ESG Evolution In Full Swing

Denver-based Change Finance is an ETF issuer with a mission to accelerate the adoption of sustainable and responsible investing. The firm is behind the U.S. Large Cap Fossil Free ETF (CHGX), which offers large cap exposure and incorporates ESG standards into the portfolio so that capital markets promote the business practices and innovation necessary to address our most pressing social and environmental challenges.

This year, Change Finance released its first annual ESG Asset Allocation Trends Report. The report discusses some of the prominent trends that are occurring in terms of building portfolios for investors and aligning those with environmental, social and governance (ESG) principles. ETF.com caught up with Dan Carreno, the firm's executive vice president of business development, to discuss the evolution of ESG investing.

The following transcript has been edited for clarity and brevity.

ETF.com: Why do you feel capital markets are a necessary piece of the puzzle in addressing ESG issues?

Dan Carreno: The incentive structures that we’ve built for corporate managers have unfortunately produced a lot of social and environmental externalities. We've really seen those externalities come to fruition here in recent years, in the form of wealth inequality here in the U.S., and globally, as well as environmental issues, like climate change.

If we want to address those issues, we believe the incentive structures for corporations need to shift. The best way to do that is through the owners of these large publicly traded corporations—that being us as stockholders, at the end of the day.

So by essentially saying that, from a capital market standpoint, if your practices as a corporation are damaging to the people in the planet in order to make profit, then you're largely going to end up in a position where you're cut off from a majority of the allocations in the capital market. And that creates some pretty strong incentives for corporations to begin to shift.

ETF.com: What do you think has been the catalyst behind increased investor interest in the ESG space?

Carreno: Some of the larger firms in the asset management industry are finally investing capital into the space, and that comes along with education.

Even though flows have accelerated here in recent years, there's still a lot of education that needs to occur among individual retail investors as well as financial advisors. There are still misconceptions that need to be overcome. And as large organizations are allocating more into that space, we’re seeing a lot of great educational resources come along with that.

The other thing is, of course, the demand aspect. You’ll see in the ESG Asset Allocation Report some of the behavioral drivers that are encouraging investors to become ESG-oriented investors. Those include things like altruism, autonomy, performance.

The younger generation now has a larger portion of assets in the U.S., and globally, they’re being driven by those three factors in various mixes. That’s leading those individuals to then either seek out these investments through online brokerages or they're bringing these demands to the financial advisors they work with.

ETF.com: There’s a perception that ESG funds often underperform their benchmark. What do you think is behind this misconception?

Carreno:  I think that perception is shifting—may have already shifted. The industry is fighting a hangover from portfolio management practices and the more traditional socially responsible mandates that existed decades ago, that were largely and exclusively exclusionary portfolios.

Oftentimes, those led to drags on performance. But as people revisit the idea of sustainable and responsible investing, they're revisiting the data now, and seeing that’s not the case. The industry has evolved over the last couple of decades, and has found more thoughtful ways to integrate values into investments.

And, of course, now we can point to a lot of different studies. One of the most recent ones is from the Stern School of Business at NYU, really validating that the integration of ESG in portfolio management at worst has a neutral impact, and at best, is actually enhancing returns for investors.

ETF.com: Regarding performance, the 2021 ESG Asset Allocation Trends Report shows that midcap and small cap ESG funds have struggled to produce the same relative performance that other asset classes have. Why do you think midcap and small cap ESG funds haven't been able to provide the same level of performance?

Carreno: We’re still trying to figure out what's going on there. This was a relatively small sample when we look at small- and midcap funds. We’re looking at the ones that are being the most commonly recommended by financial advisors—in which case, there were only six products that fell into the sample.

We see the implementation of ESG data into smaller cap portfolios as being more difficult. These companies typically aren’t quite as transparent. They don’t have the same quality of data surrounding them when it comes to ESG. So, in many cases, asset managers are more reluctant to dive into that ESG small- and midcap space, which is constraining that sample size.

The main takeaway is there simply needs to be more product in this space so that financial advisors and retail investors have a larger selection of investments to choose from.

ETF.com: Have you noticed any difference between how institutional or retail investors are implementing ESG?

Carreno: Yes. On the institutional front, oftentimes you have asset allocators trying to make decisions on behalf of a larger base of assets, whether it be a foundation that is taking in money from different sources, or pension plans—things of that nature.

You tend to see much more plain vanilla portfolio constructions that are hopefully touching on a lot of aspects of ESG. People will tailor their investments to their personal values in a much more dramatic way, which includes a lot more integration of thematic funds.

In those more institutional mandates, there’s not as much of that thematic element being pursued. How do you address the autonomy of so many different stakeholders that may be part of that institutional mandate?

ETF.com: How do you think ESG investing will evolve from here?

Carreno: We’re seeing a lot of different trends and fads occur in the investment management industry in recent years. And I think most experts agree that this is not that case [for ESG]. There is too much data supporting that this information around companies is extraordinarily valuable.

And of course, the risks that are facing corporations because of poor performance in the environmental standards, social standards now are becoming more real every day.

For that reason, it’s our expectation that ESG is going to be absorbed and become a baseline for almost every investment portfolio at some point in the not too distant future.

However, there’s going to be a lot of discussion about the uses of ESG. Sometimes we, as an industry, get confused that ESG is a style or a mandate. It’s not. It’s just data, at the end of the day.

How asset managers use that data is going to differ tremendously. Every portfolio, to some degree in the future, is going to be using that data.

Contact Jessica Ferringer at [email protected] and follow her on Twitter