Building a fixed interest portfolio while meeting your ESG goals
Marlena Lee - Head of Investment Solutions at Dimensional
In this episode, Marlena Lee, Head of Investment Solutions at Dimensional joins us to discuss the role that environment, social and governance (ESG) investing can play when building a fixed interest portfolio and why investors shouldn't have to sacrifice returns to meet their ethical objectives. Marlena also shares her views on how the markets might react to the upcoming US Presidential election.
Paul O'Connor (POC): Welcome to the Netwealth investment podcast series. My name is Paul O'Connor, and I'm the Head of Investment Management and Research for Netwealth investments. Today, we have Marlena Lee, who is Dimensional Fund Advisors' Head of Investment Solutions. Marlena previously served as co-head of research, helping shape the research agenda by working with clients and the sales and investment teams to identify research topics on a variety of investment-related matters, including asset pricing, asset allocation, and retirement.
Marlena is also a member of the investment research committee. Prior to joining Dimensional, she worked as a teaching assistant for Nobel Laureate, Eugene Farmer, a professor at the University of Chicago Booth School of Business. Marlena earned her PhD in finance and an MBA from the Chicago Booth School of Business. She also holds an MS in agricultural and resource economics and a BS in managerial economics from the University of California, Davis.
Dimensional was a U.S. funds management firm, which commenced in 1981, with its head office located in Austin, Texas, and the Australian office was opened in 1994. Dimensional also have offices in London, Vancouver, Amsterdam, Berlin, Singapore, Tokyo, Sydney, Charlotte, and more recently, in Hong Kong. So certainly have a global footprint. The firm has grown rapidly over the last 30 years and managed a total of 812 billion Australian dollars in equities, fixed interest, and listed property securities, as at March, 2019, and has over 1,400 global employees and investments in most countries.
Dimensional have numerous funds on the Netwealth investment menu, covering most asset classes, and have an investment philosophy founded on academic research with strong influences to the Fama-French three-factor model, but perhaps I'll let Marlena explain the investment style.
Today's podcast will focus on fixed interest and specifically environmental, social, and corporate governance that refers to the three factors that attempt to measure the sustainability and societal impact of an investment in a company or business. We've seen such a large growth in the number of ESG strategies offered by managers, and appears now almost every manager on the Netwealth investment menu now offers an ESG strategy, whether they employ a passive, active, or quantitative investment strategy.
ESG strategies commence typically with equity managers overlaying an ESG lens on the companies they hold in portfolio, but now we're seeing more fixed interest managers offer ESG strategies. We're fortunate to have Marlena with us today, who's certainly well-qualified to talk about Dimensional's investment style, markets, and ESG.
Perhaps for starters, Marlena, how have you and the Dimensional team coped with adjusting to the impact of COVID on the workplace? Have you been working from home a lot over the last six months?
Marlena Lee (ML): Hi, Paul. Yes. I've been working from home, and it's been an interesting time for sure. I certainly don't miss travelling almost every other week for work, but on the other hand, having two young children and balancing Zoom meetings all day with them popping in to help them with Legos, it's an interesting time.
POC: Yeah. I can imagine balancing a family life and a hectic workplace would certainly make for an interesting household of yours. So maybe for starters, can you tell us a bit about Dimensional's history?
ML: Sure thing, Paul. And you did such a great job of summarising Dimensional in a nutshell. We were founded in 1981, and it was based on this pretty simple idea that we could use what was going on in the academic research at that time to build better portfolios for clients. That was almost 40 years ago. So decades before systematic or smart beta, factor-based investing was a thing.
On the fixed interest side, where it seems like interest in systematic investing is just starting to take hold, for example, we've been managing fixed interest solutions using a systematic approach, actually a systematic approach that we still use in our fixed interest strategies today. And we've been doing that since 1983. So, certainly something that we've been doing for decades now, having a systematic approach that draws from academic research on the drivers of expected returns.
POC: Can you tell us just a little about your own background and how you came to work at Dimensional?
ML: Sure thing. I joined Dimensional in 2008, and it was right after I finished my PhD in finance from Chicago Booth. And as you mentioned in your intro, I was working for professor Fama as his teaching assistant. At that time, he was also on my dissertation committee, and I just realised that I didn't have much of an interest in becoming a professor. So he actually suggested that I reach out to Dimensional. It just felt like such a continuation of what I was doing at Chicago Booth. It was explaining what this research is around, what drives returns. And now, just having the ability to apply it into portfolios is really, and it has been, really exciting for me over the last decade. It's hard to believe that was over 12 years ago.
POC: Yeah. Time does fly there. So full-time academia wasn't for you, and you decided to work at Dimensional there. Moving onto Dimensional's approach to fixed interest, what is the approach to managing fixed interest portfolios, and how do you believe your style differs from other fixed interest managers? And noting your earlier comment there, and I fully agree that I think Dimensional was one of the first, if not the first, systematic investment manager that I'm aware of. So if you could just start, yeah, provide the listeners with a bit of background on how Dimensional approaches fixed interest management.
ML: Mm-hmm (affirmative). And actually, on both our fixed interest portfolios and our equity portfolios, it's based on one philosophy, and that's a belief that we can use market prices, that we don't have to figure out ways in which market prices are incorrect. And by flipping that, we can use market prices to extract information about differences in expected returns.
For fixed interests, that means yield curves, right? We get to see yield curves across global bond markets every day. And we use that for two ways in our fixed interest strategies. We use that to assess expected returns, but also risk management. For expected returns, we look at, the technical term would be forward rates. That just accounts for, you think about a yield curve, there's the level and the shape of the yield curve. And that tells us something about expected returns without us trying to forecast how that yield curve is going to change over time.
Because the research shows that it's pretty difficult to add value by forecasting how yield curves are going to change, but that just means that we can use that every day in a really systematic way. And we do it actually to compute expected returns over 18,000 different bonds every single day. What we do with that information is decide what segments of yield curves we want to emphasise, or what currencies of issuance we want to focus on, or even how much to focus on lower versus higher credit quality bonds.
As a good example, this year, we did see a lot of volatility in markets. And when you have a lot of volatility, prices change a lot, and you need to have that process in order to update your view of expected returns. And also, we saw heightened risk in markets.
I also mentioned that we use yield curves or market prices to assess credit qualities. And I think that this is also a different way that we manage fixed interests relative to other managers, is that we're using that information and market prices to-... is that we're using that information in market prices to make us very confident in credit qualities. For example, in March, when yield curve said, "Hey, higher expected returns are bonds with lower credit quality," we wanted to go to our maximum allocation in lower credit quality bonds, but we wanted to do it in a very risk-controlled, measured way.
So what we do is we get lots of inputs from different pricing sources, like index pricing, credit default swaps, how the stock is trading, and we take all of those different inputs and we create an internal credit rating. We use that to supplement the stated credit rating of a credit rating agency.
So just some numbers, year to date through August, we actually downgraded 155 issuers in our systems, and 122 of those were actually through this market-based process. So the credit rating agency wouldn't have changed the stated credit rating. And, in terms of additional evidence, an example for March, if you look at the U.S. credit universe, in March, about 120 bonds got downgraded from investment grade to speculative grade. But if you look at our investment grade strategies, we only held one out of those 120. So we're really seeing our process work the way we expect.
POC: Yeah, it's interesting. And it certainly differentiates you from most other fixed interest managers that we've got available on our investment platform. Fixed interest yields are at all-time lows. The outlook in duration is very constrained, and central banks' extraordinary monetary policy has made them so active in the market. So what's your view on fixed interest as an asset class at the moment?
ML: I think I've heard this question most of my 12-year career at Dimensional. Because I'm based in the U.S., and our federal funds rate has been at basically zero for almost that whole decade after the GFC. If you look at that period, though, you did see a pretty healthy return to global fixed interest. For example, if you look at the global ag, hedge it to the U.S., where we had that very low short-term rate, it still returned about 3.8% from 2009 to 2018.
So I think the lesson, and it's anecdotal, but even if you see low interest rates, there might be term or there might be credit premiums in certain segments of the global bond market. Right now, for example, yield curves point to higher expected returns for credit. And what we see if you look across both global yield curves, those positioning of the yield curves change all the time. So it's really important to have that process, the one that I mentioned, where you're looking yield curves every day and taking in the information about expected returns, and using that in a dynamic way, but systematic, to figure out how to position a portfolio in a really controlled and risk-controlled way.
POC: Yeah. In Australia, we've seen that many investors moving up the risk curve in fixed interest, and typically underweighting bonds and overweighting defensive portfolios with credit, and particularly private credit. Does Dimensional invest in private credit?
We invest in all sorts of public markets, but not private credit, actually.
POC: Moving on to ESG and the application within fixed interest strategies, ESG investing has become increasingly popular in recent years and most fund managers now seem to be offering ESG strategies. So what's Dimensional's history in this area?
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ML: Yeah. We've actually been accounting for ESG considerations all the way back to the 80s. That's when we started managing separate accounts for clients that accounted for ESG considerations, and then, on the fixed interest side, we started managing separate accounts with social screens in 2014.
Today, we integrate ESG throughout our entire investment process, on both the equity side and fixed income side, in order to manage risks. And we take it really seriously. For example, our investment stewardship committee is made up of the most senior leadership across the firm. Includes folks like our co-CEO and CIO, Gerard O'Reilly, our head of responsible investment, Joe Chi. Also has some of the academics we work with, like professors Gene Fama and Ken French.
We also, in addition to thinking about ESG as risk controls within our broad lineup, we also offer a full suite of solutions that account for either social or sustainable considerations across global equities and global fixed interests. So all of the different components that investors would need to build well-diversified portfolios.
Throughout our experience, the one really important lesson that I think we've learned is that, to apply E, S, or G considerations in a really broadly-diversified portfolio, like the type that Dimensional likes to run, with thousands of different securities, you really need a high degree of data expertise, right? Think about on the fixed interest side, where you have 18,000 bonds that we're computing expected returns on every day. And then you add in the different pricing inputs for the credit monitoring process, plus the ESG data that we've been working on now for 10, 15 years. And when you think about all that data we have, and we've purchased data from different data sources, thinking about how to link those together with the rest of our systems, and producing some of that internal data ourselves, and folding it into a process to manage the portfolios every day, that's what we've really been getting better and better at over the last 10 to 15 years.
POC: And I'd also assume that it's a continuing, ongoing action for Dimensional to further build out the ESG process there, as I've seen a lot of fund managers gathering more external data and internal data in the way they look at ESG and how corporate is making that societal impact, I guess. ESG means different things to different people, so how does Dimensional apply ESG to fixed interest solutions? What issues do you take into account and how do you implement?
ML: Absolutely. ESG can mean a lot of different things to different people, and that's why we think it's really important that you have a well-defined goal, mainly because there's so many different ESG variables that one could pay attention to. If you pay attention to all of them at the same time, you might have a reduced diversification in your portfolio. So when it comes to our sustainability trust, we are focused on sustainability. That can be roughly defined as meeting our needs today, but then not sacrificing the ability of future generations to also meet their own needs.
And when we talk to climate scientists, they say that the biggest risk when it comes to sustainability is climate change. And in terms of what is the primary drivers of climate change, the big thing there is greenhouse gas emissions. So when we look at the universe of bonds, we consider greenhouse gas emissions and also potential future emissions from reserves. So, when you're thinking about those reserves, you can think of coal or oil or gas that's in the ground. Doesn't necessarily mean emissions today, but if they are burned in the future, then that could mean future potential emissions.
So those are the things that we're considering as it relates to emissions intensities, but also, we're thinking about other ways that issuers are interacting with their environment. Things like land use or do they have a history of toxic spills, and how are they disposing operational waste or toxic waste. And then there are also some social considerations that can have impacts on future generations, things like child labour or cluster munitions. There are a lot of different variables that we'll consider, of course, with the focus on sustainability and climate change as being the primary variable that gets the biggest weight in our consideration.
... variable that gets the biggest weight in our consideration. So in terms of what we do with the information, first we exclude the worst offenders, so issuers with the least sustainable business practises will not even be eligible for investment, and then we'll also consider issuers relative to their sector. So within a sector we'll overweight bonds with lower emissions intensity, and underweight those with higher emissions. And that approach ensures that the portfolio is really focused on reducing exposure to greenhouse gas emissions, but also in a well-diversified portfolio.
POC: Yeah, I think it's very much a positive that Dimensional are offering a fixed interest solution in the ESG spaces. There's a lot of equity managers offering ESG strategies, but there's far less fixed interest ESG strategies that I think has, historically, made it challenging for investors to build fully diversified ESG portfolios. Moving on, how can investors judge the impact of ESG strategies, and what do you believe investors should be looking for when they're comparing one ESG fund with another?
ML: This is a great question, but it's one where the answer isn't actually that easy. So when you look at ESG ratings, for example, from different providers you can get very different results, and that's because you might have 40 different variables that are being considered. And how important are all of those 40 different variables, and how much weight do they get in the score? And there's just not always so much transparency into all of the different things that go into a provider's ESG rating. And also something that I mentioned earlier, is that only a handful of companies might scale score well across a lot of different variables, so you also have to think about how you start making trade-offs with diversification.
So the way we think about that is it's really important to understand the details of how a strategy incorporates ESG, and to think about how well that aligns to an investor's own ESG goals. So, for example, when it comes to our sustainability trusts, which are focused on climate change, and then therefore we try to explicitly reduce exposure to carbon emissions, that's something that can be objectives really measured. So for example, as of June, our Global Bond Sustainability Trust reduced exposure to emissions by over 90%, and had zero exposure to potential emissions from reserves. So if it's something that can be measured and quantified, and we are getting improvements in this data all the time, that's something will be easier for investors to assess and compare one ESG fund to another.
POC: Yeah. Well, as I've already mentioned, there's such a growth in the number of ESG strategies, both passive and active and quantitative, that it is becoming, I guess, more difficult for a lot of investors to choose the strategy that's most appropriate for them. And I guess, ultimately, that's where a lot of it relies on potentially getting advice in this area, from a financial advisor to assist in building the portfolio. Does investing in ESG mean that investors have to accept lower returns?
ML: So the quick answer to this one is not necessarily. So let me take a bit of a circuitous route for the long version of the answer, and I'll start with a related question, and that's whether or not ESG related risks are priced in. And if you think about climate change, you can think... Generally, the experts say there's two types of risks, plus an opportunity. So there's physical risk, that's things like sea level rise or impacts from extreme weather events, like the fires that we saw earlier in Australia and that are currently going on in California, and what are the direct impact of those on economies and companies? And then there's transitional risk, and that's the risk that governments might enact taxes or regulation that impact companies, and then there's an opportunity, as companies innovate to overcome these challenges.
But then you also add in just the amount of uncertainty around all of this. So there is uncertainty about exactly how climate change will impact future weather patterns, there's uncertainty about how those will impact different companies, and then probably the hardest thing is there's a lot of uncertainty about how companies and consumers and investors and governments, how all of those different parties will react. But, in some sense, these risks and opportunities and uncertainties, it's not really new. There's a lot of things that impact companies, we're living through one right now with the global pandemic. And at Dimensional, we think markets do a good job of incorporating all of these different sources of information about what will impact a company's future cash flows, and what required rates of returns are fair for investors who bear those different types of risks. At least the evidence doesn't point to anyone being able to systematically profit from prices being wrong, and actually when you look at bond prices, there are some studies that show that bond prices do price in environmental risks.
So for example, there are studies that show... like in the US, we have municipalities or cities that will issue bonds. And those municipalities that are at greater risk from sea level rise, they tend to have higher yields for their long-term bonds. But interestingly enough, not for their short term bonds, which makes a lot of sense if you're thinking that the sea level rise is a longer-term risk. But because there's so many different variables that can impact expected returns, it's not at all obvious that if you focus on companies with better ESG characteristics, you will end up with lower expected returns. But what we think and what our research has shown, as well as the academic research, is that if ESG, along with other systematic risks, drive differences in returns, then that should show up in market prices. So as long as your process accounts for market prices, plus fundamental data, for example, in stocks or yield curves for bonds, and remember I mentioned that we do that within our fixed interest strategies, that you can identify which companies have higher and lower expected returns, and therefore control for the drivers of returns. And as long as the companies that you want to de-emphasise for ESG reasons are not the exact same set of companies that provide the highest expected returns, then you may not have to give up expected returns in pursuit of ESG considerations.
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POC: We've seen a recent example in Australia where one of our largest miners destroyed an important Aboriginal cultural site, that ultimately resulted in the resignation of the miner's CEO. So it appears, to me anyway, that institutional investors are becoming more active in their engagement with companies they hold in their portfolios. Do you believe the companies and they are taking ESG issues more seriously?
ML: No, I think that there's a broad range, if you look across companies, and also across policymakers and investors. I think companies have always recognised what it's important to do to be successful, and there's more focus now on ESG, from both customers and investors. So I don't think it's something that companies have necessarily historically ignored, but there is a lot more focus from external parties.
If you look at some concrete data points, like if you look at emissions disclosures, for example, companies that disclose their emissions now represent about 70% of global equity market cap. Or if you look at other organisations, ones like TCFD, so that's the Task Force on Climate Related Financial Disclosures, that's been increasing over time, so now it's over 1400 different organisations representing over 12 trillion in USD and market cap. So there are a lot of different-
In market cap. So, there are a lot of different indications that companies are paying more attention to ESG issues.
POC: Yeah. And I guess my view is that ESG and incorporating it in running a company, I guess, is fundamental to the sustainability of that company over the long-term and keeping up with societal trends. So it's positive to hear that you believe that companies are now taking ESG issues more seriously. Moving to greenwashing then, and continuing on that theme, I guess for the listener, greenwashing is the process of effectively conveying a false impression or providing some misleading information about how a company's products are more environmentally sound. So really is greenwashing a challenge in how you assess a corporate's ESG stance?
ML: Yeah, they are. I think it kind of goes back to what data are you using in your process and what are the goals that you're trying to achieve and also what does the science say about what are the most impactful things for that goal and how much noise do you think is in your data. We touched on this earlier that we get data from multiple vendors. And sometimes, the data lines up really closely, and other times, you get very different estimates. And that kind of hints to how high quality the data is.
So for example, we focus a lot on emissions. And scope 1 emissions, that's the emissions that companies directly produce, those tend to line up pretty well across multiple vendors. Scope 2, that's the emissions you consume indirectly, and those also generally line up pretty well across multiple vendors. Sometimes, we've seen some differences and then you kind of need to dig in to understand what triggers those differences. But scope 3, that's submissions that may cause or that stems from downstream actions or how a company's products are used, and those don't line up at all really well across vendors. S-scores, for example, don't really line up well across vendors.
So understanding just the noise and uncertainty in that data, you have to ask yourself how willing are you to make investment decisions based on data that could be really different depending on the source? And that's where I think, if you have a goal and a process that takes into account the data quality of your inputs, becomes really important when you're faced with something like greenwashing, where you want to make sure that you're using inputs that can be objectively measured.
POC: Yeah. And I guess ultimately with greenwashing, the corporate will eventually be found out. They can make statements in the short-term, but I guess to your point, the research and the price ultimately will convey how genuine the corporate is about ESG. Finally, have you got a tip for the US Presidential election in November? And who do you think markets are supporting? A Democrat or Republican president?
ML: So I checked right before I hopped on this call. And actually right now the betting markets say that the odds favour Biden. It's about 55 to 45, but that changes over time as we get closer to the election. For investors though, I think it's really important to remember that markets have already priced in a overall expectation of what the outcome will be. And what we see, if you look over US selections over time or presidential history, is that markets have delivered positive returns pretty much whether you have a Republican president or a Democratic president in the market. So that's something that we've seen over time, so.
POC: Yeah. Interesting. I would have assumed markets may have preferred a Republican president, but yeah, yeah. Either. Either should be a positive for markets, which is a good sign ahead. Marlena, thank you very much for joining us on the Investment podcast series this morning. It's been really enjoyable to listen to your views and your insights and dimensionals, I should say, views and insights into ESG and particularly fixed interests ESG. So we very much appreciate your time you've spent with us. To the listener, thank you very much for joining us on the podcast this morning. We hope you're going well through those challenging times and look forward to joining you for the next Netwealth Investments Series podcast. Have a great day, everyone. Thank you.
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