June 13, 2021 • 53 mins
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
Mark as Played
Transcript
Episode Transcript
Available transcripts are automatically generated. Complete accuracy is not guaranteed.
Preet Banerjee (00:00):
Let's say I was with the clan, which I'm not for
(00:03):
the record, let's say I was atthe clan, and I'm responsible
for managing the pension for anIRA. And I said, Hey, we we like
this idea of ESG, but not somuch the s. Yeah, we don't care
about society. You know, wedon't care about equality. But
yeah, environment greatgovernance. Yeah, we got a
structure. So that's importantto us. So could we get like,
just eg without the S?
Ari Polychronopoulos (00:26):
I, it's funny. There are funds like
that. I mean,
Preet Banerjee (00:48):
you've likely heard terms like ESG investing,
sustainable investing, impactinvesting, socially responsible
investing in others. But arethey all the same? Today's guest
is the head of ESG. At ResearchAffiliates, we're going to
tackle some important questions.
Does ESG lead to better returnsfor investors? If you don't
(01:09):
invest in ESG tilted portfolios,are you against the environment,
or social and governance goals?
And who determines whether aportfolio or investment is ESG?
compliant is too subjective? Allthat and much more on this
episode of mostly money.
(01:39):
This is mostly money. And I'myour host, Preet Banerjee, my
guest today is Ari Pollakmonopolies who is the head of
ESG. At Research Affiliates, avery well known firm globally
for its smart beta and assetallocation work, over $170
billion worldwide is managedusing Research Affiliates
(02:01):
strategies. Ari is a partner atthe firm and focuses on smart
beta and ESG integration. He'sresponsible for multiple product
lines, including the Rafifundamental index, multi factor
ESG, and related climatetransition strategies. Ari,
welcome to the show. Thanks,Preet.
Ari Polychronopoulos (02:22):
It's great to talk to you. It's been been a
while but happy to happy to behere.
Preet Banerjee (02:26):
Yeah, it has been a long, long time. So our
paths crossed professionally.
Over a decade ago, I think. Andyou 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. Oneis you've got deep background in
the financial services. And whenwe first met, you're brand new
at Research Affiliates, I think,yeah, we're within a firm or
(02:48):
something like that. And rightbefore that, you were at a
company called indymac, whichwent under which no longer
exists, right?
Ari Polychronopoulos (03:00):
Yeah, it it, I guess, has the title. It
was one of the first banks thatwas taken over by the US
government during the globalfinancial crisis.
Preet Banerjee (03:09):
Yeah. And I remember at the time you telling
me the story of what washappening, because just to put
this into context, so this wasjust a few years after the great
financial crisis. And it wasstill fresh on everyone's minds.
And I had this opportunity totalk to this guy who had lived
right through it like right onthe ground, what was happening
(03:31):
in the US the epicenter of whatwas happening. So and I remember
when you were telling me thestory, I was like, my jaw was on
the ground, I forget thedetails, because it's been like,
you know, 13 years or whatever.
But can you walk us through?
First of all, what did you do atany Mac? What was your role
there? And what happened duringthe great financial crisis?
Ari Polychronopoulos (03:51):
Yeah, so in the Mac was a mortgage bank.
So basically, the role of thebank was to is as a lender, you
would want to buy a house, youneed to take out a mortgage you
would any bank bank wouldobviously give you a loan. And
the my role of the bank was Iwas an analyst on a trading desk
(04:12):
that was responsible for hedgingwhat was called the bank's MSR
or mortgage servicing rightsportfolio. Basically, what that
is, is when you take out amortgage, there's really three
components to a mortgage fromreally kind of a fixed income
perspective or a cash flowperspective, there's kind of
your principal payment thatmakes it part of your mortgage,
there's your interest paymentthat you pay for the loan you've
(04:34):
taken. And then there's what'scalled the mortgage servicing
rights. That's usually like aquarter of a basis point of your
loan that goes to the companythat's actually servicing your
mortgage. So sending outstatements and collecting
payments and things like that.
And so the bank would, would dowhat a lot pretty much every
mortgage bank was doing at thetime is they would package up
fixed income products, basicallyprincipal only pools of
(04:54):
mortgages and they strip out theinterest only portions and they
would sell those off thedifferent event. Banks. And we
were we would retain themortgage servicing rights
because we had a big mortgageservicing business. And so our
job was to hedge that mortgageservicing rights portfolio,
because essentially, what youhad to do is you had to mark to
market that portfolio every day.
(05:15):
And so based on how interestrates will move, the value of
that portfolio could swing bymillions of dollars, we were, I
think, at the time, had amortgage servicing right
portfolio of a few billiondollars. So you could have huge
fluctuations. And so we werebuying, you know, different
fixed income swap contracts,futures, contracts, things like
that, to basically hedge outthe, what's called the interest
(05:37):
rate risk in that portfolio. Andas the, as the, I guess, the
credit quality of any Mac beganto deteriorate, going into the
global financial crisis,essentially, what was happening
is, you know, ourcounterparties, were getting
more and more afraid ofbasically, the company
defaulting, you know, the loans,we're collecting the loans we
were selling, you know, as, asnot only any macro, pretty much
(06:04):
every bank was, you know, at theheight of the crisis crisis,
basically lending to anybody whowanted 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 hedgeour portfolio, because, really,
at the end there, we couldn'teven find counterparties, you
know, we'd have differentinvestment investment banks
(06:25):
calling us up and saying, youknow, hey, you know, our
compliance group says, we can'ttrade with you anymore, we have
done one unwind all of ourtrades. And it just got to be
like this really scary situationwhere, you know, towards the
end, we were basically not evenable to fully hedge the
portfolio, it was kind of movingup and down by a million dollars
a day, the credit quality of thecompany started to deteriorate,
(06:48):
and that eventually causebasically a run on the bank, you
know, people kind of showing up,the bank did have a commercial
bank, side of the business, andpeople were showing up saying,
Give me my deposits. And, youknow, once that starts, you
know, it just gets it gets, youknow, I remember going into work
sometimes, and it'd be lines,because we had a bank at the on
the ground floor of ourbuilding, I was up on like, the
fourth floor, whatever. Andthere'd be lines of people
(07:11):
around the corner, just waitingfor the bank to open so they can
go in and withdraw theirdeposits. And they'd be
screaming at you like, just likeyou're the devil basically
trying to spit at you as you'rewalking in trying to go. It's
like, I'm just, I'm just tryingto do my job and trying to hedge
your portfolio here. I'm sorry.
But
Preet Banerjee (07:29):
when when do you remember when you first had like
that, that holy shit moment.
During that time, in the greatfinancial crisis, where you're
like, Man, this is we're allgonna lose their jobs, like,
when that occurred to you.
Ari Polychronopoulos (07:43):
So I would probably say, so I left in the
Mac in about late June of 2008.
And I would probably say about acouple months before that,
things, you know, startednoticing the writing on the
wall. And, and started, Istarted looking for a new job,
you know, any Mac was eventuallytaken over by the government.
(08:05):
And then it was sold andrebranded 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 Iturned to some of the other
(08:26):
people on the desk and said,hey, it's probably time for us
to start looking for somethingelse.
Preet Banerjee (08:33):
Oh, man, and yeah, so shortly after that, you
ended up at Research Affiliates.
And I remember being down at theoffices, beautiful offices down
in Newport Beach. Are you guysstill in Newport? Yep, we are
still here in Newport Beach. AndI remember walking into the
reception, and under this glasscase was I think it was a first
edition of Adam Smith's Wealthof Nations. Yeah, cool office.
(08:54):
And I have a lot of respect forRob Arnott and everyone at the
firm, really, I miss workingwith you guys back in the day.
But in any case, you're here totalk about, you know, what
you've been focusing on lately,as you know, a new partner of
the firm, congratulations onthat. You're heading up ESG. And
this has been exploding in termsof headline coverage, demand
(09:19):
from investors. Some pensionfunds need to divest from oil
investments. And so it's it'shuge. And that's why you're
here, you're going to sort ofhelp explain what what is going
on in the world of ESG what itis what it means to investors.
So let's let's start with thevery basics. And what does ESG
stand for?
Ari Polychronopoulos (09:44):
So yeah, ESG stands for environmental,
social and governance,investing. at a very high level,
if you want to define it, it'sreally an approach to managing
assets where as an investor, youexplicitly acknowledge the
relevance of these factors,these environmental, social and
governance factors in yourinvestment decisions. And it's a
(10:07):
really broad area. So when yousay it's even something like
environmental factors, what doesthat mean? It actually means a
lot of things. It's really anytheme that pertains to the
natural world. And it deals withconcepts like climate change,
resource depletion, pollution,deforestation, biodiversity,
these are all kind of themeswithin the environmental space.
(10:28):
On the social side, you'relooking at themes that affect
the lives of humans, like humanrights, child labor, employee
relations, human resources,issues, diversity, these are all
the types of things you dealwith, when you're looking at the
social aspect of ESG. Investing.
And then finally, governance isreally issues inherent to
business models, like boardmakeup, executive pay, lobbying,
(10:50):
practices, bribery, corruption,and so you, you literally have,
you know, hundreds of sceneswithin ESG. And an ESG
investment strategy could besomething that's very specific,
like a strategy, an investmentstrategy that focuses on gender
diversity. Or it could be verybroad by saying, hey, I want a
broad ESG strategy that, thatinvest in companies that that
(11:13):
rank really well on a ESGperspective holistically. So
it's really kind of a broadspace. And when you say ESG,
you're, you're talking reallyabout a lot of things. And it's
something that means reallydifferent things to different
people. If you are talking to alarge pension fund concerned
(11:33):
about climate change, they'relikely going to have a very
different idea of what a goodESG company is compared to a
faith based organization lookingto invest based on their values.
And so it varies quite a bit.
Preet Banerjee (11:47):
In any sort of new ish space terms often get
conflated or confused. So canyou explain what sustainable
investing, Sri sociallyresponsible investing and impact
investing? They all seem to bein the same world? But they do
have different meanings? Can youexplain the differences?
Ari Polychronopoulos (12:08):
Yeah. So let's start with Sri so. So
they're all they all kind ofmean the same thing. And they're
often used interchangeably. Sri,or socially responsible
investing is kind of what I'dsay is like, I would term maybe
first generation type of ESGinvesting. You know, Sri
investing actually goes all theway back to the the late 1700s,
(12:31):
early 1800s, you could seethere's, there's, you know, you
could read about different kindsof Quaker and Methodist churches
for bidding their members frominvesting in a slave trade or
buying sin stocks, guns, liquor,alcohol, things like that
tobacco. And so Sri is reallymore of thinking about, you
know, excluding a lot of type ofinvest, about type of companies
(12:54):
you wouldn't want to invest in,based on what they do. That's
really evolved more recentlyinto what we now kind of call
ESG, where you're looking alittle bit more quantitatively,
you're not just excludingcertain industries, but you're
actually looking at a lot ofdifferent factors within those
themes to kind of score acompany or rate a company. And
(13:17):
it's much more what we call anintegrated approach. impact
investing is actually anentirely different type of
strategy where an impactinvesting is where you're going
to only invest in areas thathave a positive impact on the
environment or society. And soan impact investor might be
investing in certain projects,like perhaps a micro financing
(13:39):
project in a third world countryto get, you know, small
businesses up and running, andexpect to get a return but
probably not expecting to getthe type of return they would
get if they were just going toinvest in the market. And so
impact is a little bit differentthan then your traditional Sri
and what we now call ESG.
Preet Banerjee (13:55):
Now, it seems like there's a whole bunch of
different factors that you'vetalked about. So how do you how
do ESG investment strategiestackle these themes? So if I
say, Yes, I want to be an ESGinvestor, because seven of those
things that you just talkedabout, they, they mean something
to me, and they're aligned withmy values? How do I actually
(14:17):
implement that in a portfolio?
Ari Polychronopoulos (14:21):
Great question. So there's a lot to
unpack there. You know, as Ipreviously mentioned, there's no
universally accepted definitionof ESG. And so you know, even if
you do a quick Google search, onESG ETFs, for example, you're
going to find everything fromclimate specific funds, clean
water funds, funds that try toencourage minority empowerment
(14:47):
faith based funds, genderdiversity. So as an investor, I
think step one is determiningwhat are your ESG preferences,
and then second, trying to findan investment strategy that's
aligned with those preferences.
I think, you know, more so thanreally anywhere else in the
investment space and enjoys doyour homework when you're
(15:08):
investing in something. But theESG space is just, it's just so
broad. And there's just so manydifferent options. It's really
understanding what you want toaccomplish through your
investments and then finding aninvestment strategy that's
aligned with that.
Preet Banerjee (15:23):
My understanding is that there's a number of
different ways that maybe anIndex Provider might say, Well,
here's something that is alignedwith ESG. And it could be
through negative screening,where they say, we're going to
exclude certain companies basedon criteria or others might say,
well, we'll place more weight oncompanies that, you know, hit
(15:43):
certain objectives or targets.
So can you talk about, what arethose different metrics that are
used those ratings that are usedthat that will allow someone to
say, yes, this company has agood ESG rating? And this one
doesn't?
Ari Polychronopoulos (15:58):
Yeah. So.
So when you're implementing anESG strategy, as you mentioned,
there's a couple ways to goabout it. So we can start there.
You mentioned divestment, andthat's that's kind of the the
easiest approach to ESGinvesting. It's, it's what's
called, I'm not going to excludecompanies, or I'm just going to
divest from these companies, I'mnot going to own them.
Typically, you see investmentstrategies that divest from
things like fossil fuels, forexample, where there'll be no
(16:20):
oil companies or energycompanies in the portfolio that
that are using fossil fuels ordivesting from weapons or coal
or tobacco. And so that's reallythe simplest route. Second is
what we call integration ESGintegration where, where you
might say, I'm going to updatecompanies that rank really well,
(16:41):
from an ESG perspective, I'mgoing to downgrade companies
that rank poorly from an ESGperspective. And the benefit of
the ESG integration approach isthat by not excluding the
companies, a lot of investmentmanagers say, Well, I can
actually, you know, influencechange at a company, I can vote
my proxies, I can get members onthe board that might be
(17:01):
sympathetic to some of these ESGissues. And so we've seen this
movement away from just broadbased exclusions into more ESG
integration and what we callengagement, where you're
actually engaging with thecompany and trying to influence
change, through your throughyour voting rights, and through
your interactions with thecompany itself. Now, when you're
(17:22):
trying to determine what makes agood ESG company, and this is
probably the the biggest kind ofarea of in terms of issues
associated with ESG is how doyou determine what a good
company is? Typically, the wayyou do this is, you can work
well with what we call ESGratings agencies. So there's a
(17:46):
lot of different ratingscompanies out there that provide
ESG data. That data is based ona lot of different data sources.
So starting from the beginning,typically, you'll have large
companies that provide sets ofESG disclosures each year,
similar to their annual filingsare in financial statements. But
unlike financial statements,there isn't a single uniform
(18:07):
framework for disclosing ESGrisks and opportunities. For
example, I guess the mostpopular framework is what's
called the G ri, the globalreporting initiative, about 70%
of publicly traded companiesreport using this framework. But
there's some other popular onesas well, there's Saxby, the
sustainability accountingstandards boards that has their
own framework for companies onhow to report. There's one
(18:29):
called the taskforce for climaterelated financial disclosures,
which is more aboutenvironmental issues. And so
starting from the beginning,it's okay, these companies are
gonna report what type offramework are they going to use.
And then you have the dataproviders that are collecting a
lot of those disclosures andreports, and also doing
interviews with the companylooking for other publicly
(18:50):
available information to come upwith an ESG rating. And when you
look at I wrote some researchlast year on on ESG ratings
providers, and basically that'sa field where there's you know,
identified over 70, differentESG ratings providers. And so as
an as an investment manager, ifI'm going to create an ESG Fund,
the question is now, okay, onceI've defined what my ESG
(19:14):
preferences are going to be, Igotta go out and get the data.
Who am I going to get the datafrom all of these different ESG
data providers have differentmethodologies for how they rate
companies, and you can get somevery different results? by just
looking at the data from thefrom these different companies.
Preet Banerjee (19:33):
Let's say I was managing a lot of money. And
let's say I was responsible tosome investors and they said,
Hey, we want ESG NFL, let's sayI had a particular investment
philosophy. Could I just gorating shopping and say, all
right, well, I will pick thisrating because that is most in
line with my investmentphilosophy 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
(19:56):
you know, when you go to thegrocery store, and you see those
little You know, those littlecheckmarks that say, hey, this
has been approved by this, thisand 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 toplay? Is there like shopping
around and agencies? How doesthis work?
Ari Polychronopoulos (20:14):
Yeah. So I'll talk about kind of our, our
experience when we launched ourfirst ESG index strategy several
years ago, I would say it's alittle bit more than that, I
wouldn't say it's just kind of apay to play scheme or anything
like that. Most of these ESGratings providers will have
really well thought outmethodologies, I don't you know,
that some of the leadingproviders the MSCI
(20:36):
sustainalytics, ISS are a few ofthem of the world, they have
very well thought outmethodologies. But again, these
methodologies aren't uniform,there's no regulatory agency
that says this is, you know, theframework you should use for
determining what a good ESGcompany is. And so they're all
going to be a little bitsubjective and a little bit
different based on themethodology that they've
(20:58):
developed. And so that's kindof, you know, the the issue with
the ESG ratings agencies. Sowhen we launched our first ESG
strategies, we basically did,our research team did did a
pretty long project, where welooked at several different ESG
ratings providers, we got trialdata from all of them, read
(21:20):
through their methodology,documents, looked at the data,
and and really ended up choosingthe one that we thought we were
most comfortable with. And wewere looking for things like, do
they have broad data coverage?
Do they cover a lot of companiesso that we can make sure we can
build a broadly diversifiedinvestment strategy? Is there
you know, kind of any? Is theredata quality good in terms of
how there's kind of sourcing thedata and delivering the data?
(21:41):
And does their methodology makesense to us? And so, you know,
for full disclosure, for our owninvestment strategies, we use a
company called ISS. And that'sthe company that we settled on.
But even when looking at thedifferent companies, you see
some some interestingidiosyncrasies, some interesting
differences between thecompanies. A good example is we
have a index strategy thatexcludes energy companies. And
(22:05):
when you look at a company likeToyota, for example, you would
think what's when you thinkToyota, you think auto
manufacturer doesn't seem verycontroversial? I probably
wouldn't exclude it as a as aenergy company. So some of the
data providers don't excludeToyota. Some of the data
providers do exclude Toyotabecause they have a 20% stake in
(22:26):
a subsidiary that engages inthermal coal mining. So now, the
question is, you know, this kindof gets into the different
methodologies, you know, do youconsider the ownership and
subsidiary means that Toyotaitself should also get excluded?
And so there's all these kind oflittle idiosyncrasies? Well,
yeah,
Preet Banerjee (22:44):
I could give a perfect example, which would be,
hey, look, here's atransportation company that, you
know, it's not a sin company.
And like, Oh, yeah, they justlike move stuff from place to
place. What in the move justguns? Yeah.
Ari Polychronopoulos (22:58):
So that would be an effort by some
screens that we like, well,that's another one other screens
like, well, it's justtransportation. But that's kind
of like to your point. Yeah. Andtypically, the way we deal with
that is we use kind of a revenuebased model for determining if a
company is engaging in what wecall a controversial activity.
So if a company is deriving morethan, let's say, 5% of its
revenue, or 10% of its revenuefrom either the production the
(23:21):
sale the distribution of cost ofguns, for example, you know, we
might exclude it. Andinteresting cases, Walmart,
Walmart gets excluded from somemore indices because they have a
significant part of theirrevenue is from selling guns.
And you wouldn't think that butyou know, that that it does fail
that screen because because theydo sell I think it's more than
(23:43):
5% of revenue or something likethat comes from the sale of
guns.
Preet Banerjee (23:55):
Conversation with Ari Pollak monopolies
continues in just a minute, butfirst, a few thank yous to
listeners who left comments onApple podcasts. Thank you to
Cedric Nola, J. barshop, Medibakery. Andrew Lutz and Omar mo
93. All listeners from theUnited States where oddly the
(24:16):
podcast has a higher rating thanin Canada. But do everyone who
leaves ratings and comments onApple podcast, I appreciate
them. And I do read them all. Iproduced the podcast for you
listening. And just a heads up aNavy taking a hiatus on the
podcast towards the end ofsummer I really need to put my
(24:37):
head down and finish up mydissertation and hopefully
defended in the fall. It reallyshould have been done by now. So
I'm going to turn my focus ontothat to really get it buttoned
up. But for now, back to theconversation with Ari Paulo
kanopolis from ResearchAffiliates.
(25:07):
So when it comes to, here'sanother analogy. There's this
old movies called the big hit,not super popular, but kind of
like a little cult action comedymovie. And there's this one
scene where this guy, they wantto place a phone call, but they
don't want to get traced. Sothey had this trace buster. And
(25:29):
then they've also thought ahead,and they thought, well, in case
the people on the other end ofthe line have a way of
identifying if you've got atrace buster, and they can still
trace you, we've got this traceBuster buster, and it was just
this little thing. So thequestion is, is there in ESG,
ratings ratings agency? Becauseif there are so many different
ratings, isn't there going to besome kind of value to have some
(25:53):
kind of unification? Becausethis seems quite problematic. It
seems like this is an area whereyou know, people could get
exploited, or they could, youknow, pick a ratings agency that
gives you different results. Andthe reason I asked this is
because I know that you've donesome work on this, you've done
some work on measuring thereturns of portfolios with these
(26:14):
different ratings agenciesscreens applied. And I wonder if
you could talk about thedifferences in returns between
providers? Yeah,
Ari Polychronopoulos (26:22):
yeah. So that's the first part of your
question there, there isn't asingle kind of global framework
for determining kind of an ESGrating, or there isn't the
oversight the board in anycountry that oversight oversees
ESG ratings. What we arestarting to see though, is some
uniformed regulations around ESGdisclosures, which is a good
(26:43):
thing, I think that's step onein the right direction. For
example, in the UK, they'verecently passed a law where
basically all large companies,public and private have to
disclose climate issues, climaterisks and opportunities.
According to the what's calledthe TCF D standards. They also
have mandated that largecompanies and all investment
(27:06):
managers start start offeringmandatory disclosures on the
sustainability of theirinvestment strategies. And
they're also developingsomething that you call the EU
taxonomy, which is basically aglobal framework for reporting
on ESG risks and opportunities.
And so we're starting to seethat in some areas of the world
where I think we're going tostart seeing a lot more uniform
disclosure reporting, and whichwill probably start lending
(27:28):
itself to kind of better andhigher quality and more
consistent ESG ratings. But Butyou're right, we looked at a
couple of different ratingsproviders last year, and a paper
that I wrote, where weessentially built the exact same
investment strategy, but we usetwo different ratings providers.
So basically, what we did was wetook the top 50% of companies by
(27:50):
ESG score, and then justcalculated the portfolio and
then ran a simulation over about10 years to see you know, how
similar the portfolios were, andyou got fairly different
results, both in terms ofreturn. volatility is about the
same, but the return was acouple percentage points
different. But then you when youlooked at things like turnover
(28:12):
in the top holdings at theportfolios, they were very
different. One portfolio had ahigh waiting and wellsfargo
where the other portfolioexcluded that company entirely.
And then vice versa. Facebookwas rated really low by by that
by the first company, and wasone of the top holdings in the
second portfolio. And so, yeah,with this
Preet Banerjee (28:33):
governance specific governance factor that
both will that differentiatedWells Fargo, because I know
they've got some governanceissues. Yes,
Ari Polychronopoulos (28:39):
it was the governance factor. And then on
the Facebook side, it was isreally just kind of dealing with
issues of data privacy. ReallyHow surprising and and, you
know, it's it comes down to howis that treated in the
methodology? And how much of aweight does that ESG data
provider put on one on one ofthose issues? Because they all
determine make their owndeterminations of what's
(29:00):
material? And how much of shouldyou wait that issue in
determining the overall ESGscore? And that's, that's where
you can kind of get these verydifferent results.
Preet Banerjee (29:09):
In terms of the amount of the difference in
results, was it statisticallysignificantly different between
readings providers, like Do youhave enough time in the dataset
to really draw meaningfulconclusions? Because, you know,
the reporting of these metricshasn't really been around that
long as it
Ari Polychronopoulos (29:27):
Yeah, that's that's kind of the other.
The other issue is his dataavailability. You know, if you
get if you're lucky, you can geta ESG data set that goes back
maybe a decade or a littlelonger. So obviously,
determining statisticalsignificance off of 10 years of
data is it's nothing is going tobe statistically significant.
Yeah,
Preet Banerjee (29:45):
cuz that starts after the great financial crisis
troughs, so everything's gonnalook pretty good. But yeah, so
that that kind of brings me toanother question, which is, is
ESG a factor and I want toexplain Just a little bit
because we know that with, youknow, the world and I guess I
guess was pre 1993 we lived in acap m world and then post 93
(30:08):
we're kind of like in this famof French three factor world.
And factor investing has risenin prominence, including things
like the market factor, thevalue, size cetera. What about
ESG? Is ESG? a factor inreturns?
Ari Polychronopoulos (30:25):
Yeah, that's a that's a great
question. I think that'sprobably the question I get more
from investors when we'retalking about ESG than anything
else is, you know, do I gethigher returns if I invest in
ESG. And there's really a coupleschools of thought here. I mean,
there's the traditional academicview that, you know, excluding
stocks and constraining youruniverse will lead to a lower
(30:45):
return. Also, that you know,that ESG companies have to
compensate investors willing tobuy their stocks, with a with a
higher cost of capital. And soyou should expect as an issue
investor, you're gonna get a lowreturn. And so we tried to test
the theory of is ESG factor doesit provide a robust return
premium over time, what I didwas we looked at companies
(31:08):
within the US and within Europe.
So we took two sample to sitdifferent sets of samples. And
we created some long, shortstrategies. So we went long the
top 30% of companies by ESGscore, short the bottom 30% of
companies in our universe by ESGscore. And we did the same thing
for individual environmental,social and governance scores,
try to see if we can determineif there's a factor return
associated with any one of thesethemes are with the broad
(31:30):
overall theme itself. And whatwe found was, when we're doing
that test, again, nothing wasstatistically significant, we
didn't really find alpha inthese in these tests. Now,
again, it was a back test thatwent back about 10 years. So I
don't want to say definitivelythat ESG is not a factor. But we
didn't really find statisticallysignificant alpha, running these
(31:54):
tests. Also, within ESG. Again,it's such a broad space. So even
when I say we're going to testthis, the environmental scene,
you know, if we looked at maybejust something like carbon
emissions, or certain otherthemes within environmental,
maybe we could have found a datapoint that that might have
provided something interesting.
(32:16):
But the one thing I think isimportant to think about is, I
don't think ESG needs to be afactor to be able to take
advantage of it over the comingdecades. And why I say that is
that I think ESG is going to bea powerful theme that might lead
to rising valuations for goodESG companies, and higher return
as a result, as more and moreinvestors start investing in ESG
(32:39):
strategies. So you can kind ofthink of this as, as an
opportunity, a thematicopportunity more so than this is
a robust premium that's going todeliver over the next five
decades. And the reason I saythat is, you know, there's a lot
of arguments around kind of whatwe're seeing within ESG
investing, there's, there's thewhat's called the stranded
assets argument that a lot ofthese energy companies are gonna
(33:01):
have to take massive writedownson their assets of these oil
fields that aren't really goingto might not be produced deucing
in a decade or so. And we'restarting to see that a little
bit. Now we're starting to seesome big oil companies starting
to take write downs on some oftheir assets. And they're we're
also seeing, you know, there's abank of america study from 2019.
That's that highlighted that 20trillion in assets are poised to
(33:23):
flow into ESG funds over thenext two decades, driven by you
know, women and millennialinvestors, which are
increasingly making up a largershare of the investment pie. We
talked about greater regulationsthat are forcing kind of more
flows into the into the ESGspace. And then if you look at
fund flows, you know, 2020 wasactually a record year for ESG
fund flows. If you look at inEurope, 50% of all mutual fund
(33:47):
and ETF flows were in ESGstrategies. In the US, that was
about 25%. And in Canada, thatwas about 10%. And so we're I
think we're at this inflectionpoint where there's a lot of
money flowing in thesestrategies. There's one thing to
consider, though, we talkedabout the difference in ESG
ratings. And in that paper, wemake a point my co author
actually made up came up withthis line, which I thought was
(34:08):
hilarious, but they say a risingtide lifts all boats, but all
boats need to be in the sameharbor and in the water the same
time. And with with ESG when youhave such different views and
different on what ESG Is it thequestion is, you know, will we
be able to capitalize on thistheme because
Preet Banerjee (34:26):
of that? Kind of tangentially, but we talked
about whether or not ESG is afactor jury's out at this point.
The data doesn't support thatright now. We also you mentioned
something about you know,thematic investing and how
that's seen a rise inprominence. Are meme stocks a
factor? Have you done anyresearch on Wall Street bets and
(34:46):
whether or not they have nowmade a big enough an impact that
you can statistically say thatmeans are a factor. Like is
there gonna be a fam of French?
I don't know what they're up tonow, five factors so will there
be a sixth factor of mean stocks
Ari Polychronopoulos (35:00):
That's an interesting question. I wish I
had an answer for it, I think. Idon't know. I think, again, we
talked about the dataavailability, I think it's that
that's kind of been a thing formuch shorter than even ESG
investing had so right. I thinkthat the jury will be out on
that one for a much longer time.
But it's been interesting overthe past year, observing that
(35:20):
and just watching,
Preet Banerjee (35:23):
if we, you know, I just saw yesterday that the
latest meme stock is going to beWendy's stock, because one of
the reasons here's the actualrationale, one of the reasons
is, they literally sell chickentenders. And I don't know if
you're familiar with the theparlance in, you know, meme
stock world, but 10, DS is a bigthing. It just basically means
(35:44):
gains. And so because theyactually sell attendees, they're
like, yeah, they should be amean stock. And also, they're
pretty active on Twitter. Andthey have a pretty good sense of
humor with their Twitteraccounts, so they become the
next darling of the world. Andnot that I'm advocating buying,
you know, deep out of the moneycall options, just in case but
Ari Polychronopo (36:02):
unfortunately, it Research Affiliates were
prohibited from buyingindividual stocks, our
compliance group prohibits it,so I can't to take advantage of
the Wendy's trend now
Preet Banerjee (36:12):
interesting. Are you prohibited from buying
individual crypto assets?
Ari Polychronopoulos (36:16):
No, not on crypto assets, just since most
of our strategies are long, onlyequity indices. And we know, you
know, when we're rebalancing, Iknow what what we're going to be
rebalancing into. So we don'twant to even have the slightest
appearance of some sort ofconflict of interest. So
Preet Banerjee (36:31):
Right, right, I can only buy, are you guys gonna
release a fundamental index ofcrypto assets anytime soon? Is
that on the horizon? That's aninteresting question. It was a
joke, but are you actuallyconsidering it?
Ari Polychronopoulos (36:42):
Well, so we have one of our senior
advisors is, as is, is aprofessor by the name of cam
Harvey Campbell Harvey, I don'tknow if you're familiar with
him. He's at Duke University,but he's probably at the
forefront of cryptocurrencies interms of his research. And so
we've been discussing, you know,internally, you know,
Preet Banerjee (37:03):
we are
Ari Polychronopoulos (37:04):
looking at cryptocurrencies, from a
research perspective, no plansto launch an index at this time,
but it's just, it's aninteresting space. And, and
we've got, we've got the expertin house, so it's just something
that we're looking at right now.
Preet Banerjee (37:18):
Oh, maybe we'll have to book him for a future
episode. I'd love to hear histhoughts. Okay, so, one of the
things that I've been seeing alot lately is that, you know,
industry responds to demand andconsumer preferences, and there
has been a demand for ESG typeof products and strategies. And
so, as an example, you know, ifyou have, you know, turnkey
(37:42):
portfolios as your productoffering, and let's say you've
got, I don't know, call it fivefor five different levels of
risk. Now, all of a sudden,you've got 10, because you've
got those same five differentlist risk levels, but now you
can get it with an ESG versionof those portfolios. So, here's
the question. If I don't investin an ESG portfolio, does that
(38:02):
make me anti ESG?
Ari Polychronopoulos (38:07):
That's an interesting question. I, I
wouldn't say it makes you antiESG.
Preet Banerjee (38:11):
I don't feel
Ari Polychronopoulos (38:11):
like I'm anti ice. I think one of the
things to be cognizant of, andso this kind of going back to
the ESG portfolios, and I'llbring it back to the non issue
ones. There's a concept you needto look for when it when
investing in ESG. And it'scalled greenwashing.
Essentially, it's a term thatmeans that a company or an
investment strategy is marketingitself as ESG, when it's really
(38:33):
not doing much at all. And sogiven the growing popularity of
ESG, investing, a lot of fundsare rebranding themselves as
ESG, even though they're not,there might not be much going on
under the hood. In regards toESG. There was actually a
article in Bloomberg that cameout last month it was called, it
was called many ESG funds areexpensive s&p 500 indexers it's
(38:55):
a great article about thistopic, where basically they're
looking at some of the top ESGETFs. And saying, These look
exactly like the broad marketindex. What's going on here in
terms of ESG? And more profit?
Yeah, and it's, it's three timesthe expense ratio. Yeah. And so,
you know, some ESG investors areessentially by buying those
funds or just buying the broadmarket index. And so I think
(39:17):
this kind of goes back to, likeI said earlier, you got to do
your homework and make sure thatyou're not just buying, you
know, the s&p 500 or just thebroad market index and saying,
Hey, this is ESG because thatmay might make some ESG
investors anti ESG.
Preet Banerjee (39:35):
Yeah, so when it comes to individual investors
who are looking to say, Hey, youknow, I, you know, I agree with
the philosophy, but I don't wantto pay more and then not get it
to like you say a closetindexing greenwashed ESG.
marketed fund. So what should aninvestor be looking for when
(39:57):
thinking about adopting ESGstrategy?
Ari Polychronopoulos (40:02):
I think, first off, as I said earlier, is
make sure you know what yourpreferences are, you know, do
you want broad ESG? Do you wantdiversity? Do you want climate
related? Second, when you'relooking at the different funds
available to you, you know, lookat, you know, what's the active
(40:22):
share of this fund relative tothe benchmark? You know, how
different is it if if they'vegot a correlation of 99%, you're
getting a market fund, you'regetting a greenwashed bond. So
it's really looking at theholdings, looking at how those
holdings differ from the broadmarket index, it's benchmark
two. And I think that's, that'sreally kind of where to start.
(40:44):
Then also, it's kind of where doyou go from there? I think
typically, when when investorsthink about ESG, they're
thinking about equitystrategies. But, you know, do
you want to try to get thesimilar exposures in the fixed
income space, you know, greenbonds have been around for about
15 years now. And they'rebecoming an increasingly large
part of the fixed income space,where it's basically you're
(41:06):
you're, you're investing in bondissues that are specifically
targeting, you know, maybe aClimate Initiative or some some
other type of initiative thathas some sort of green or, or
ESG outcome associated with it.
And so, again, finding out whatyour preferences are, and then
trying to find a strategy thataligns with those preference
preferences. That's, that'sinteresting. So
Preet Banerjee (41:29):
I'll use a humorous example. So let's say I
was with the clan, which I'm notfor the record, but let's say I
was at the clan, and I'mresponsible for managing the
pension for an IRA. And I said,Hey, we we like this idea of
ESG, but not so much the s. Wedon't care about society, you
know, we don't care aboutequality. But yeah, environment,
great governance. Yeah, we got astructure. So that's important
(41:51):
to us. So could we get like,just eg without the s.
Ari Polychronopoulos (41:57):
I, it's funny, there, there are funds
like that. I mean, you can lookat just environmentally focused
funds, it's a big thing,actually, one of the things that
probably the biggest space thatwe're working on right now, with
large pension plans, orenvironmentally focused funds,
or what we're calling climatetransition strategies, where,
you know, they're not excludingany companies based on kind of
(42:18):
controversial activities,they're not concerned about the
social or governance aspectswithin their equity investments,
what they want to do is ensurethat they're aligned with, you
know, something like the ParisClimate accords, where the
carbon intensity of theportfolio is going to be reduced
on an annual basis. So by thetime we get to 2015, the carbon
intensity is, you know, netneutral. So that's kind of
(42:39):
really the in terms of what'sgoing on now in the ESG space,
and where I'm seeing the mostinterest, it's really the
climate related side of ESG.
Investing.
Preet Banerjee (42:49):
And you mentioned, you know, considering
ESG, with respect to fixedincome and green bonds, but what
about other asset classes is itas as easy to come up with ESG
strategies for something likecommodities or private credit or
private equity? Because Iimagine, I'm just thinking off
the top of my head, but withcommodities, what could you do
(43:10):
other than screen say, well, wedon't want fossil fuels, but
we're okay with gold. Like,yeah. What about those other
asset classes?
Ari Polychronopoulos (43:17):
Yeah, the commodity space is a little
tricky. It's exactly kind ofwhat you said is, it's it's
investing in commodities thatthat 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 ofget a little bit bigger and can
see kind of moving into thecommodity space. Also, on the
(43:40):
private equity side, it's a lot,it's a little bit easier. I
think, as an investor on theprivate equity side, you can,
you know, you might you mightpurchase companies with the
specific objective of improvingtheir ESG metrics, or of
investing in certain projectsthat might yield you yield a
good return and might bepositive for the environment or
(44:01):
something like that. So it's inthe private equity space. It's
something that's been going onfor a while now. commodities is
it's really hasn't really pickedup yet. I think there's, there's
a way to go before we startseeing a lot more interested in
commodities in the ESG space.
Preet Banerjee (44:15):
I was wondering if maybe you tell us a little
bit about because I noticed Iwas just going on the website.
It's been a while since I'vevisited the Research Affiliates
website, but I see that you havelike a Rafi ESG. So can you
first maybe give like a crashcourse in what fundamental
indexing is, as opposed to capweighting? And then explain how
(44:36):
that applies to ESG? Yeah,
Ari Polychronopoulos (44:39):
so the Rafi fundamental index approach
was something that we developedback in 2004. So it's been
around for quite a while. Andthe main premise of fundamental
indexing is that markets are notefficient and they tend to mean
revert over time. And so whenyou invest in something like the
cap weighted index, which ismarket capitalization, weighted
(44:59):
Which is just number of stocksoutstanding times market price,
you are systematically overweighting overvalued securities
and under weighting undervaluedsecurities as a company becomes
more expensive. And I think theposter child for this was
looking at the tech bubble, it'sa company becomes more
expensive, it becomes a largerand larger portion of your
overall index. So you look atthe height of the tech bubble
(45:20):
and 30% of your s&p 500 indexwas invested in tech stocks. And
what happens is when the techbubble crashes and stock prices
mean revert you suffersignificant draw downs, because
of that, fundamental indexingbreaks the link between stock
price and weight in yourportfolio. And so in the
(45:40):
fundamental index, we weightcompanies based on their
fundamental measures of size. Sowe look at things like a
company's sales, its cash flow,its dividends, its book value,
basically to create a compositeweight based on company
fundamental size. And we usethat weight as a rebalancing
anchor to trade against marketprice movements. So over the
(46:01):
course of the year, as the priceof a company becomes more
expensive, at rebalance willactually rebalance back down. So
trim the company's weight andcapture those gains, the company
becomes cheaper and moreattractive from a valuation
perspective. We'll rebounds intothat company. And so it's really
a contrarian, systematic, buylow sell high rebalancing
process embedded within theindex design. And so that's Rafi
(46:24):
fundamental indexing ourexpectation is that it adds
about one and a half percentover the broad market index per
year over long, long marketcycles. And we've seen that play
out kind of in our life history,as well and kind of the
simulated history before welaunched the strategy 2004. So
that's fundamental indexing. Andthen yeah, we do have ESG
(46:46):
versions of Rafi fundamentalindex available. What we do
there is essentially, weintegrate. So what we're doing
is we're upgrading companiesthat rank well on an ESG
perspective, and downgradingcompanies. But we're also
excluding certain companies.
Basically, we exclude certaincontroversial industries. So our
raft, our broad, Rafi ESG index,excludes fossil fuel companies,
(47:08):
gambling, tobacco, andcontroversial weapon companies.
And then another thing we dothat's pretty interesting is
that we actually exclude thebottom 10% of companies in our
universe based on individual ESGscores. And this actually helps
to limit that greenwashingeffect that I talked about
earlier, essentially, when youlook at certain companies, and
(47:29):
I'll pick on the Fang stocks,because they're a great example,
a lot of the things I thinkstocks, like Facebook, and
Amazon, and alphabet have reallyhave pretty decent overall ESG
scores, because they typicallyhave really high environmental
scores. But they all have poorsocial or governance scores. If
you look at Facebook, forexample, they typically fail a
(47:50):
lot of governance screens, orthey have a very low governance
rating. Apple has some some low,typically ranks low on the
social rating, Amazon typicallyranks low on the social reading
as well. And so when you includethem in your index, then since
they're such large companies,they usually take up a very
large weight in your index. Andthat's why they that's why a lot
(48:11):
of ESG funds look like the broadmarket index, by excluding kind
of the worst offenders in eachcategory, you end up getting rid
of a lot of these companies thatmight do well in a couple
themes, but not in the third orfourth thing. And so we exclude
the companies that rank in thebottom 10% by environmental
social governance. And we have acouple additional screens called
(48:31):
diversity and financialdiscipline from the portfolio as
well. And then from there, webasically update companies that
score well on it from an overallESG perspective and down way
companies that score poorly.
Preet Banerjee (48:45):
Yeah, I think if anyone is interested in learning
more, you can check out ResearchAffiliates. But one more
question before I turn the floorover to you for your commercial,
although that was part of it.
One more question. For you. Thisis totally off topic. And I
don't remember where this cameinto my head. I don't know if it
was someone who I don't know ifit was maybe it was Doug grots
son or these with the companyanymore, but maybe it was you I
(49:05):
don't remember. But I want youto confirm or deny the story or
let me know if you know anythingabout it. So I understand that.
For people who don't know JayLeno, former host of The Tonight
Show has his massive carcollection. And it's so big that
he has a mechanic like adedicated mechanic just oversees
his fleet, apparently for justfour and a half days of the
(49:28):
week, though. And that last halfday is servicing someone's
motorcycle fleet. And thatperson would be Rob are not the
basically the head of ResearchAffiliates. Is that true? Did I
make that up? Why is that storyin my head?
Ari Polychronopoulos (49:46):
I I'm I'm not entirely sure. I do know. So
Rob. Rob does have a fairlyextensive motorcycle collection.
Preet Banerjee (49:53):
Yeah, and really quick and vintage motorcycles
right. Like I'm a I'm amotorcycle or so.
Ari Polychronopoulos (49:57):
Yeah, I can confirm that. Yeah. I've
I've I've seen some of themotorcycles he does right into
the office on occasion. They'repretty impressive. I can't
comment on the management of hisfleet though. Maybe someone
maybe you heard that story fromsomeone else but but, but yes,
Rob does have a pretty extensivemotors.
Preet Banerjee (50:18):
Can you ask him that? Like, just flip him an
email and say, Hey, Dee, is JayLeno's mechanic your mechanic
for your motorcycles? And he'seither gonna be like, we made
you a partner or Yeah, no,that's absolutely true. Anyways,
okay, all right now The floor isyours. Whatever it is, you want
to communicate to listeners, ifyou want to promote your
(50:39):
research, research affiliates,whatever it is, go to it my man.
Ari Polychronopoulos (50:42):
Yeah, if if you're interested in learning
more about some of the researchthat I talked about today, you
can find all of our researchpapers at Research Affiliates
Comm. We're also on LinkedIn,under the same company name
Research Affiliates, we're ontwitter at ra underscore
insights. So those are a fewplaces you can go and none of
(51:04):
our research is under a paywallor anything like that. So I'll
just freely available on ourwebsite. And and please go visit
the website. And if you have anyquestions there's a there's an
email box, there's an info lineand just shoot us an email.
Preet Banerjee (51:20):
Excellent. Our it's been really great chatting
with you and catching up beforewe started recording this
podcast. I'm so so happy to seeyou know what's happened in the
last 10 years since we last sortof connected but done some
really great things. And yeah,it's just so nice to hang with
you.
Ari Polychronopoulos (51:39):
Great. It was it was a pleasure to be
here. Thanks a lot. And yeah, Ihad a lot of fun.
Preet Banerjee (52:07):
If you want more personal finance content or you
have questions for me or topicsuggestions for the podcast, you
can follow me on Twitter orInstagram and ask away the same
handle in both cases at PreetBanerjee, I also have two
YouTube channels, you cansubscribe to my main channel
which covers personal financinginvesting topics that are global
(52:29):
in scope, and a Canadianspecific channel as well. And
that is it for this episode.
Thanks as always for listening
Let's say I was with the clan, which I'm not for
(00:03):
the record, let's say I was atthe clan, and I'm responsible
for managing the pension for anIRA. And I said, Hey, we we like
this idea of ESG, but not somuch the s. Yeah, we don't care
about society. You know, wedon't care about equality. But
yeah, environment greatgovernance. Yeah, we got a
structure. So that's importantto us. So could we get like,
just eg without the S?
Ari Polychronopoulos (00:26):
I, it's funny. There are funds like
that. I mean,
Preet Banerjee (00:48):
you've likely heard terms like ESG investing,
sustainable investing, impactinvesting, socially responsible
investing in others. But arethey all the same? Today's guest
is the head of ESG. At ResearchAffiliates, we're going to
tackle some important questions.
Does ESG lead to better returnsfor investors? If you don't
(01:09):
invest in ESG tilted portfolios,are you against the environment,
or social and governance goals?
And who determines whether aportfolio or investment is ESG?
compliant is too subjective? Allthat and much more on this
episode of mostly money.
(01:39):
This is mostly money. And I'myour host, Preet Banerjee, my
guest today is Ari Pollakmonopolies who is the head of
ESG. At Research Affiliates, avery well known firm globally
for its smart beta and assetallocation work, over $170
billion worldwide is managedusing Research Affiliates
(02:01):
strategies. Ari is a partner atthe firm and focuses on smart
beta and ESG integration. He'sresponsible for multiple product
lines, including the Rafifundamental index, multi factor
ESG, and related climatetransition strategies. Ari,
welcome to the show. Thanks,Preet.
Ari Polychronopoulos (02:22):
It's great to talk to you. It's been been a
while but happy to happy to behere.
Preet Banerjee (02:26):
Yeah, it has been a long, long time. So our
paths crossed professionally.
Over a decade ago, I think. Andyou 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. Oneis you've got deep background in
the financial services. And whenwe first met, you're brand new
at Research Affiliates, I think,yeah, we're within a firm or
(02:48):
something like that. And rightbefore that, you were at a
company called indymac, whichwent under which no longer
exists, right?
Ari Polychronopoulos (03:00):
Yeah, it it, I guess, has the title. It
was one of the first banks thatwas taken over by the US
government during the globalfinancial crisis.
Preet Banerjee (03:09):
Yeah. And I remember at the time you telling
me the story of what washappening, because just to put
this into context, so this wasjust a few years after the great
financial crisis. And it wasstill fresh on everyone's minds.
And I had this opportunity totalk to this guy who had lived
right through it like right onthe ground, what was happening
(03:31):
in the US the epicenter of whatwas happening. So and I remember
when you were telling me thestory, I was like, my jaw was on
the ground, I forget thedetails, because it's been like,
you know, 13 years or whatever.
But can you walk us through?
First of all, what did you do atany Mac? What was your role
there? And what happened duringthe great financial crisis?
Ari Polychronopoulos (03:51):
Yeah, so in the Mac was a mortgage bank.
So basically, the role of thebank was to is as a lender, you
would want to buy a house, youneed to take out a mortgage you
would any bank bank wouldobviously give you a loan. And
the my role of the bank was Iwas an analyst on a trading desk
(04:12):
that was responsible for hedgingwhat was called the bank's MSR
or mortgage servicing rightsportfolio. Basically, what that
is, is when you take out amortgage, there's really three
components to a mortgage fromreally kind of a fixed income
perspective or a cash flowperspective, there's kind of
your principal payment thatmakes it part of your mortgage,
there's your interest paymentthat you pay for the loan you've
(04:34):
taken. And then there's what'scalled the mortgage servicing
rights. That's usually like aquarter of a basis point of your
loan that goes to the companythat's actually servicing your
mortgage. So sending outstatements and collecting
payments and things like that.
And so the bank would, would dowhat a lot pretty much every
mortgage bank was doing at thetime is they would package up
fixed income products, basicallyprincipal only pools of
(04:54):
mortgages and they strip out theinterest only portions and they
would sell those off thedifferent event. Banks. And we
were we would retain themortgage servicing rights
because we had a big mortgageservicing business. And so our
job was to hedge that mortgageservicing rights portfolio,
because essentially, what youhad to do is you had to mark to
market that portfolio every day.
(05:15):
And so based on how interestrates will move, the value of
that portfolio could swing bymillions of dollars, we were, I
think, at the time, had amortgage servicing right
portfolio of a few billiondollars. So you could have huge
fluctuations. And so we werebuying, you know, different
fixed income swap contracts,futures, contracts, things like
that, to basically hedge outthe, what's called the interest
(05:37):
rate risk in that portfolio. Andas the, as the, I guess, the
credit quality of any Mac beganto deteriorate, going into the
global financial crisis,essentially, what was happening
is, you know, ourcounterparties, were getting
more and more afraid ofbasically, the company
defaulting, you know, the loans,we're collecting the loans we
were selling, you know, as, asnot only any macro, pretty much
(06:04):
every bank was, you know, at theheight of the crisis crisis,
basically lending to anybody whowanted 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 hedgeour portfolio, because, really,
at the end there, we couldn'teven find counterparties, you
know, we'd have differentinvestment investment banks
(06:25):
calling us up and saying, youknow, hey, you know, our
compliance group says, we can'ttrade with you anymore, we have
done one unwind all of ourtrades. And it just got to be
like this really scary situationwhere, you know, towards the
end, we were basically not evenable to fully hedge the
portfolio, it was kind of movingup and down by a million dollars
a day, the credit quality of thecompany started to deteriorate,
(06:48):
and that eventually causebasically a run on the bank, you
know, people kind of showing up,the bank did have a commercial
bank, side of the business, andpeople were showing up saying,
Give me my deposits. And, youknow, once that starts, you
know, it just gets it gets, youknow, I remember going into work
sometimes, and it'd be lines,because we had a bank at the on
the ground floor of ourbuilding, I was up on like, the
fourth floor, whatever. Andthere'd be lines of people
(07:11):
around the corner, just waitingfor the bank to open so they can
go in and withdraw theirdeposits. And they'd be
screaming at you like, just likeyou're the devil basically
trying to spit at you as you'rewalking in trying to go. It's
like, I'm just, I'm just tryingto do my job and trying to hedge
your portfolio here. I'm sorry.
But
Preet Banerjee (07:29):
when when do you remember when you first had like
that, that holy shit moment.
During that time, in the greatfinancial crisis, where you're
like, Man, this is we're allgonna lose their jobs, like,
when that occurred to you.
Ari Polychronopoulos (07:43):
So I would probably say, so I left in the
Mac in about late June of 2008.
And I would probably say about acouple months before that,
things, you know, startednoticing the writing on the
wall. And, and started, Istarted looking for a new job,
you know, any Mac was eventuallytaken over by the government.
(08:05):
And then it was sold andrebranded 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 Iturned to some of the other
(08:26):
people on the desk and said,hey, it's probably time for us
to start looking for somethingelse.
Preet Banerjee (08:33):
Oh, man, and yeah, so shortly after that, you
ended up at Research Affiliates.
And I remember being down at theoffices, beautiful offices down
in Newport Beach. Are you guysstill in Newport? Yep, we are
still here in Newport Beach. AndI remember walking into the
reception, and under this glasscase was I think it was a first
edition of Adam Smith's Wealthof Nations. Yeah, cool office.
(08:54):
And I have a lot of respect forRob Arnott and everyone at the
firm, really, I miss workingwith you guys back in the day.
But in any case, you're here totalk about, you know, what
you've been focusing on lately,as you know, a new partner of
the firm, congratulations onthat. You're heading up ESG. And
this has been exploding in termsof headline coverage, demand
(09:19):
from investors. Some pensionfunds need to divest from oil
investments. And so it's it'shuge. And that's why you're
here, you're going to sort ofhelp explain what what is going
on in the world of ESG what itis what it means to investors.
So let's let's start with thevery basics. And what does ESG
stand for?
Ari Polychronopoulos (09:44):
So yeah, ESG stands for environmental,
social and governance,investing. at a very high level,
if you want to define it, it'sreally an approach to managing
assets where as an investor, youexplicitly acknowledge the
relevance of these factors,these environmental, social and
governance factors in yourinvestment decisions. And it's a
(10:07):
really broad area. So when yousay it's even something like
environmental factors, what doesthat mean? It actually means a
lot of things. It's really anytheme that pertains to the
natural world. And it deals withconcepts like climate change,
resource depletion, pollution,deforestation, biodiversity,
these are all kind of themeswithin the environmental space.
(10:28):
On the social side, you'relooking at themes that affect
the lives of humans, like humanrights, child labor, employee
relations, human resources,issues, diversity, these are all
the types of things you dealwith, when you're looking at the
social aspect of ESG. Investing.
And then finally, governance isreally issues inherent to
business models, like boardmakeup, executive pay, lobbying,
(10:50):
practices, bribery, corruption,and so you, you literally have,
you know, hundreds of sceneswithin ESG. And an ESG
investment strategy could besomething that's very specific,
like a strategy, an investmentstrategy that focuses on gender
diversity. Or it could be verybroad by saying, hey, I want a
broad ESG strategy that, thatinvest in companies that that
(11:13):
rank really well on a ESGperspective holistically. So
it's really kind of a broadspace. And when you say ESG,
you're, you're talking reallyabout a lot of things. And it's
something that means reallydifferent things to different
people. If you are talking to alarge pension fund concerned
(11:33):
about climate change, they'relikely going to have a very
different idea of what a goodESG company is compared to a
faith based organization lookingto invest based on their values.
And so it varies quite a bit.
Preet Banerjee (11:47):
In any sort of new ish space terms often get
conflated or confused. So canyou explain what sustainable
investing, Sri sociallyresponsible investing and impact
investing? They all seem to bein the same world? But they do
have different meanings? Can youexplain the differences?
Ari Polychronopoulos (12:08):
Yeah. So let's start with Sri so. So
they're all they all kind ofmean the same thing. And they're
often used interchangeably. Sri,or socially responsible
investing is kind of what I'dsay is like, I would term maybe
first generation type of ESGinvesting. You know, Sri
investing actually goes all theway back to the the late 1700s,
(12:31):
early 1800s, you could seethere's, there's, you know, you
could read about different kindsof Quaker and Methodist churches
for bidding their members frominvesting in a slave trade or
buying sin stocks, guns, liquor,alcohol, things like that
tobacco. And so Sri is reallymore of thinking about, you
know, excluding a lot of type ofinvest, about type of companies
(12:54):
you wouldn't want to invest in,based on what they do. That's
really evolved more recentlyinto what we now kind of call
ESG, where you're looking alittle bit more quantitatively,
you're not just excludingcertain industries, but you're
actually looking at a lot ofdifferent factors within those
themes to kind of score acompany or rate a company. And
(13:17):
it's much more what we call anintegrated approach. impact
investing is actually anentirely different type of
strategy where an impactinvesting is where you're going
to only invest in areas thathave a positive impact on the
environment or society. And soan impact investor might be
investing in certain projects,like perhaps a micro financing
(13:39):
project in a third world countryto get, you know, small
businesses up and running, andexpect to get a return but
probably not expecting to getthe type of return they would
get if they were just going toinvest in the market. And so
impact is a little bit differentthan then your traditional Sri
and what we now call ESG.
Preet Banerjee (13:55):
Now, it seems like there's a whole bunch of
different factors that you'vetalked about. So how do you how
do ESG investment strategiestackle these themes? So if I
say, Yes, I want to be an ESGinvestor, because seven of those
things that you just talkedabout, they, they mean something
to me, and they're aligned withmy values? How do I actually
(14:17):
implement that in a portfolio?
Ari Polychronopoulos (14:21):
Great question. So there's a lot to
unpack there. You know, as Ipreviously mentioned, there's no
universally accepted definitionof ESG. And so you know, even if
you do a quick Google search, onESG ETFs, for example, you're
going to find everything fromclimate specific funds, clean
water funds, funds that try toencourage minority empowerment
(14:47):
faith based funds, genderdiversity. So as an investor, I
think step one is determiningwhat are your ESG preferences,
and then second, trying to findan investment strategy that's
aligned with those preferences.
I think, you know, more so thanreally anywhere else in the
investment space and enjoys doyour homework when you're
(15:08):
investing in something. But theESG space is just, it's just so
broad. And there's just so manydifferent options. It's really
understanding what you want toaccomplish through your
investments and then finding aninvestment strategy that's
aligned with that.
Preet Banerjee (15:23):
My understanding is that there's a number of
different ways that maybe anIndex Provider might say, Well,
here's something that is alignedwith ESG. And it could be
through negative screening,where they say, we're going to
exclude certain companies basedon criteria or others might say,
well, we'll place more weight oncompanies that, you know, hit
(15:43):
certain objectives or targets.
So can you talk about, what arethose different metrics that are
used those ratings that are usedthat that will allow someone to
say, yes, this company has agood ESG rating? And this one
doesn't?
Ari Polychronopoulos (15:58):
Yeah. So.
So when you're implementing anESG strategy, as you mentioned,
there's a couple ways to goabout it. So we can start there.
You mentioned divestment, andthat's that's kind of the the
easiest approach to ESGinvesting. It's, it's what's
called, I'm not going to excludecompanies, or I'm just going to
divest from these companies, I'mnot going to own them.
Typically, you see investmentstrategies that divest from
things like fossil fuels, forexample, where there'll be no
(16:20):
oil companies or energycompanies in the portfolio that
that are using fossil fuels ordivesting from weapons or coal
or tobacco. And so that's reallythe simplest route. Second is
what we call integration ESGintegration where, where you
might say, I'm going to updatecompanies that rank really well,
(16:41):
from an ESG perspective, I'mgoing to downgrade companies
that rank poorly from an ESGperspective. And the benefit of
the ESG integration approach isthat by not excluding the
companies, a lot of investmentmanagers say, Well, I can
actually, you know, influencechange at a company, I can vote
my proxies, I can get members onthe board that might be
(17:01):
sympathetic to some of these ESGissues. And so we've seen this
movement away from just broadbased exclusions into more ESG
integration and what we callengagement, where you're
actually engaging with thecompany and trying to influence
change, through your throughyour voting rights, and through
your interactions with thecompany itself. Now, when you're
(17:22):
trying to determine what makes agood ESG company, and this is
probably the the biggest kind ofarea of in terms of issues
associated with ESG is how doyou determine what a good
company is? Typically, the wayyou do this is, you can work
well with what we call ESGratings agencies. So there's a
(17:46):
lot of different ratingscompanies out there that provide
ESG data. That data is based ona lot of different data sources.
So starting from the beginning,typically, you'll have large
companies that provide sets ofESG disclosures each year,
similar to their annual filingsare in financial statements. But
unlike financial statements,there isn't a single uniform
(18:07):
framework for disclosing ESGrisks and opportunities. For
example, I guess the mostpopular framework is what's
called the G ri, the globalreporting initiative, about 70%
of publicly traded companiesreport using this framework. But
there's some other popular onesas well, there's Saxby, the
sustainability accountingstandards boards that has their
own framework for companies onhow to report. There's one
(18:29):
called the taskforce for climaterelated financial disclosures,
which is more aboutenvironmental issues. And so
starting from the beginning,it's okay, these companies are
gonna report what type offramework are they going to use.
And then you have the dataproviders that are collecting a
lot of those disclosures andreports, and also doing
interviews with the companylooking for other publicly
(18:50):
available information to come upwith an ESG rating. And when you
look at I wrote some researchlast year on on ESG ratings
providers, and basically that'sa field where there's you know,
identified over 70, differentESG ratings providers. And so as
an as an investment manager, ifI'm going to create an ESG Fund,
the question is now, okay, onceI've defined what my ESG
(19:14):
preferences are going to be, Igotta go out and get the data.
Who am I going to get the datafrom all of these different ESG
data providers have differentmethodologies for how they rate
companies, and you can get somevery different results? by just
looking at the data from thefrom these different companies.
Preet Banerjee (19:33):
Let's say I was managing a lot of money. And
let's say I was responsible tosome investors and they said,
Hey, we want ESG NFL, let's sayI had a particular investment
philosophy. Could I just gorating shopping and say, all
right, well, I will pick thisrating because that is most in
line with my investmentphilosophy 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
(19:56):
you know, when you go to thegrocery store, and you see those
little You know, those littlecheckmarks that say, hey, this
has been approved by this, thisand 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 toplay? Is there like shopping
around and agencies? How doesthis work?
Ari Polychronopoulos (20:14):
Yeah. So I'll talk about kind of our, our
experience when we launched ourfirst ESG index strategy several
years ago, I would say it's alittle bit more than that, I
wouldn't say it's just kind of apay to play scheme or anything
like that. Most of these ESGratings providers will have
really well thought outmethodologies, I don't you know,
that some of the leadingproviders the MSCI
(20:36):
sustainalytics, ISS are a few ofthem of the world, they have
very well thought outmethodologies. But again, these
methodologies aren't uniform,there's no regulatory agency
that says this is, you know, theframework you should use for
determining what a good ESGcompany is. And so they're all
going to be a little bitsubjective and a little bit
different based on themethodology that they've
(20:58):
developed. And so that's kindof, you know, the the issue with
the ESG ratings agencies. Sowhen we launched our first ESG
strategies, we basically did,our research team did did a
pretty long project, where welooked at several different ESG
ratings providers, we got trialdata from all of them, read
(21:20):
through their methodology,documents, looked at the data,
and and really ended up choosingthe one that we thought we were
most comfortable with. And wewere looking for things like, do
they have broad data coverage?
Do they cover a lot of companiesso that we can make sure we can
build a broadly diversifiedinvestment strategy? Is there
you know, kind of any? Is theredata quality good in terms of
how there's kind of sourcing thedata and delivering the data?
(21:41):
And does their methodology makesense to us? And so, you know,
for full disclosure, for our owninvestment strategies, we use a
company called ISS. And that'sthe company that we settled on.
But even when looking at thedifferent companies, you see
some some interestingidiosyncrasies, some interesting
differences between thecompanies. A good example is we
have a index strategy thatexcludes energy companies. And
(22:05):
when you look at a company likeToyota, for example, you would
think what's when you thinkToyota, you think auto
manufacturer doesn't seem verycontroversial? I probably
wouldn't exclude it as a as aenergy company. So some of the
data providers don't excludeToyota. Some of the data
providers do exclude Toyotabecause they have a 20% stake in
(22:26):
a subsidiary that engages inthermal coal mining. So now, the
question is, you know, this kindof gets into the different
methodologies, you know, do youconsider the ownership and
subsidiary means that Toyotaitself should also get excluded?
And so there's all these kind oflittle idiosyncrasies? Well,
yeah,
Preet Banerjee (22:44):
I could give a perfect example, which would be,
hey, look, here's atransportation company that, you
know, it's not a sin company.
And like, Oh, yeah, they justlike move stuff from place to
place. What in the move justguns? Yeah.
Ari Polychronopoulos (22:58):
So that would be an effort by some
screens that we like, well,that's another one other screens
like, well, it's justtransportation. But that's kind
of like to your point. Yeah. Andtypically, the way we deal with
that is we use kind of a revenuebased model for determining if a
company is engaging in what wecall a controversial activity.
So if a company is deriving morethan, let's say, 5% of its
revenue, or 10% of its revenuefrom either the production the
(23:21):
sale the distribution of cost ofguns, for example, you know, we
might exclude it. Andinteresting cases, Walmart,
Walmart gets excluded from somemore indices because they have a
significant part of theirrevenue is from selling guns.
And you wouldn't think that butyou know, that that it does fail
that screen because because theydo sell I think it's more than
(23:43):
5% of revenue or something likethat comes from the sale of
guns.
Preet Banerjee (23:55):
Conversation with Ari Pollak monopolies
continues in just a minute, butfirst, a few thank yous to
listeners who left comments onApple podcasts. Thank you to
Cedric Nola, J. barshop, Medibakery. Andrew Lutz and Omar mo
93. All listeners from theUnited States where oddly the
(24:16):
podcast has a higher rating thanin Canada. But do everyone who
leaves ratings and comments onApple podcast, I appreciate
them. And I do read them all. Iproduced the podcast for you
listening. And just a heads up aNavy taking a hiatus on the
podcast towards the end ofsummer I really need to put my
(24:37):
head down and finish up mydissertation and hopefully
defended in the fall. It reallyshould have been done by now. So
I'm going to turn my focus ontothat to really get it buttoned
up. But for now, back to theconversation with Ari Paulo
kanopolis from ResearchAffiliates.
(25:07):
So when it comes to, here'sanother analogy. There's this
old movies called the big hit,not super popular, but kind of
like a little cult action comedymovie. And there's this one
scene where this guy, they wantto place a phone call, but they
don't want to get traced. Sothey had this trace buster. And
(25:29):
then they've also thought ahead,and they thought, well, in case
the people on the other end ofthe line have a way of
identifying if you've got atrace buster, and they can still
trace you, we've got this traceBuster buster, and it was just
this little thing. So thequestion is, is there in ESG,
ratings ratings agency? Becauseif there are so many different
ratings, isn't there going to besome kind of value to have some
(25:53):
kind of unification? Becausethis seems quite problematic. It
seems like this is an area whereyou know, people could get
exploited, or they could, youknow, pick a ratings agency that
gives you different results. Andthe reason I asked this is
because I know that you've donesome work on this, you've done
some work on measuring thereturns of portfolios with these
(26:14):
different ratings agenciesscreens applied. And I wonder if
you could talk about thedifferences in returns between
providers? Yeah,
Ari Polychronopoulos (26:22):
yeah. So that's the first part of your
question there, there isn't asingle kind of global framework
for determining kind of an ESGrating, or there isn't the
oversight the board in anycountry that oversight oversees
ESG ratings. What we arestarting to see though, is some
uniformed regulations around ESGdisclosures, which is a good
(26:43):
thing, I think that's step onein the right direction. For
example, in the UK, they'verecently passed a law where
basically all large companies,public and private have to
disclose climate issues, climaterisks and opportunities.
According to the what's calledthe TCF D standards. They also
have mandated that largecompanies and all investment
(27:06):
managers start start offeringmandatory disclosures on the
sustainability of theirinvestment strategies. And
they're also developingsomething that you call the EU
taxonomy, which is basically aglobal framework for reporting
on ESG risks and opportunities.
And so we're starting to seethat in some areas of the world
where I think we're going tostart seeing a lot more uniform
disclosure reporting, and whichwill probably start lending
(27:28):
itself to kind of better andhigher quality and more
consistent ESG ratings. But Butyou're right, we looked at a
couple of different ratingsproviders last year, and a paper
that I wrote, where weessentially built the exact same
investment strategy, but we usetwo different ratings providers.
So basically, what we did was wetook the top 50% of companies by
(27:50):
ESG score, and then justcalculated the portfolio and
then ran a simulation over about10 years to see you know, how
similar the portfolios were, andyou got fairly different
results, both in terms ofreturn. volatility is about the
same, but the return was acouple percentage points
different. But then you when youlooked at things like turnover
(28:12):
in the top holdings at theportfolios, they were very
different. One portfolio had ahigh waiting and wellsfargo
where the other portfolioexcluded that company entirely.
And then vice versa. Facebookwas rated really low by by that
by the first company, and wasone of the top holdings in the
second portfolio. And so, yeah,with this
Preet Banerjee (28:33):
governance specific governance factor that
both will that differentiatedWells Fargo, because I know
they've got some governanceissues. Yes,
Ari Polychronopoulos (28:39):
it was the governance factor. And then on
the Facebook side, it was isreally just kind of dealing with
issues of data privacy. ReallyHow surprising and and, you
know, it's it comes down to howis that treated in the
methodology? And how much of aweight does that ESG data
provider put on one on one ofthose issues? Because they all
determine make their owndeterminations of what's
(29:00):
material? And how much of shouldyou wait that issue in
determining the overall ESGscore? And that's, that's where
you can kind of get these verydifferent results.
Preet Banerjee (29:09):
In terms of the amount of the difference in
results, was it statisticallysignificantly different between
readings providers, like Do youhave enough time in the dataset
to really draw meaningfulconclusions? Because, you know,
the reporting of these metricshasn't really been around that
long as it
Ari Polychronopoulos (29:27):
Yeah, that's that's kind of the other.
The other issue is his dataavailability. You know, if you
get if you're lucky, you can geta ESG data set that goes back
maybe a decade or a littlelonger. So obviously,
determining statisticalsignificance off of 10 years of
data is it's nothing is going tobe statistically significant.
Yeah,
Preet Banerjee (29:45):
cuz that starts after the great financial crisis
troughs, so everything's gonnalook pretty good. But yeah, so
that that kind of brings me toanother question, which is, is
ESG a factor and I want toexplain Just a little bit
because we know that with, youknow, the world and I guess I
guess was pre 1993 we lived in acap m world and then post 93
(30:08):
we're kind of like in this famof French three factor world.
And factor investing has risenin prominence, including things
like the market factor, thevalue, size cetera. What about
ESG? Is ESG? a factor inreturns?
Ari Polychronopoulos (30:25):
Yeah, that's a that's a great
question. I think that'sprobably the question I get more
from investors when we'retalking about ESG than anything
else is, you know, do I gethigher returns if I invest in
ESG. And there's really a coupleschools of thought here. I mean,
there's the traditional academicview that, you know, excluding
stocks and constraining youruniverse will lead to a lower
(30:45):
return. Also, that you know,that ESG companies have to
compensate investors willing tobuy their stocks, with a with a
higher cost of capital. And soyou should expect as an issue
investor, you're gonna get a lowreturn. And so we tried to test
the theory of is ESG factor doesit provide a robust return
premium over time, what I didwas we looked at companies
(31:08):
within the US and within Europe.
So we took two sample to sitdifferent sets of samples. And
we created some long, shortstrategies. So we went long the
top 30% of companies by ESGscore, short the bottom 30% of
companies in our universe by ESGscore. And we did the same thing
for individual environmental,social and governance scores,
try to see if we can determineif there's a factor return
associated with any one of thesethemes are with the broad
(31:30):
overall theme itself. And whatwe found was, when we're doing
that test, again, nothing wasstatistically significant, we
didn't really find alpha inthese in these tests. Now,
again, it was a back test thatwent back about 10 years. So I
don't want to say definitivelythat ESG is not a factor. But we
didn't really find statisticallysignificant alpha, running these
(31:54):
tests. Also, within ESG. Again,it's such a broad space. So even
when I say we're going to testthis, the environmental scene,
you know, if we looked at maybejust something like carbon
emissions, or certain otherthemes within environmental,
maybe we could have found a datapoint that that might have
provided something interesting.
(32:16):
But the one thing I think isimportant to think about is, I
don't think ESG needs to be afactor to be able to take
advantage of it over the comingdecades. And why I say that is
that I think ESG is going to bea powerful theme that might lead
to rising valuations for goodESG companies, and higher return
as a result, as more and moreinvestors start investing in ESG
(32:39):
strategies. So you can kind ofthink of this as, as an
opportunity, a thematicopportunity more so than this is
a robust premium that's going todeliver over the next five
decades. And the reason I saythat is, you know, there's a lot
of arguments around kind of whatwe're seeing within ESG
investing, there's, there's thewhat's called the stranded
assets argument that a lot ofthese energy companies are gonna
(33:01):
have to take massive writedownson their assets of these oil
fields that aren't really goingto might not be produced deucing
in a decade or so. And we'restarting to see that a little
bit. Now we're starting to seesome big oil companies starting
to take write downs on some oftheir assets. And they're we're
also seeing, you know, there's abank of america study from 2019.
That's that highlighted that 20trillion in assets are poised to
(33:23):
flow into ESG funds over thenext two decades, driven by you
know, women and millennialinvestors, which are
increasingly making up a largershare of the investment pie. We
talked about greater regulationsthat are forcing kind of more
flows into the into the ESGspace. And then if you look at
fund flows, you know, 2020 wasactually a record year for ESG
fund flows. If you look at inEurope, 50% of all mutual fund
(33:47):
and ETF flows were in ESGstrategies. In the US, that was
about 25%. And in Canada, thatwas about 10%. And so we're I
think we're at this inflectionpoint where there's a lot of
money flowing in thesestrategies. There's one thing to
consider, though, we talkedabout the difference in ESG
ratings. And in that paper, wemake a point my co author
actually made up came up withthis line, which I thought was
(34:08):
hilarious, but they say a risingtide lifts all boats, but all
boats need to be in the sameharbor and in the water the same
time. And with with ESG when youhave such different views and
different on what ESG Is it thequestion is, you know, will we
be able to capitalize on thistheme because
Preet Banerjee (34:26):
of that? Kind of tangentially, but we talked
about whether or not ESG is afactor jury's out at this point.
The data doesn't support thatright now. We also you mentioned
something about you know,thematic investing and how
that's seen a rise inprominence. Are meme stocks a
factor? Have you done anyresearch on Wall Street bets and
(34:46):
whether or not they have nowmade a big enough an impact that
you can statistically say thatmeans are a factor. Like is
there gonna be a fam of French?
I don't know what they're up tonow, five factors so will there
be a sixth factor of mean stocks
Ari Polychronopoulos (35:00):
That's an interesting question. I wish I
had an answer for it, I think. Idon't know. I think, again, we
talked about the dataavailability, I think it's that
that's kind of been a thing formuch shorter than even ESG
investing had so right. I thinkthat the jury will be out on
that one for a much longer time.
But it's been interesting overthe past year, observing that
(35:20):
and just watching,
Preet Banerjee (35:23):
if we, you know, I just saw yesterday that the
latest meme stock is going to beWendy's stock, because one of
the reasons here's the actualrationale, one of the reasons
is, they literally sell chickentenders. And I don't know if
you're familiar with the theparlance in, you know, meme
stock world, but 10, DS is a bigthing. It just basically means
(35:44):
gains. And so because theyactually sell attendees, they're
like, yeah, they should be amean stock. And also, they're
pretty active on Twitter. Andthey have a pretty good sense of
humor with their Twitteraccounts, so they become the
next darling of the world. Andnot that I'm advocating buying,
you know, deep out of the moneycall options, just in case but
Ari Polychronopo (36:02):
unfortunately, it Research Affiliates were
prohibited from buyingindividual stocks, our
compliance group prohibits it,so I can't to take advantage of
the Wendy's trend now
Preet Banerjee (36:12):
interesting. Are you prohibited from buying
individual crypto assets?
Ari Polychronopoulos (36:16):
No, not on crypto assets, just since most
of our strategies are long, onlyequity indices. And we know, you
know, when we're rebalancing, Iknow what what we're going to be
rebalancing into. So we don'twant to even have the slightest
appearance of some sort ofconflict of interest. So
Preet Banerjee (36:31):
Right, right, I can only buy, are you guys gonna
release a fundamental index ofcrypto assets anytime soon? Is
that on the horizon? That's aninteresting question. It was a
joke, but are you actuallyconsidering it?
Ari Polychronopoulos (36:42):
Well, so we have one of our senior
advisors is, as is, is aprofessor by the name of cam
Harvey Campbell Harvey, I don'tknow if you're familiar with
him. He's at Duke University,but he's probably at the
forefront of cryptocurrencies interms of his research. And so
we've been discussing, you know,internally, you know,
Preet Banerjee (37:03):
we are
Ari Polychronopoulos (37:04):
looking at cryptocurrencies, from a
research perspective, no plansto launch an index at this time,
but it's just, it's aninteresting space. And, and
we've got, we've got the expertin house, so it's just something
that we're looking at right now.
Preet Banerjee (37:18):
Oh, maybe we'll have to book him for a future
episode. I'd love to hear histhoughts. Okay, so, one of the
things that I've been seeing alot lately is that, you know,
industry responds to demand andconsumer preferences, and there
has been a demand for ESG typeof products and strategies. And
so, as an example, you know, ifyou have, you know, turnkey
(37:42):
portfolios as your productoffering, and let's say you've
got, I don't know, call it fivefor five different levels of
risk. Now, all of a sudden,you've got 10, because you've
got those same five differentlist risk levels, but now you
can get it with an ESG versionof those portfolios. So, here's
the question. If I don't investin an ESG portfolio, does that
(38:02):
make me anti ESG?
Ari Polychronopoulos (38:07):
That's an interesting question. I, I
wouldn't say it makes you antiESG.
Preet Banerjee (38:11):
I don't feel
Ari Polychronopoulos (38:11):
like I'm anti ice. I think one of the
things to be cognizant of, andso this kind of going back to
the ESG portfolios, and I'llbring it back to the non issue
ones. There's a concept you needto look for when it when
investing in ESG. And it'scalled greenwashing.
Essentially, it's a term thatmeans that a company or an
investment strategy is marketingitself as ESG, when it's really
(38:33):
not doing much at all. And sogiven the growing popularity of
ESG, investing, a lot of fundsare rebranding themselves as
ESG, even though they're not,there might not be much going on
under the hood. In regards toESG. There was actually a
article in Bloomberg that cameout last month it was called, it
was called many ESG funds areexpensive s&p 500 indexers it's
(38:55):
a great article about thistopic, where basically they're
looking at some of the top ESGETFs. And saying, These look
exactly like the broad marketindex. What's going on here in
terms of ESG? And more profit?
Yeah, and it's, it's three timesthe expense ratio. Yeah. And so,
you know, some ESG investors areessentially by buying those
funds or just buying the broadmarket index. And so I think
(39:17):
this kind of goes back to, likeI said earlier, you got to do
your homework and make sure thatyou're not just buying, you
know, the s&p 500 or just thebroad market index and saying,
Hey, this is ESG because thatmay might make some ESG
investors anti ESG.
Preet Banerjee (39:35):
Yeah, so when it comes to individual investors
who are looking to say, Hey, youknow, I, you know, I agree with
the philosophy, but I don't wantto pay more and then not get it
to like you say a closetindexing greenwashed ESG.
marketed fund. So what should aninvestor be looking for when
(39:57):
thinking about adopting ESGstrategy?
Ari Polychronopoulos (40:02):
I think, first off, as I said earlier, is
make sure you know what yourpreferences are, you know, do
you want broad ESG? Do you wantdiversity? Do you want climate
related? Second, when you'relooking at the different funds
available to you, you know, lookat, you know, what's the active
(40:22):
share of this fund relative tothe benchmark? You know, how
different is it if if they'vegot a correlation of 99%, you're
getting a market fund, you'regetting a greenwashed bond. So
it's really looking at theholdings, looking at how those
holdings differ from the broadmarket index, it's benchmark
two. And I think that's, that'sreally kind of where to start.
(40:44):
Then also, it's kind of where doyou go from there? I think
typically, when when investorsthink about ESG, they're
thinking about equitystrategies. But, you know, do
you want to try to get thesimilar exposures in the fixed
income space, you know, greenbonds have been around for about
15 years now. And they'rebecoming an increasingly large
part of the fixed income space,where it's basically you're
(41:06):
you're, you're investing in bondissues that are specifically
targeting, you know, maybe aClimate Initiative or some some
other type of initiative thathas some sort of green or, or
ESG outcome associated with it.
And so, again, finding out whatyour preferences are, and then
trying to find a strategy thataligns with those preference
preferences. That's, that'sinteresting. So
Preet Banerjee (41:29):
I'll use a humorous example. So let's say I
was with the clan, which I'm notfor the record, but let's say I
was at the clan, and I'mresponsible for managing the
pension for an IRA. And I said,Hey, we we like this idea of
ESG, but not so much the s. Wedon't care about society, you
know, we don't care aboutequality. But yeah, environment,
great governance. Yeah, we got astructure. So that's important
(41:51):
to us. So could we get like,just eg without the s.
Ari Polychronopoulos (41:57):
I, it's funny, there, there are funds
like that. I mean, you can lookat just environmentally focused
funds, it's a big thing,actually, one of the things that
probably the biggest space thatwe're working on right now, with
large pension plans, orenvironmentally focused funds,
or what we're calling climatetransition strategies, where,
you know, they're not excludingany companies based on kind of
(42:18):
controversial activities,they're not concerned about the
social or governance aspectswithin their equity investments,
what they want to do is ensurethat they're aligned with, you
know, something like the ParisClimate accords, where the
carbon intensity of theportfolio is going to be reduced
on an annual basis. So by thetime we get to 2015, the carbon
intensity is, you know, netneutral. So that's kind of
(42:39):
really the in terms of what'sgoing on now in the ESG space,
and where I'm seeing the mostinterest, it's really the
climate related side of ESG.
Investing.
Preet Banerjee (42:49):
And you mentioned, you know, considering
ESG, with respect to fixedincome and green bonds, but what
about other asset classes is itas as easy to come up with ESG
strategies for something likecommodities or private credit or
private equity? Because Iimagine, I'm just thinking off
the top of my head, but withcommodities, what could you do
(43:10):
other than screen say, well, wedon't want fossil fuels, but
we're okay with gold. Like,yeah. What about those other
asset classes?
Ari Polychronopoulos (43:17):
Yeah, the commodity space is a little
tricky. It's exactly kind ofwhat you said is, it's it's
investing in commodities thatthat 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 ofget a little bit bigger and can
see kind of moving into thecommodity space. Also, on the
(43:40):
private equity side, it's a lot,it's a little bit easier. I
think, as an investor on theprivate equity side, you can,
you know, you might you mightpurchase companies with the
specific objective of improvingtheir ESG metrics, or of
investing in certain projectsthat might yield you yield a
good return and might bepositive for the environment or
(44:01):
something like that. So it's inthe private equity space. It's
something that's been going onfor a while now. commodities is
it's really hasn't really pickedup yet. I think there's, there's
a way to go before we startseeing a lot more interested in
commodities in the ESG space.
Preet Banerjee (44:15):
I was wondering if maybe you tell us a little
bit about because I noticed Iwas just going on the website.
It's been a while since I'vevisited the Research Affiliates
website, but I see that you havelike a Rafi ESG. So can you
first maybe give like a crashcourse in what fundamental
indexing is, as opposed to capweighting? And then explain how
(44:36):
that applies to ESG? Yeah,
Ari Polychronopoulos (44:39):
so the Rafi fundamental index approach
was something that we developedback in 2004. So it's been
around for quite a while. Andthe main premise of fundamental
indexing is that markets are notefficient and they tend to mean
revert over time. And so whenyou invest in something like the
cap weighted index, which ismarket capitalization, weighted
(44:59):
Which is just number of stocksoutstanding times market price,
you are systematically overweighting overvalued securities
and under weighting undervaluedsecurities as a company becomes
more expensive. And I think theposter child for this was
looking at the tech bubble, it'sa company becomes more
expensive, it becomes a largerand larger portion of your
overall index. So you look atthe height of the tech bubble
(45:20):
and 30% of your s&p 500 indexwas invested in tech stocks. And
what happens is when the techbubble crashes and stock prices
mean revert you suffersignificant draw downs, because
of that, fundamental indexingbreaks the link between stock
price and weight in yourportfolio. And so in the
(45:40):
fundamental index, we weightcompanies based on their
fundamental measures of size. Sowe look at things like a
company's sales, its cash flow,its dividends, its book value,
basically to create a compositeweight based on company
fundamental size. And we usethat weight as a rebalancing
anchor to trade against marketprice movements. So over the
(46:01):
course of the year, as the priceof a company becomes more
expensive, at rebalance willactually rebalance back down. So
trim the company's weight andcapture those gains, the company
becomes cheaper and moreattractive from a valuation
perspective. We'll rebounds intothat company. And so it's really
a contrarian, systematic, buylow sell high rebalancing
process embedded within theindex design. And so that's Rafi
(46:24):
fundamental indexing ourexpectation is that it adds
about one and a half percentover the broad market index per
year over long, long marketcycles. And we've seen that play
out kind of in our life history,as well and kind of the
simulated history before welaunched the strategy 2004. So
that's fundamental indexing. Andthen yeah, we do have ESG
(46:46):
versions of Rafi fundamentalindex available. What we do
there is essentially, weintegrate. So what we're doing
is we're upgrading companiesthat rank well on an ESG
perspective, and downgradingcompanies. But we're also
excluding certain companies.
Basically, we exclude certaincontroversial industries. So our
raft, our broad, Rafi ESG index,excludes fossil fuel companies,
(47:08):
gambling, tobacco, andcontroversial weapon companies.
And then another thing we dothat's pretty interesting is
that we actually exclude thebottom 10% of companies in our
universe based on individual ESGscores. And this actually helps
to limit that greenwashingeffect that I talked about
earlier, essentially, when youlook at certain companies, and
(47:29):
I'll pick on the Fang stocks,because they're a great example,
a lot of the things I thinkstocks, like Facebook, and
Amazon, and alphabet have reallyhave pretty decent overall ESG
scores, because they typicallyhave really high environmental
scores. But they all have poorsocial or governance scores. If
you look at Facebook, forexample, they typically fail a
(47:50):
lot of governance screens, orthey have a very low governance
rating. Apple has some some low,typically ranks low on the
social rating, Amazon typicallyranks low on the social reading
as well. And so when you includethem in your index, then since
they're such large companies,they usually take up a very
large weight in your index. Andthat's why they that's why a lot
(48:11):
of ESG funds look like the broadmarket index, by excluding kind
of the worst offenders in eachcategory, you end up getting rid
of a lot of these companies thatmight do well in a couple
themes, but not in the third orfourth thing. And so we exclude
the companies that rank in thebottom 10% by environmental
social governance. And we have acouple additional screens called
(48:31):
diversity and financialdiscipline from the portfolio as
well. And then from there, webasically update companies that
score well on it from an overallESG perspective and down way
companies that score poorly.
Preet Banerjee (48:45):
Yeah, I think if anyone is interested in learning
more, you can check out ResearchAffiliates. But one more
question before I turn the floorover to you for your commercial,
although that was part of it.
One more question. For you. Thisis totally off topic. And I
don't remember where this cameinto my head. I don't know if it
was someone who I don't know ifit was maybe it was Doug grots
son or these with the companyanymore, but maybe it was you I
(49:05):
don't remember. But I want youto confirm or deny the story or
let me know if you know anythingabout it. So I understand that.
For people who don't know JayLeno, former host of The Tonight
Show has his massive carcollection. And it's so big that
he has a mechanic like adedicated mechanic just oversees
his fleet, apparently for justfour and a half days of the
(49:28):
week, though. And that last halfday is servicing someone's
motorcycle fleet. And thatperson would be Rob are not the
basically the head of ResearchAffiliates. Is that true? Did I
make that up? Why is that storyin my head?
Ari Polychronopoulos (49:46):
I I'm I'm not entirely sure. I do know. So
Rob. Rob does have a fairlyextensive motorcycle collection.
Preet Banerjee (49:53):
Yeah, and really quick and vintage motorcycles
right. Like I'm a I'm amotorcycle or so.
Ari Polychronopoulos (49:57):
Yeah, I can confirm that. Yeah. I've
I've I've seen some of themotorcycles he does right into
the office on occasion. They'repretty impressive. I can't
comment on the management of hisfleet though. Maybe someone
maybe you heard that story fromsomeone else but but, but yes,
Rob does have a pretty extensivemotors.
Preet Banerjee (50:18):
Can you ask him that? Like, just flip him an
email and say, Hey, Dee, is JayLeno's mechanic your mechanic
for your motorcycles? And he'seither gonna be like, we made
you a partner or Yeah, no,that's absolutely true. Anyways,
okay, all right now The floor isyours. Whatever it is, you want
to communicate to listeners, ifyou want to promote your
(50:39):
research, research affiliates,whatever it is, go to it my man.
Ari Polychronopoulos (50:42):
Yeah, if if you're interested in learning
more about some of the researchthat I talked about today, you
can find all of our researchpapers at Research Affiliates
Comm. We're also on LinkedIn,under the same company name
Research Affiliates, we're ontwitter at ra underscore
insights. So those are a fewplaces you can go and none of
(51:04):
our research is under a paywallor anything like that. So I'll
just freely available on ourwebsite. And and please go visit
the website. And if you have anyquestions there's a there's an
email box, there's an info lineand just shoot us an email.
Preet Banerjee (51:20):
Excellent. Our it's been really great chatting
with you and catching up beforewe started recording this
podcast. I'm so so happy to seeyou know what's happened in the
last 10 years since we last sortof connected but done some
really great things. And yeah,it's just so nice to hang with
you.
Ari Polychronopoulos (51:39):
Great. It was it was a pleasure to be
here. Thanks a lot. And yeah, Ihad a lot of fun.
Preet Banerjee (52:07):
If you want more personal finance content or you
have questions for me or topicsuggestions for the podcast, you
can follow me on Twitter orInstagram and ask away the same
handle in both cases at PreetBanerjee, I also have two
YouTube channels, you cansubscribe to my main channel
which covers personal financinginvesting topics that are global
(52:29):
in scope, and a Canadianspecific channel as well. And
that is it for this episode.
Thanks as always for listening
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