Mostly Money

98: Does ESG investing lead to better returns for investors?

June 13, 2021 Preet Banerjee
Mostly Money
98: Does ESG investing lead to better returns for investors?
Chapters
Mostly Money
98: Does ESG investing lead to better returns for investors?
Jun 13, 2021
Preet Banerjee

You’ve likely heard terms like ESG investing, sustainable investing, impact investing, socially responsible investing and others. But are they all the same? Today’s guest is the head of ESG at Research Affiliates. And we’re going to tackle some important questions: 

  • Does ESG lead to better returns for investors? 
  • If you don’t invest in ESG tilted portfolios, are you against the environment,  or social and governance goals? 
  • Who determines whether a portfolio or investment is ESG compliant? 
  • Is it too subjective? 

All that and much more on this episode of Mostly Money with guest Ari Polychronopoulos of Research Affiliates.


LINKS

Research Affiliates' website
Research Affiliates on Twitter: @RA_Insights

White papers:

1. Is ESG a factor in returns?

2. What a difference an ESG ratings provider makes

Show Notes Transcript

You’ve likely heard terms like ESG investing, sustainable investing, impact investing, socially responsible investing and others. But are they all the same? Today’s guest is the head of ESG at Research Affiliates. And we’re going to tackle some important questions: 

  • Does ESG lead to better returns for investors? 
  • If you don’t invest in ESG tilted portfolios, are you against the environment,  or social and governance goals? 
  • Who determines whether a portfolio or investment is ESG compliant? 
  • Is it too subjective? 

All that and much more on this episode of Mostly Money with guest Ari Polychronopoulos of Research Affiliates.


LINKS

Research Affiliates' website
Research Affiliates on Twitter: @RA_Insights

White papers:

1. Is ESG a factor in returns?

2. What a difference an ESG ratings provider makes

Preet Banerjee:

Let's say I was with the clan, which I'm not for the record, let's say I was at the clan, and I'm responsible for managing the pension for an IRA. And I said, Hey, we we like this idea of ESG, but not so much the s. Yeah, we don't care about society. You know, we don't care about equality. But yeah, environment great governance. Yeah, we got a structure. So that's important to us. So could we get like, just eg without the S?

Ari Polychronopoulos:

I, it's funny. There are funds like that. I mean,

Preet Banerjee:

you've likely heard terms like ESG investing, sustainable investing, impact investing, socially responsible investing in others. But are they all the same? Today's guest is the head of ESG. At Research Affiliates, we're going to tackle some important questions. Does ESG lead to better returns for investors? If you don't invest in ESG tilted portfolios, are you against the environment, or social and governance goals? And who determines whether a portfolio or investment is ESG? compliant is too subjective? All that and much more on this episode of mostly money. This is mostly money. And I'm your host, Preet Banerjee, my guest today is Ari Pollak monopolies who is the head of ESG. At Research Affiliates, a very well known firm globally for its smart beta and asset allocation work, over $170 billion worldwide is managed using Research Affiliates strategies. Ari is a partner at the firm and focuses on smart beta and ESG integration. He's responsible for multiple product lines, including the Rafi fundamental index, multi factor ESG, and related climate transition strategies. Ari, welcome to the show. Thanks, Preet.

Ari Polychronopoulos:

It's great to talk to you. It's been been a while but happy to happy to be here.

Preet Banerjee:

Yeah, it has been a long, long time. So our paths crossed professionally. Over a decade ago, I think. And you know, there's there's one thing I want to talk about, actually, there's so many things I want to talk to you about. One is you've got deep background in the financial services. And when we first met, you're brand new at Research Affiliates, I think, yeah, we're within a firm or something like that. And right before that, you were at a company called indymac, which went under which no longer exists, right?

Ari Polychronopoulos:

Yeah, it it, I guess, has the title. It was one of the first banks that was taken over by the US government during the global financial crisis.

Preet Banerjee:

Yeah. And I remember at the time you telling me the story of what was happening, because just to put this into context, so this was just a few years after the great financial crisis. And it was still fresh on everyone's minds. And I had this opportunity to talk to this guy who had lived right through it like right on the ground, what was happening in the US the epicenter of what was happening. So and I remember when you were telling me the story, I was like, my jaw was on the ground, I forget the details, because it's been like, you know, 13 years or whatever. But can you walk us through? First of all, what did you do at any Mac? What was your role there? And what happened during the great financial crisis?

Ari Polychronopoulos:

Yeah, so in the Mac was a mortgage bank. So basically, the role of the bank was to is as a lender, you would want to buy a house, you need to take out a mortgage you would any bank bank would obviously give you a loan. And the my role of the bank was I was an analyst on a trading desk that was responsible for hedging what was called the bank's MSR or mortgage servicing rights portfolio. Basically, what that is, is when you take out a mortgage, there's really three components to a mortgage from really kind of a fixed income perspective or a cash flow perspective, there's kind of your principal payment that makes it part of your mortgage, there's your interest payment that you pay for the loan you've taken. And then there's what's called the mortgage servicing rights. That's usually like a quarter of a basis point of your loan that goes to the company that's actually servicing your mortgage. So sending out statements and collecting payments and things like that. And so the bank would, would do what a lot pretty much every mortgage bank was doing at the time is they would package up fixed income products, basically principal only pools of mortgages and they strip out the interest only portions and they would sell those off the different event. Banks. And we were we would retain the mortgage servicing rights because we had a big mortgage servicing business. And so our job was to hedge that mortgage servicing rights portfolio, because essentially, what you had to do is you had to mark to market that portfolio every day. And so based on how interest rates will move, the value of that portfolio could swing by millions of dollars, we were, I think, at the time, had a mortgage servicing right portfolio of a few billion dollars. So you could have huge fluctuations. And so we were buying, you know, different fixed income swap contracts, futures, contracts, things like that, to basically hedge out the, what's called the interest rate risk in that portfolio. And as the, as the, I guess, the credit quality of any Mac began to deteriorate, going into the global financial crisis, essentially, what was happening is, you know, our counterparties, were getting more and more afraid of basically, the company defaulting, you know, the loans, we're collecting the loans we were selling, you know, as, as not only any macro, pretty much every bank was, you know, at the height of the crisis crisis, basically lending to anybody who wanted to borrow to buy a house, regardless of credit quality, obviously, there was a lot of bad debt on the books. And so, you know, it was getting just more and more difficult to hedge our portfolio, because, really, at the end there, we couldn't even find counterparties, you know, we'd have different investment investment banks calling us up and saying, you know, hey, you know, our compliance group says, we can't trade with you anymore, we have done one unwind all of our trades. And it just got to be like this really scary situation where, you know, towards the end, we were basically not even able to fully hedge the portfolio, it was kind of moving up and down by a million dollars a day, the credit quality of the company started to deteriorate, and that eventually cause basically a run on the bank, you know, people kind of showing up, the bank did have a commercial bank, side of the business, and people were showing up saying, Give me my deposits. And, you know, once that starts, you know, it just gets it gets, you know, I remember going into work sometimes, and it'd be lines, because we had a bank at the on the ground floor of our building, I was up on like, the fourth floor, whatever. And there'd be lines of people around the corner, just waiting for the bank to open so they can go in and withdraw their deposits. And they'd be screaming at you like, just like you're the devil basically trying to spit at you as you're walking in trying to go. It's like, I'm just, I'm just trying to do my job and trying to hedge your portfolio here. I'm sorry. But

Preet Banerjee:

when when do you remember when you first had like that, that holy shit moment. During that time, in the great financial crisis, where you're like, Man, this is we're all gonna lose their jobs, like, when that occurred to you.

Ari Polychronopoulos:

So I would probably say, so I left in the Mac in about late June of 2008. And I would probably say about a couple months before that, things, you know, started noticing the writing on the wall. And, and started, I started looking for a new job, you know, any Mac was eventually taken over by the government. And then it was sold and rebranded as one West Bank. So it actually still exists today, in another form. And to my knowledge, it's still, you know, a mortgage bank and in a commercial bank as well. But, but yeah, it was it was, I would say a couple months before I turned to some of the other people on the desk and said, hey, it's probably time for us to start looking for something else.

Preet Banerjee:

Oh, man, and yeah, so shortly after that, you ended up at Research Affiliates. And I remember being down at the offices, beautiful offices down in Newport Beach. Are you guys still in Newport? Yep, we are still here in Newport Beach. And I remember walking into the reception, and under this glass case was I think it was a first edition of Adam Smith's Wealth of Nations. Yeah, cool office. And I have a lot of respect for Rob Arnott and everyone at the firm, really, I miss working with you guys back in the day. But in any case, you're here to talk about, you know, what you've been focusing on lately, as you know, a new partner of the firm, congratulations on that. You're heading up ESG. And this has been exploding in terms of headline coverage, demand from investors. Some pension funds need to divest from oil investments. And so it's it's huge. And that's why you're here, you're going to sort of help explain what what is going on in the world of ESG what it is what it means to investors. So let's let's start with the very basics. And what does ESG stand for?

Ari Polychronopoulos:

So yeah, ESG stands for environmental, social and governance, investing. at a very high level, if you want to define it, it's really an approach to managing assets where as an investor, you explicitly acknowledge the relevance of these factors, these environmental, social and governance factors in your investment decisions. And it's a really broad area. So when you say it's even something like environmental factors, what does that mean? It actually means a lot of things. It's really any theme that pertains to the natural world. And it deals with concepts like climate change, resource depletion, pollution, deforestation, biodiversity, these are all kind of themes within the environmental space. On the social side, you're looking at themes that affect the lives of humans, like human rights, child labor, employee relations, human resources, issues, diversity, these are all the types of things you deal with, when you're looking at the social aspect of ESG. Investing. And then finally, governance is really issues inherent to business models, like board makeup, executive pay, lobbying, practices, bribery, corruption, and so you, you literally have, you know, hundreds of scenes within ESG. And an ESG investment strategy could be something that's very specific, like a strategy, an investment strategy that focuses on gender diversity. Or it could be very broad by saying, hey, I want a broad ESG strategy that, that invest in companies that that rank really well on a ESG perspective holistically. So it's really kind of a broad space. And when you say ESG, you're, you're talking really about a lot of things. And it's something that means really different things to different people. If you are talking to a large pension fund concerned about climate change, they're likely going to have a very different idea of what a good ESG company is compared to a faith based organization looking to invest based on their values. And so it varies quite a bit.

Preet Banerjee:

In any sort of new ish space terms often get conflated or confused. So can you explain what sustainable investing, Sri socially responsible investing and impact investing? They all seem to be in the same world? But they do have different meanings? Can you explain the differences?

Ari Polychronopoulos:

Yeah. So let's start with Sri so. So they're all they all kind of mean the same thing. And they're often used interchangeably. Sri, or socially responsible investing is kind of what I'd say is like, I would term maybe first generation type of ESG investing. You know, Sri investing actually goes all the way back to the the late 1700s, early 1800s, you could see there's, there's, you know, you could read about different kinds of Quaker and Methodist churches for bidding their members from investing in a slave trade or buying sin stocks, guns, liquor, alcohol, things like that tobacco. And so Sri is really more of thinking about, you know, excluding a lot of type of invest, about type of companies you wouldn't want to invest in, based on what they do. That's really evolved more recently into what we now kind of call ESG, where you're looking a little bit more quantitatively, you're not just excluding certain industries, but you're actually looking at a lot of different factors within those themes to kind of score a company or rate a company. And it's much more what we call an integrated approach. impact investing is actually an entirely different type of strategy where an impact investing is where you're going to only invest in areas that have a positive impact on the environment or society. And so an impact investor might be investing in certain projects, like perhaps a micro financing project in a third world country to get, you know, small businesses up and running, and expect to get a return but probably not expecting to get the type of return they would get if they were just going to invest in the market. And so impact is a little bit different than then your traditional Sri and what we now call ESG.

Preet Banerjee:

Now, it seems like there's a whole bunch of different factors that you've talked about. So how do you how do ESG investment strategies tackle these themes? So if I say, Yes, I want to be an ESG investor, because seven of those things that you just talked about, they, they mean something to me, and they're aligned with my values? How do I actually implement that in a portfolio?

Ari Polychronopoulos:

Great question. So there's a lot to unpack there. You know, as I previously mentioned, there's no universally accepted definition of ESG. And so you know, even if you do a quick Google search, on ESG ETFs, for example, you're going to find everything from climate specific funds, clean water funds, funds that try to encourage minority empowerment faith based funds, gender diversity. So as an investor, I think step one is determining what are your ESG preferences, and then second, trying to find an investment strategy that's aligned with those preferences. I think, you know, more so than really anywhere else in the investment space and enjoys do your homework when you're investing in something. But the ESG space is just, it's just so broad. And there's just so many different options. It's really understanding what you want to accomplish through your investments and then finding an investment strategy that's aligned with that.

Preet Banerjee:

My understanding is that there's a number of different ways that maybe an Index Provider might say, Well, here's something that is aligned with ESG. And it could be through negative screening, where they say, we're going to exclude certain companies based on criteria or others might say, well, we'll place more weight on companies that, you know, hit certain objectives or targets. So can you talk about, what are those different metrics that are used those ratings that are used that that will allow someone to say, yes, this company has a good ESG rating? And this one doesn't?

Ari Polychronopoulos:

Yeah. So. So when you're implementing an ESG strategy, as you mentioned, there's a couple ways to go about it. So we can start there. You mentioned divestment, and that's that's kind of the the easiest approach to ESG investing. It's, it's what's called, I'm not going to exclude companies, or I'm just going to divest from these companies, I'm not going to own them. Typically, you see investment strategies that divest from things like fossil fuels, for example, where there'll be no oil companies or energy companies in the portfolio that that are using fossil fuels or divesting from weapons or coal or tobacco. And so that's really the simplest route. Second is what we call integration ESG integration where, where you might say, I'm going to update companies that rank really well, from an ESG perspective, I'm going to downgrade companies that rank poorly from an ESG perspective. And the benefit of the ESG integration approach is that by not excluding the companies, a lot of investment managers say, Well, I can actually, you know, influence change at a company, I can vote my proxies, I can get members on the board that might be sympathetic to some of these ESG issues. And so we've seen this movement away from just broad based exclusions into more ESG integration and what we call engagement, where you're actually engaging with the company and trying to influence change, through your through your voting rights, and through your interactions with the company itself. Now, when you're trying to determine what makes a good ESG company, and this is probably the the biggest kind of area of in terms of issues associated with ESG is how do you determine what a good company is? Typically, the way you do this is, you can work well with what we call ESG ratings agencies. So there's a lot of different ratings companies out there that provide ESG data. That data is based on a lot of different data sources. So starting from the beginning, typically, you'll have large companies that provide sets of ESG disclosures each year, similar to their annual filings are in financial statements. But unlike financial statements, there isn't a single uniform framework for disclosing ESG risks and opportunities. For example, I guess the most popular framework is what's called the G ri, the global reporting initiative, about 70% of publicly traded companies report using this framework. But there's some other popular ones as well, there's Saxby, the sustainability accounting standards boards that has their own framework for companies on how to report. There's one called the taskforce for climate related financial disclosures, which is more about environmental issues. And so starting from the beginning, it's okay, these companies are gonna report what type of framework are they going to use. And then you have the data providers that are collecting a lot of those disclosures and reports, and also doing interviews with the company looking for other publicly available information to come up with an ESG rating. And when you look at I wrote some research last year on on ESG ratings providers, and basically that's a field where there's you know, identified over 70, different ESG ratings providers. And so as an as an investment manager, if I'm going to create an ESG Fund, the question is now, okay, once I've defined what my ESG preferences are going to be, I gotta go out and get the data. Who am I going to get the data from all of these different ESG data providers have different methodologies for how they rate companies, and you can get some very different results? by just looking at the data from the from these different companies.

Preet Banerjee:

Let's say I was managing a lot of money. And let's say I was responsible to some investors and they said, Hey, we want ESG NFL, let's say I had a particular investment philosophy. Could I just go rating shopping and say, all right, well, I will pick this rating because that is most in line with my investment philosophy and I would have to make the least amount of change, but I can keep my investors happy because I could say hey, look at me, I'm ESG Is it like you know, when you go to the grocery store, and you see those little You know, those little checkmarks that say, hey, this has been approved by this, this and this ratings company that says it's super healthy for you, if you buy this right, like, Is it just a matter of like pay to play? Is there like shopping around and agencies? How does this work?

Ari Polychronopoulos:

Yeah. So I'll talk about kind of our, our experience when we launched our first ESG index strategy several years ago, I would say it's a little bit more than that, I wouldn't say it's just kind of a pay to play scheme or anything like that. Most of these ESG ratings providers will have really well thought out methodologies, I don't you know, that some of the leading providers the MSCI sustainalytics, ISS are a few of them of the world, they have very well thought out methodologies. But again, these methodologies aren't uniform, there's no regulatory agency that says this is, you know, the framework you should use for determining what a good ESG company is. And so they're all going to be a little bit subjective and a little bit different based on the methodology that they've developed. And so that's kind of, you know, the the issue with the ESG ratings agencies. So when we launched our first ESG strategies, we basically did, our research team did did a pretty long project, where we looked at several different ESG ratings providers, we got trial data from all of them, read through their methodology, documents, looked at the data, and and really ended up choosing the one that we thought we were most comfortable with. And we were looking for things like, do they have broad data coverage? Do they cover a lot of companies so that we can make sure we can build a broadly diversified investment strategy? Is there you know, kind of any? Is there data quality good in terms of how there's kind of sourcing the data and delivering the data? And does their methodology make sense to us? And so, you know, for full disclosure, for our own investment strategies, we use a company called ISS. And that's the company that we settled on. But even when looking at the different companies, you see some some interesting idiosyncrasies, some interesting differences between the companies. A good example is we have a index strategy that excludes energy companies. And when you look at a company like Toyota, for example, you would think what's when you think Toyota, you think auto manufacturer doesn't seem very controversial? I probably wouldn't exclude it as a as a energy company. So some of the data providers don't exclude Toyota. Some of the data providers do exclude Toyota because they have a 20% stake in a subsidiary that engages in thermal coal mining. So now, the question is, you know, this kind of gets into the different methodologies, you know, do you consider the ownership and subsidiary means that Toyota itself should also get excluded? And so there's all these kind of little idiosyncrasies? Well, yeah,

Preet Banerjee:

I could give a perfect example, which would be, hey, look, here's a transportation company that, you know, it's not a sin company. And like, Oh, yeah, they just like move stuff from place to place. What in the move just guns? Yeah.

Ari Polychronopoulos:

So that would be an effort by some screens that we like, well, that's another one other screens like, well, it's just transportation. But that's kind of like to your point. Yeah. And typically, the way we deal with that is we use kind of a revenue based model for determining if a company is engaging in what we call a controversial activity. So if a company is deriving more than, let's say, 5% of its revenue, or 10% of its revenue from either the production the sale the distribution of cost of guns, for example, you know, we might exclude it. And interesting cases, Walmart, Walmart gets excluded from some more indices because they have a significant part of their revenue is from selling guns. And you wouldn't think that but you know, that that it does fail that screen because because they do sell I think it's more than 5% of revenue or something like that comes from the sale of guns.

Preet Banerjee:

Conversation with Ari Pollak monopolies continues in just a minute, but first, a few thank yous to listeners who left comments on Apple podcasts. Thank you to Cedric Nola, J. barshop, Medi bakery. Andrew Lutz and Omar mo 93. All listeners from the United States where oddly the podcast has a higher rating than in Canada. But do everyone who leaves ratings and comments on Apple podcast, I appreciate them. And I do read them all. I produced the podcast for you listening. And just a heads up a Navy taking a hiatus on the podcast towards the end of summer I really need to put my head down and finish up my dissertation and hopefully defended in the fall. It really should have been done by now. So I'm going to turn my focus onto that to really get it buttoned up. But for now, back to the conversation with Ari Paulo kanopolis from Research Affiliates. So when it comes to, here's another analogy. There's this old movies called the big hit, not super popular, but kind of like a little cult action comedy movie. And there's this one scene where this guy, they want to place a phone call, but they don't want to get traced. So they had this trace buster. And then they've also thought ahead, and they thought, well, in case the people on the other end of the line have a way of identifying if you've got a trace buster, and they can still trace you, we've got this trace Buster buster, and it was just this little thing. So the question is, is there in ESG, ratings ratings agency? Because if there are so many different ratings, isn't there going to be some kind of value to have some kind of unification? Because this seems quite problematic. It seems like this is an area where you know, people could get exploited, or they could, you know, pick a ratings agency that gives you different results. And the reason I asked this is because I know that you've done some work on this, you've done some work on measuring the returns of portfolios with these different ratings agencies screens applied. And I wonder if you could talk about the differences in returns between providers? Yeah,

Ari Polychronopoulos:

yeah. So that's the first part of your question there, there isn't a single kind of global framework for determining kind of an ESG rating, or there isn't the oversight the board in any country that oversight oversees ESG ratings. What we are starting to see though, is some uniformed regulations around ESG disclosures, which is a good thing, I think that's step one in the right direction. For example, in the UK, they've recently passed a law where basically all large companies, public and private have to disclose climate issues, climate risks and opportunities. According to the what's called the TCF D standards. They also have mandated that large companies and all investment managers start start offering mandatory disclosures on the sustainability of their investment strategies. And they're also developing something that you call the EU taxonomy, which is basically a global framework for reporting on ESG risks and opportunities. And so we're starting to see that in some areas of the world where I think we're going to start seeing a lot more uniform disclosure reporting, and which will probably start lending itself to kind of better and higher quality and more consistent ESG ratings. But But you're right, we looked at a couple of different ratings providers last year, and a paper that I wrote, where we essentially built the exact same investment strategy, but we use two different ratings providers. So basically, what we did was we took the top 50% of companies by ESG score, and then just calculated the portfolio and then ran a simulation over about 10 years to see you know, how similar the portfolios were, and you got fairly different results, both in terms of return. volatility is about the same, but the return was a couple percentage points different. But then you when you looked at things like turnover in the top holdings at the portfolios, they were very different. One portfolio had a high waiting and wellsfargo where the other portfolio excluded that company entirely. And then vice versa. Facebook was rated really low by by that by the first company, and was one of the top holdings in the second portfolio. And so, yeah, with this

Preet Banerjee:

governance specific governance factor that both will that differentiated Wells Fargo, because I know they've got some governance issues. Yes,

Ari Polychronopoulos:

it was the governance factor. And then on the Facebook side, it was is really just kind of dealing with issues of data privacy. Really How surprising and and, you know, it's it comes down to how is that treated in the methodology? And how much of a weight does that ESG data provider put on one on one of those issues? Because they all determine make their own determinations of what's material? And how much of should you wait that issue in determining the overall ESG score? And that's, that's where you can kind of get these very different results.

Preet Banerjee:

In terms of the amount of the difference in results, was it statistically significantly different between readings providers, like Do you have enough time in the dataset to really draw meaningful conclusions? Because, you know, the reporting of these metrics hasn't really been around that long as it

Ari Polychronopoulos:

Yeah, that's that's kind of the other. The other issue is his data availability. You know, if you get if you're lucky, you can get a ESG data set that goes back maybe a decade or a little longer. So obviously, determining statistical significance off of 10 years of data is it's nothing is going to be statistically significant. Yeah,

Preet Banerjee:

cuz that starts after the great financial crisis troughs, so everything's gonna look pretty good. But yeah, so that that kind of brings me to another question, which is, is ESG a factor and I want to explain Just a little bit because we know that with, you know, the world and I guess I guess was pre 1993 we lived in a cap m world and then post 93 we're kind of like in this fam of French three factor world. And factor investing has risen in prominence, including things like the market factor, the value, size cetera. What about ESG? Is ESG? a factor in returns?

Ari Polychronopoulos:

Yeah, that's a that's a great question. I think that's probably the question I get more from investors when we're talking about ESG than anything else is, you know, do I get higher returns if I invest in ESG. And there's really a couple schools of thought here. I mean, there's the traditional academic view that, you know, excluding stocks and constraining your universe will lead to a lower return. Also, that you know, that ESG companies have to compensate investors willing to buy their stocks, with a with a higher cost of capital. And so you should expect as an issue investor, you're gonna get a low return. And so we tried to test the theory of is ESG factor does it provide a robust return premium over time, what I did was we looked at companies within the US and within Europe. So we took two sample to sit different sets of samples. And we created some long, short strategies. So we went long the top 30% of companies by ESG score, short the bottom 30% of companies in our universe by ESG score. And we did the same thing for individual environmental, social and governance scores, try to see if we can determine if there's a factor return associated with any one of these themes are with the broad overall theme itself. And what we found was, when we're doing that test, again, nothing was statistically significant, we didn't really find alpha in these in these tests. Now, again, it was a back test that went back about 10 years. So I don't want to say definitively that ESG is not a factor. But we didn't really find statistically significant alpha, running these tests. Also, within ESG. Again, it's such a broad space. So even when I say we're going to test this, the environmental scene, you know, if we looked at maybe just something like carbon emissions, or certain other themes within environmental, maybe we could have found a data point that that might have provided something interesting. But the one thing I think is important to think about is, I don't think ESG needs to be a factor to be able to take advantage of it over the coming decades. And why I say that is that I think ESG is going to be a powerful theme that might lead to rising valuations for good ESG companies, and higher return as a result, as more and more investors start investing in ESG strategies. So you can kind of think of this as, as an opportunity, a thematic opportunity more so than this is a robust premium that's going to deliver over the next five decades. And the reason I say that is, you know, there's a lot of arguments around kind of what we're seeing within ESG investing, there's, there's the what's called the stranded assets argument that a lot of these energy companies are gonna have to take massive writedowns on their assets of these oil fields that aren't really going to might not be produced deucing in a decade or so. And we're starting to see that a little bit. Now we're starting to see some big oil companies starting to take write downs on some of their assets. And they're we're also seeing, you know, there's a bank of america study from 2019. That's that highlighted that 20 trillion in assets are poised to flow into ESG funds over the next two decades, driven by you know, women and millennial investors, which are increasingly making up a larger share of the investment pie. We talked about greater regulations that are forcing kind of more flows into the into the ESG space. And then if you look at fund flows, you know, 2020 was actually a record year for ESG fund flows. If you look at in Europe, 50% of all mutual fund and ETF flows were in ESG strategies. In the US, that was about 25%. And in Canada, that was about 10%. And so we're I think we're at this inflection point where there's a lot of money flowing in these strategies. There's one thing to consider, though, we talked about the difference in ESG ratings. And in that paper, we make a point my co author actually made up came up with this line, which I thought was hilarious, but they say a rising tide lifts all boats, but all boats need to be in the same harbor and in the water the same time. And with with ESG when you have such different views and different on what ESG Is it the question is, you know, will we be able to capitalize on this theme because

Preet Banerjee:

of that? Kind of tangentially, but we talked about whether or not ESG is a factor jury's out at this point. The data doesn't support that right now. We also you mentioned something about you know, thematic investing and how that's seen a rise in prominence. Are meme stocks a factor? Have you done any research on Wall Street bets and whether or not they have now made a big enough an impact that you can statistically say that means are a factor. Like is there gonna be a fam of French? I don't know what they're up to now, five factors so will there be a sixth factor of mean stocks

Ari Polychronopoulos:

That's an interesting question. I wish I had an answer for it, I think. I don't know. I think, again, we talked about the data availability, I think it's that that's kind of been a thing for much shorter than even ESG investing had so right. I think that the jury will be out on that one for a much longer time. But it's been interesting over the past year, observing that and just watching,

Preet Banerjee:

if we, you know, I just saw yesterday that the latest meme stock is going to be Wendy's stock, because one of the reasons here's the actual rationale, one of the reasons is, they literally sell chicken tenders. And I don't know if you're familiar with the the parlance in, you know, meme stock world, but 10, DS is a big thing. It just basically means gains. And so because they actually sell attendees, they're like, yeah, they should be a mean stock. And also, they're pretty active on Twitter. And they have a pretty good sense of humor with their Twitter accounts, so they become the next darling of the world. And not that I'm advocating buying, you know, deep out of the money call options, just in case but

Ari Polychronopoulos:

unfortunately, it Research Affiliates were prohibited from buying individual stocks, our compliance group prohibits it, so I can't to take advantage of the Wendy's trend now

Preet Banerjee:

interesting. Are you prohibited from buying individual crypto assets?

Ari Polychronopoulos:

No, not on crypto assets, just since most of our strategies are long, only equity indices. And we know, you know, when we're rebalancing, I know what what we're going to be rebalancing into. So we don't want to even have the slightest appearance of some sort of conflict of interest. So

Preet Banerjee:

Right, right, I can only buy, are you guys gonna release a fundamental index of crypto assets anytime soon? Is that on the horizon? That's an interesting question. It was a joke, but are you actually considering it?

Ari Polychronopoulos:

Well, so we have one of our senior advisors is, as is, is a professor by the name of cam Harvey Campbell Harvey, I don't know if you're familiar with him. He's at Duke University, but he's probably at the forefront of cryptocurrencies in terms of his research. And so we've been discussing, you know, internally, you know,

Preet Banerjee:

we are

Ari Polychronopoulos:

looking at cryptocurrencies, from a research perspective, no plans to launch an index at this time, but it's just, it's an interesting space. And, and we've got, we've got the expert in house, so it's just something that we're looking at right now.

Preet Banerjee:

Oh, maybe we'll have to book him for a future episode. I'd love to hear his thoughts. Okay, so, one of the things that I've been seeing a lot lately is that, you know, industry responds to demand and consumer preferences, and there has been a demand for ESG type of products and strategies. And so, as an example, you know, if you have, you know, turnkey portfolios as your product offering, and let's say you've got, I don't know, call it five for five different levels of risk. Now, all of a sudden, you've got 10, because you've got those same five different list risk levels, but now you can get it with an ESG version of those portfolios. So, here's the question. If I don't invest in an ESG portfolio, does that make me anti ESG?

Ari Polychronopoulos:

That's an interesting question. I, I wouldn't say it makes you anti ESG.

Preet Banerjee:

I don't feel

Ari Polychronopoulos:

like I'm anti ice. I think one of the things to be cognizant of, and so this kind of going back to the ESG portfolios, and I'll bring it back to the non issue ones. There's a concept you need to look for when it when investing in ESG. And it's called greenwashing. Essentially, it's a term that means that a company or an investment strategy is marketing itself as ESG, when it's really not doing much at all. And so given the growing popularity of ESG, investing, a lot of funds are rebranding themselves as ESG, even though they're not, there might not be much going on under the hood. In regards to ESG. There was actually a article in Bloomberg that came out last month it was called, it was called many ESG funds are expensive s&p 500 indexers it's a great article about this topic, where basically they're looking at some of the top ESG ETFs. And saying, These look exactly like the broad market index. What's going on here in terms of ESG? And more profit? Yeah, and it's, it's three times the expense ratio. Yeah. And so, you know, some ESG investors are essentially by buying those funds or just buying the broad market index. And so I think this kind of goes back to, like I said earlier, you got to do your homework and make sure that you're not just buying, you know, the s&p 500 or just the broad market index and saying, Hey, this is ESG because that may might make some ESG investors anti ESG.

Preet Banerjee:

Yeah, so when it comes to individual investors who are looking to say, Hey, you know, I, you know, I agree with the philosophy, but I don't want to pay more and then not get it to like you say a closet indexing greenwashed ESG. marketed fund. So what should an investor be looking for when thinking about adopting ESG strategy?

Ari Polychronopoulos:

I think, first off, as I said earlier, is make sure you know what your preferences are, you know, do you want broad ESG? Do you want diversity? Do you want climate related? Second, when you're looking at the different funds available to you, you know, look at, you know, what's the active share of this fund relative to the benchmark? You know, how different is it if if they've got a correlation of 99%, you're getting a market fund, you're getting a greenwashed bond. So it's really looking at the holdings, looking at how those holdings differ from the broad market index, it's benchmark two. And I think that's, that's really kind of where to start. Then also, it's kind of where do you go from there? I think typically, when when investors think about ESG, they're thinking about equity strategies. But, you know, do you want to try to get the similar exposures in the fixed income space, you know, green bonds have been around for about 15 years now. And they're becoming an increasingly large part of the fixed income space, where it's basically you're you're, you're investing in bond issues that are specifically targeting, you know, maybe a Climate Initiative or some some other type of initiative that has some sort of green or, or ESG outcome associated with it. And so, again, finding out what your preferences are, and then trying to find a strategy that aligns with those preference preferences. That's, that's interesting. So

Preet Banerjee:

I'll use a humorous example. So let's say I was with the clan, which I'm not for the record, but let's say I was at the clan, and I'm responsible for managing the pension for an IRA. And I said, Hey, we we like this idea of ESG, but not so much the s. We don't care about society, you know, we don't care about equality. But yeah, environment, great governance. Yeah, we got a structure. So that's important to us. So could we get like, just eg without the s.

Ari Polychronopoulos:

I, it's funny, there, there are funds like that. I mean, you can look at just environmentally focused funds, it's a big thing, actually, one of the things that probably the biggest space that we're working on right now, with large pension plans, or environmentally focused funds, or what we're calling climate transition strategies, where, you know, they're not excluding any companies based on kind of controversial activities, they're not concerned about the social or governance aspects within their equity investments, what they want to do is ensure that they're aligned with, you know, something like the Paris Climate accords, where the carbon intensity of the portfolio is going to be reduced on an annual basis. So by the time we get to 2015, the carbon intensity is, you know, net neutral. So that's kind of really the in terms of what's going on now in the ESG space, and where I'm seeing the most interest, it's really the climate related side of ESG. Investing.

Preet Banerjee:

And you mentioned, you know, considering ESG, with respect to fixed income and green bonds, but what about other asset classes is it as as easy to come up with ESG strategies for something like commodities or private credit or private equity? Because I imagine, I'm just thinking off the top of my head, but with commodities, what could you do other than screen say, well, we don't want fossil fuels, but we're okay with gold. Like, yeah. What about those other asset classes?

Ari Polychronopoulos:

Yeah, the commodity space is a little tricky. It's exactly kind of what you said is, it's it's investing in commodities that that that are not, you know, harmful to ESG, you know, objectives. Also, you know, things like, you know, alternative energy, solar, those things are starting to kind of get a little bit bigger and can see kind of moving into the commodity space. Also, on the private equity side, it's a lot, it's a little bit easier. I think, as an investor on the private equity side, you can, you know, you might you might purchase companies with the specific objective of improving their ESG metrics, or of investing in certain projects that might yield you yield a good return and might be positive for the environment or something like that. So it's in the private equity space. It's something that's been going on for a while now. commodities is it's really hasn't really picked up yet. I think there's, there's a way to go before we start seeing a lot more interested in commodities in the ESG space.

Preet Banerjee:

I was wondering if maybe you tell us a little bit about because I noticed I was just going on the website. It's been a while since I've visited the Research Affiliates website, but I see that you have like a Rafi ESG. So can you first maybe give like a crash course in what fundamental indexing is, as opposed to cap weighting? And then explain how that applies to ESG? Yeah,

Ari Polychronopoulos:

so the Rafi fundamental index approach was something that we developed back in 2004. So it's been around for quite a while. And the main premise of fundamental indexing is that markets are not efficient and they tend to mean revert over time. And so when you invest in something like the cap weighted index, which is market capitalization, weighted Which is just number of stocks outstanding times market price, you are systematically over weighting overvalued securities and under weighting undervalued securities as a company becomes more expensive. And I think the poster child for this was looking at the tech bubble, it's a company becomes more expensive, it becomes a larger and larger portion of your overall index. So you look at the height of the tech bubble and 30% of your s&p 500 index was invested in tech stocks. And what happens is when the tech bubble crashes and stock prices mean revert you suffer significant draw downs, because of that, fundamental indexing breaks the link between stock price and weight in your portfolio. And so in the fundamental index, we weight companies based on their fundamental measures of size. So we look at things like a company's sales, its cash flow, its dividends, its book value, basically to create a composite weight based on company fundamental size. And we use that weight as a rebalancing anchor to trade against market price movements. So over the course of the year, as the price of a company becomes more expensive, at rebalance will actually rebalance back down. So trim the company's weight and capture those gains, the company becomes cheaper and more attractive from a valuation perspective. We'll rebounds into that company. And so it's really a contrarian, systematic, buy low sell high rebalancing process embedded within the index design. And so that's Rafi fundamental indexing our expectation is that it adds about one and a half percent over the broad market index per year over long, long market cycles. And we've seen that play out kind of in our life history, as well and kind of the simulated history before we launched the strategy 2004. So that's fundamental indexing. And then yeah, we do have ESG versions of Rafi fundamental index available. What we do there is essentially, we integrate. So what we're doing is we're upgrading companies that rank well on an ESG perspective, and downgrading companies. But we're also excluding certain companies. Basically, we exclude certain controversial industries. So our raft, our broad, Rafi ESG index, excludes fossil fuel companies, gambling, tobacco, and controversial weapon companies. And then another thing we do that's pretty interesting is that we actually exclude the bottom 10% of companies in our universe based on individual ESG scores. And this actually helps to limit that greenwashing effect that I talked about earlier, essentially, when you look at certain companies, and I'll pick on the Fang stocks, because they're a great example, a lot of the things I think stocks, like Facebook, and Amazon, and alphabet have really have pretty decent overall ESG scores, because they typically have really high environmental scores. But they all have poor social or governance scores. If you look at Facebook, for example, they typically fail a lot of governance screens, or they have a very low governance rating. Apple has some some low, typically ranks low on the social rating, Amazon typically ranks low on the social reading as well. And so when you include them in your index, then since they're such large companies, they usually take up a very large weight in your index. And that's why they that's why a lot of ESG funds look like the broad market index, by excluding kind of the worst offenders in each category, you end up getting rid of a lot of these companies that might do well in a couple themes, but not in the third or fourth thing. And so we exclude the companies that rank in the bottom 10% by environmental social governance. And we have a couple additional screens called diversity and financial discipline from the portfolio as well. And then from there, we basically update companies that score well on it from an overall ESG perspective and down way companies that score poorly.

Preet Banerjee:

Yeah, I think if anyone is interested in learning more, you can check out Research Affiliates. But one more question before I turn the floor over to you for your commercial, although that was part of it. One more question. For you. This is totally off topic. And I don't remember where this came into my head. I don't know if it was someone who I don't know if it was maybe it was Doug grots son or these with the company anymore, but maybe it was you I don't remember. But I want you to confirm or deny the story or let me know if you know anything about it. So I understand that. For people who don't know Jay Leno, former host of The Tonight Show has his massive car collection. And it's so big that he has a mechanic like a dedicated mechanic just oversees his fleet, apparently for just four and a half days of the week, though. And that last half day is servicing someone's motorcycle fleet. And that person would be Rob are not the basically the head of Research Affiliates. Is that true? Did I make that up? Why is that story in my head?

Ari Polychronopoulos:

I I'm I'm not entirely sure. I do know. So Rob. Rob does have a fairly extensive motorcycle collection.

Preet Banerjee:

Yeah, and really quick and vintage motorcycles right. Like I'm a I'm a motorcycle or so.

Ari Polychronopoulos:

Yeah, I can confirm that. Yeah. I've I've I've seen some of the motorcycles he does right into the office on occasion. They're pretty impressive. I can't comment on the management of his fleet though. Maybe someone maybe you heard that story from someone else but but, but yes, Rob does have a pretty extensive motors.

Preet Banerjee:

Can you ask him that? Like, just flip him an email and say, Hey, Dee, is Jay Leno's mechanic your mechanic for your motorcycles? And he's either gonna be like, we made you a partner or Yeah, no, that's absolutely true. Anyways, okay, all right now The floor is yours. Whatever it is, you want to communicate to listeners, if you want to promote your research, research affiliates, whatever it is, go to it my man.

Ari Polychronopoulos:

Yeah, if if you're interested in learning more about some of the research that I talked about today, you can find all of our research papers at Research Affiliates Comm. We're also on LinkedIn, under the same company name Research Affiliates, we're on twitter at ra underscore insights. So those are a few places you can go and none of our research is under a paywall or anything like that. So I'll just freely available on our website. And and please go visit the website. And if you have any questions there's a there's an email box, there's an info line and just shoot us an email.

Preet Banerjee:

Excellent. Our it's been really great chatting with you and catching up before we started recording this podcast. I'm so so happy to see you know what's happened in the last 10 years since we last sort of connected but done some really great things. And yeah, it's just so nice to hang with you.

Ari Polychronopoulos:

Great. It was it was a pleasure to be here. Thanks a lot. And yeah, I had a lot of fun.

Preet Banerjee:

If you want more personal finance content or you have questions for me or topic suggestions for the podcast, you can follow me on Twitter or Instagram and ask away the same handle in both cases at Preet Banerjee, I also have two YouTube channels, you can subscribe to my main channel which covers personal financing investing topics that are global in scope, and a Canadian specific channel as well. And that is it for this episode. Thanks as always for listening