies. Therefore, our process takes advantage of investing in companies that are at intersection of high quality and high ESG metrics in a manner that complements each.
PEK: Can you discuss the genesis of your own portfolio-building strategy for your Northern U.S. Quality ESG mutual fund (NUESX)?
MH: When we surveyed the landscape back in 2013, much of the ESG exposure was evolving in a richer and more impactful way, however that exposure was untested from the perspective of delivering alpha or outperformance. Many of the leading indexes at the time, and even to this day, led solely with the ESG characteristics, leaving to chance whether the strategy would deliver outperformance. This approach lacked a fundamental tenet of what defines sustainability in an investment context, namely financial health. We conceived the strategy on group which NUESX was ultimately based in 2013. The strategy is rooted in our strong belief that those companies that demonstrate ESG leadership, and which are high-quality in nature, would outperform. Time has proven us to be correct to the benefit of shareholders of NUESX, which we launched in 2017, and which has earned an overall 4-star rating from Morningstar based on 1,261 large blend funds derived from a weighted average of the fund’s 3-year risk-adjusted returns as of 05/31/21.
PEK: Your website describes the strategy as a proprietary quantitative, multi-factor one. Without giving away the secret formula, can you briefly describe it in simple terms?
MH: To define factors, we apply a framework that we have been using since 1994. We start by identifying the multiple dimensions that describe a given factor. For example, as previously noted, the dimensions of quality are management efficiency, profitability, and cash flow. We then conduct substantial research into identifying individual metrics that are aligned with these dimensions. Importantly, we measure exposures in a sector neutral manner. This is a key step to controlling risk because it provides an even proportional number of high and low scoring stocks in each sector.
Of course, the factors utilized are only one, albeit important, element of the strategy. How NUESX uses the factors during portfolio construction is no less important. During the portfolio construction process, our quantitative approach returns what we believe is the optimal portfolio. Given the multiple objectives around quality, ESG and controlling risk, this quantitative approach can effectively handle all our requirements and seeks to deliver the best possible portfolio. Given the dynamic market environment, our approach allows us to efficiently monitor changes to a variety of inputs over time and inform periodic changes made to the portfolio.
PEK: Should advisors think of NUESX as appropriate to be used as a core holding or is it better as a satellite fund?
MH: We designed NUESX to be appropriate as a core holding and most of our investors use it in this manner. The funds diversification benefits and risk-profile are supportive of a typical core portfolio holding. While most investors are using it in this fashion, we have seen some investors, especially those investing in ESG funds for the first time, use NUESX as a complement within their portfolios to other allocations. The fund has lower excess return correlations with both Large Cap and ESG peers and makes a good complement to existing allocations within client portfolios. But over time, we have seen investors who use NUESX as a satellite allocate more of their core equity holdings to it given the fund’s risk/return profile and performance.
PEK: Please discuss the role of stewardship in the development of sustainable ESG performance, particularly your role as signatory to the very ambitious Climate Action 100+ initiative.
MH: Our stewardship process is rooted in our firmly held belief that is our duty to regularly engage with the companies in our portfolios. That’s why we identify long-term risks that have the potential to pose challenges to shareholder value, and we engage on issues of substance – those that can affect business on many levels. After all, ESG issues impact the long-term success of most firms, and therefore, are important to most investors.
Thus, stewardship is very much aligned with prudent investing principles that we deploy on behalf of our broad assets under management and in NUESX. Following a core philosophy, we exercise our perspective on sustainability, informed by the Principles for Responsible Investment (PRI) and leveraging the SASB materiality standards, through direct, outsourced and collaborative engagements.
For example, as a founding signatory of Climate Action 100+, which is now composed of 545 investors representing over $52 trillion in assets under management, and coordinates engagement efforts across 167 companies responsible for the highest greenhouse gas emissions, calling on these companies to develop clear transition plans aligned with net zero greenhouse gas emissions by 2050. We are active participants in the dialogue on topics such as improving governance over climate management.
We became a part of this important initiative because we recognize the role that investors and companies have in addressing climate change, and the power that collective engagement has to exert influence with engagement targets. We have been very active in the initiative, serving as lead or co-lead in three groups, while also participating in a dozen other engagement groups. While 2020 brought many sustainability topics to the forefront, there’s still more work to do. Purposeful stewardship comes down to achieving tangible and lasting commitments to long term sustainability on critical topics like climate risk management, diversity and inclusion, workforce safety and human capital management. Looking ahead, we will continue to use our platform to directly influence companies to encourage sustainable practices.
Please carefully read the prospectus and summary prospectus and consider the investment objectives, risks, charges and expenses of Northern Funds carefully before investing. Call 800-595-9111 to obtain a prospectus and summary prospectus, which contain this and other information about the funds.
Environmental, Social and Governance (ESG) Risk: The Funds ESG screening process may affect exposures to certain companies or industries and cause the Fund to forego certain investment opportunities.
Equity Risk: Equity securities (stocks) are more volatile and carry more risk than other forms of investments, including investments in high-grade fixed-income securities. The net asset value per share of this Fund will fluctuate as the value of the securities in the portfolio changes.
Alpha: Outperformance versus the benchmark.
Free Cash Flow: Free cash flow represents the cash available to the company after adjusting net income for non-cash items.
Tracking Error: Represents how closely a portfolio tracks its benchmark.
NUESX did not hold any shares of Exxon as of 3-31-21. Fund holdings and sector allocations are subject to change and should not be considered recommendations to buy or sell any security.
Northern US Quality ESG (Class K) received 4 stars for the 3-year rating among 1,261 large blend funds.
The Morningstar RatingTM for funds, or “star rating,” is calculated for managed products (including mutual funds, variable annuity and variable life subaccounts, exchange-traded funds, closed-end funds, and separate accounts) with at least a three-year history. Exchange-traded funds and open-ended mutual funds are considered a single population for comparative purposes. It is calculated based on a Morningstar Risk-Adjusted Return measure that accounts for variation in a managed product’s monthly excess performance, placing more emphasis on downward variations and rewarding consistent performance. The top 10% of products in each product category receive 5 stars, the next 22.5% receive 4 stars, the next 35% receive 3 stars, the next 22.5% receive 2 stars, and the bottom 10% receive 1 star. The Overall Morningstar Rating for a managed product is derived from a weighted average of the performance figures associated with its three-, five-, and 10-year (if applicable) Morningstar Rating metrics. The weights are: 100% three-year rating for 36-59 months of total returns, 60% five-year rating/40% three-year rating for 60-119 months of total returns, and 50% 10-year rating/30% five-year rating/20% three-year rating for 120 or more months of total returns. While the 10-year overall star rating formula seems to give the most weight to the 10-year period, the most recent three-year period actually has the greatest impact because it is included in all three rating periods. Past performance is no guarantee of future results.
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