How socially responsible investing can help you avoid catastrophic drops within your portfolio

• Martin Kremenstein, head of retirement and ETF solutions at Nuveen, explains how ESG metrics serve as an indicator of quality and can be used as a risk management tool.
• According to research from MSCI, companies in the bottom ESG quintile have been twice as likely to suffer a catastrophic loss (over 95% cumulative loss) within three years.
• MSCI downgraded Equifax to the lowest ESG rating on cybersecurity concerns a year before the data breach was announced.
• Kremenstein says that Facebook was excluded from Nuveen's NuShares ESG Large-Cap Growth ETF from the time it launched in December 2016. He explains, "it scored relatively poorly, compared to other tech companies over data privacy concerns."
  

Following is a transcript of the video.

Sara Silverstein: I'm here with Martin Kremenstein, the head of Retirement and ETF Solutions at Nuveen.

Can you talk to me about the ESG metrics, and what do they measure? And how good are they of measures of social responsibility, and where do they fall short?

Martin Kremenstein: Sure, so ESG stands for environmental, social, and governance. And what that really is, is a framework for analyzing companies and really assessing how well they compare to their peers in terms of performance against these metrics. Under E for environmental, you have water usage, waste production, and general kind of environmental behavior, like how efficient they are at managing their resources, and also looking after the environment around them. Under social, it's around how well do they treat their clients, how well do they treat their workers. And then there's also some diversity aspects around the management in the workforce. And then under governance, I mean that's around share class structure, and government structure within the company, how well run is the company? When you take it all together, what you're really looking at is another way of assessing a company, without looking at its balance sheet, and looking at how it impacts the broader society at large.

Silverstein: And where do these do a really good job, and where do you think that they fall a little short? What can't they measure?

Kremenstein: Sure, so I think they do a good job in terms of how well is Company A doing compared to Company B. But it's less good, I think, in looking at what is the overall mission of a company, in terms of, is it out there to do good, and if so, how do you manage that? I think the other way, where it kinda falls a little bit short is that it's a little bit of a framework. So, lots of people have different views around what is more important. For some people it's around environmental is more important, for others it's social, for others it's governance. As many people as there are in a room, there are gonna be different opinions as to what actually is important. And so, unless you are gonna go and build a bespoke portfolio for someone in a separately managed account, there has to be some degree of compromise around how that ESG framework is actually gonna be applied.

Silverstein: And are they self-reported? Are companies sharing these metrics with you, I mean, with investors at large?

Kremenstein: Yeah, so most of the data is public. It's a combination of self-reported, and also analysis done by analysts who are pouring over company fact sheets, their regulatory reporting, and so forth. So because of that, you do tend to get better reporting from larger companies. But you can get reporting for companies all the way down to cap structure, cap size, and also internationally as well. We're able to produce an ESG framework that enables you to look at large cap value, as well as small cap, but also emerging markets, and developed markets as well.

Silverstein: And do you have advice for people who want to invest along their values, and who, maybe haven't spent a lot of time looking at the ESG metrics? What is some way to get them over the hurdle, where it feels like there's just too many options, and they wanna put their money where their values are?

Kremenstein: Sure, so I think there are a couple things. First of all, they are gonna have to define for themselves, what's important to them? And you know, there are certain ESG providers that have a very specific slant to how they're doing it, and they have to decide whether that's what they're looking for, or whether it's based on religious, or certain other social aspects. If they're looking for just general ESG, in terms of framework, for companies that are better stewards of the environment and social, then really they should either look for ESG providers. There are certain companies that have been this way for a long, long time, and all ESG funds will be labeled ESG, or responsible investing, or impact, because if you have an ESG fund, you are gonna put that in the name somewhere. And then you need to look at how the products work. You know, look at the criteria by which companies are being scored. That should be very, very clear, and apparent within the funds literature. If it isn't, maybe then move on to another provider. If you're looking at your retirement plan, maybe talk to whoever runs your company's retirement plan, and ask them about responsible investing options for that plan.

Silverstein: Great, and is there a trade off? Do you feel like you can still make money, and invest it responsibly?

Kremenstein: So historically the knock has been that to actually have responsible investing, you had to give up some performance. I think we're seeing now that that isn't the case, and we're actually seeing lots of times where using a ESG framework, can actually help you avoid companies with bad practices. For example, we had the Equifax scandal sometime last year, right? Well, Equifax had actually been downgraded by major ESG data providers over data privacy and security issues, about 18 months to 2 years beforehand. Markets Insider

Kremenstein: Within our large cap growth ETF, Facebook hadn't been included, because it scored relatively poorly, compared to other tech companies over data privacy concerns.

Silverstein: That was not something that I ever considered as part of an ESG framework, is data privacy, but it's very important to a lot of people, a lot of people are divesting for Facebook now. How does that metric work in ESG?

Silverstein: And divesting seems to be one way in which a lot of people want to express their values. Is that something that you're seeing? And how effective is divesting, as a method of making a difference?

Kremenstein: So divestment is one tactic you can use, I think we have certain industries where we do divest from, so weapons manufacturers, alcohol, gambling, tobacco, and then nuclear power. However, those are industries that we feel they're essentially - they're put in that sin stock basket, and so we divest. Beyond that, I think if you are just doing straight divesting, what you are doing is taking yourself out of the conversation with the company, with the issuer of the stock. For example, if you're to divest from energy companies, you couldn't actually be in a conversation with them as a major shareholder, encouraging them to look at say, renewables. Alright, so you need to kind of weigh out divesting, which is alright, I feel good, cause I'm not invested in what I think is a sin stock, versus, well I have no say in trying to influence that company's behavior. So it can be a little bit self-defeating, because you've now removed yourself from that conversation with the company.

Silverstein: And how much does it cost to be a socially responsible investor? Are fees higher on socially responsible investment products?

Kremenstein: Not particularly, I mean, we price our ETFs, somewhere between the straight kind of market cap-weighted benchmarks, and smart beta. And when you look at how we're scoring the companies, someone once said to me, "Well, it's very much like non-financial quality factors." You could look at ESGs almost like a smart beta overlay, particularly when you consider the risk management aspects of it. We actually put together a series of portfolios using all the building blocks within our ESG ETF suite, and it came in most of the time under 30 basis points. So we think investors can actually invest according to their beliefs, without paying over the odds to do so.

Silverstein: And could you talk about that a little bit, like the smart beta, and the benefit from not investing in things like Facebook?

Kremenstein: Well, so if you think about the factors themselves, they are effectively, how well run is the company? So you're looking at quality factors, right? And quality is one of the more nebulous of the smart beta major factors. And so you could say, "Well actually, this is just another way of defining quality in the company, right?" Does it waste resources? Does it look after its customers, and stay out of trouble with the regulators? And does it have a decent management structure that encourages accountability?

And so, by having that framework in place, you're able to avoid companies like Volkswagen. BP, before the Deepwater Horizon incident, had actually been downgraded and removed from major ESG indices over concerns about its outsourcing of maintenance of offshore oil wells, which is precisely what happened there.

So it's really a very, very good risk management tool, and MSCI did research, and I think they found that companies in the bottom 10% for ESG score, had a much, much higher likelihood of what they deemed to be a catastrophic, or a material drop in share price from an incident. And by material, they were talking 90%. And so, by actually having this framework in place, you are really putting in place a method for trying to avoid tail risk from companies that are badly run, and may end up having serious, serious scandals in the press.