If climate change somehow wasn’t already front and center of your headspace, 2019 likely changed that.
In February, Rep. Alexandria Ocasio-Cortez and Sen. Markey released their Green New Deal resolution. By August, the Amazon rainforest, often referred to as the “Earth’s lungs”, was on fire, as climate activist Greta Thunberg sailed across the Atlantic in a carbon-neutral, solar-powered yacht. In New York, she’d address the United Nations, and go on to be named Time’s youngest ever Person of the Year for sounding “a moral clarion call to those who are willing to act.”
Later that fall, inspired by Thunberg, actress Jane Fonda partnered with Greenpeace to kick off “Fire Drill Fridays”, a series of weekly protests through Washington D.C. The final week’s theme was “The Role of Financial Institutions in the Climate Crisis”.
Dr. Ayana Johnson, a climate scientist and a friend, extended an invitation to join her at this protest. I never thought of myself as an activist, but I had spent the better part of a decade helping to build a different kind of financial institution at Betterment. I knew this was an opportunity I couldn’t miss and soon found myself aboard an Amtrak headed to D.C.
Curbing greenhouse gas emissions from human activity must center on dramatically reducing reliance on fossil fuels across every sector of the global economy. No surprise then, that the rallying cry that weekend was cutting off the flow of capital to the fossil fuel industry. One word reverberated across every speech and conversation: “divestment.”
As we marched together towards the Capitol, one phrase ran through my mind: “if only it were that simple.” What did feel simple, however, was that those of us pushing for change within the financial services industry hadn’t come close to channeling the remarkable energy on display. In our goal to bring more American investors off the sidelines and into sustainable investing, we were clearly falling short.
Since 2017, Betterment has offered one “Socially Responsible Investing” option, constructed from funds that tilt towards companies which rate highly on a scale that considers each of three pillars: Environmental, Social and Governance (“ESG”). ESG is often embraced as the gold standard for sustainable investing by professionals, but is not tailored to a specific investor’s values.
In that moment, seeing the power and conviction of thousands who were mobilized by climate change, our sole ESG offering no longer felt like enough.
The Betterment Way
Back in NYC at Betterment’s headquarters, it was becoming clear that adding a climate-specific portfolio would better reflect some of our customers’ values even more than our broadly-focused offering could alone. If so, greater adoption would further amplify the signal to the industry that values-based investing, despite its recent growth, was still underserved.
For over a decade, Betterment has been working to maximize our customers’ expected returns following the principles of global diversification and low cost. We’ve sought to tackle the complexities behind implementing a sophisticated investing strategy, so that our customers don’t have to, while maintaining transparency around the choices that go into our products.
We applied this framework to the challenges of integrating our customers’ values into their investments. We felt well-positioned to make this daunting process simpler, wherever we could. Where some amount of complexity was unavoidable, we would be transparent about how we chose to address it.
Broadly speaking, there are three distinct approaches to climate-conscious investing, and all three are integrated into Betterment’s Climate Impact portfolio.
- Divestment (i.e. excluding companies holding fossil fuel reserves)
- Low carbon exposure (i.e. overweighting carbon footprint leaders within each industry)
- The equities basket includes CRBN, a global ETF whose objective is to reduce the carbon footprint of a globally diversified portfolio.
- Impact (i.e. financing environmentally beneficial activities directly)
- The fixed income basket includes BGRN, holding “green bonds”, which fund projects across the world, including alternative energy, pollution control, and climate adaptation.
The nuances behind how these approaches interact with each other is discussed below.
What exactly was I going on about, muttering “It’s not that simple”, while surrounded by passionate cries to “divest” from fossil fuels? Like a good student of finance, I was referring back to another mantra: “Capital naturally wants to flow toward where it earns the highest return.”
A core argument for divestment is that it “increases the cost of capital”. Less demand for a stock means a lower stock price, which means the company needs to give away more of itself to raise the same amount of money. The problem is that the more successful you are at driving up a company’s cost of capital, the higher the expected return for the financier. As long as the business you want to starve is engaged in activity that remains both profitable and legal, another investor will come along. The fewer investors are willing, the more those who remain willing stand to make.
The alternative to divestment is engagement. By owning a stock, and using your rights to vote on shareholder resolutions, you can attempt to change the company’s activities from the inside. This path is long and messy. What seems like a victory, often curdles into an empty gesture, as management’s words produce no meaningful action. It’s a grind, and success is far from assured.
Engagement is rife with compromise and disappointment. Divestment, on the other hand, feels principled and decisive. It offers immediate action in the face of a crisis that feels unstoppable. Yet its economic impact on the perpetrators of harm is negligible, particularly if it’s applied in a vacuum.
Both strategies have their advocates, whose vigorous debates occasionally lose sight of the fact that they are on the same team. Moreover, conflicting appeals to absolutes run the risk of paralyzing millions of their fellow citizens, deeply sympathetic to the cause, but reluctant to wade into the confusion.
Can the two approaches be meaningfully reconciled? Michael O’Leary and Warren Valdmanis offer a compelling argument that they can. In their recent book, Accountable: The Rise of Citizen Capitalism, they consider the question through the lens of the Divest Harvard campaign, which took center stage on campus in the spring of 2019.
While O’Leary and Valdmanis believe in the effectiveness of engagement, they express great admiration for the campaign’s leaders, which include both students and faculty. By directly examining these leaders’ expressed views, O’Leary and Valdmanis conclude the following:
- Divestment advocates have done the climate movement a great service, by forcing a broad recognition that “there is no value-neutral way to invest”.
- These leaders aren’t naive. They view engagement with suspicion—as a fig leaf for complacency. But they also understand the limits of divestment within our existing legal and financial framework.
- Rather than narrowly fixate on proximate effects, these leaders take a longer view of divestment—as a political act of civic leadership.
- Under this theory, divestment seeks to impose “a cultural toll, labeling oil and gas companies as morally repugnant … making it easier to pass bold legislation rapidly, with broad political support.”
- Accordingly, the measure of success for divestment should not anchor on the number of dollars diverted, but on its ability to “center climate change in broader discourse”.
- Furthermore, if you are able to advance that objective, while also pushing for change via engagement, there is no reason why pursuing both in parallel cannot be a coherent strategy.
In other words, if an act of divestment, however great or small, aims to achieve more than a feeling of moral satisfaction, it needs to be heard. It needs to help start conversations, trigger chain reactions, grab headlines. And it doesn’t preclude pushing for change within the shareholder framework, if integrated thoughtfully.
It’s a lot to ask of your investment account. Here’s how we approached it at Betterment.
Divestment And Engagement In Your Climate Impact Portfolio
A divestment strategy is implemented in a globally diversified portfolio by applying a screen to an index of all available stocks, expunging those that hold large fossil fuel reserves, and producing a so-called “ex Fossil Fuels” index. The problem with relying solely on an “ex Fossil Fuels” approach, is that it is both under-inclusive, and over-inclusive.
First, let’s look at how it is under-inclusive:
An “ex Fossil Fuels” index is highly effective at screening out stocks of companies with familiar logos that we’ve seen plastered on gas stations. But, such indexes generally do not exclude the hundreds of companies that don’t necessarily own reserves, but are integral to the fossil fuel industry (e.g. pipeline operators, and the utilities that actually burn the fuels).
Critics of a divestment-only approach refer to this phenomenon as “greenwashing”. There are powerful incentives for investment managers to expunge the familiar fossil fuel companies and call it a day. This goes a long way towards providing an investor with emotional satisfaction, but it ignores the complex enmeshment of fossil fuels throughout every sector of the economy.
As for how it is over-inclusive:
A handful of energy companies have staked their futures on renewable energy, and are actively diversifying away from fossil fuels. However, these transitions take time and today they qualify for exclusion under a blunt divestment criteria.
We believe there is merit to the divestment approach. In Betterment’s Climate Impact portfolio, 50% of the stock basket is allocated to SPYX, EEMX, and EFAX, “Fossil Fuel Reserves Free” equity funds for US, Developed, and Emerging markets.
For an act of divestment to be effective, it must be heard, and for most investors, this is uniquely possible by joining with other like-minded investors through index funds. For “ex-Fossil Fuels” funds to grow in assets and stature, sends an increasingly loud message, that the public views the industry as a whole as a pariah.
We also believe there is merit for the engagement approach. In Betterment’s Climate Impact portfolio, 50% of the stock basket is allocated to CRBN, a global ETF whose objective is to reduce the carbon footprint of a globally diversified portfolio, with an expense ratio of only 0.20%. CRBN was launched on Earth Day, 2015, seeded with an initial investment from the United Nations Joint Staff Pension Fund. Today, it holds nearly $650mm, and is gaining scale rapidly.
By excluding companies holding fossil fuel reserves, ex-Fossil Fuel indexes are effectively concerned only with future, not ongoing emissions. CRBN takes aim at both, with more precision, by assigning every company in every sector a “carbon exposure” score, which incorporates any fossil fuel reserve holdings, but also greenhouse gas emissions from the company’s activities (measured per dollar of revenue).
It then uses the scores to minimize carbon exposure across the entire index while maintaining tracking error constraints, by overweighting companies that are managing the lowest carbon footprint within their sphere of activity, including in the energy sector, and underweighting companies that lag their peers, with some of the worst offenders getting dropped from the index entirely.
Boosting The Leaders
Not surprisingly, a rigorous, quantitative methodology is highly effective in service of a clear objective. When compared to the equity basket of Betterment’s core portfolio, CRBN achieves a 50% reduction in carbon emissions. Perhaps more surprising, is that CRBN’s holdings also emit less carbon than the companies collectively held by the “ex-Fossil Fuels” funds, in spite of the latter’s targeted exclusions.
CRBN achieves these results by mathematically expressing preference for “best-in-class” leaders in every sector. In practice, this means that CRBN adds back a handful of energy companies which were screened out by one of the three “ex-Fossil Fuels” funds.
An energy company can wind up in the index if it’s shifting out of legacy fossil fuel activities, and driving significant investments in renewables or bio fuels. A couple of illustrative examples held by CRBN as of 1/31/21:
- Neste is the largest producer of renewable diesel jet fuel, which will significantly reduce aviation emissions (it has two renewable refineries but also two conventional refineries).
- NextEra Energy Inc is the world’s largest producer of wind and solar energy (but also has generating plants powered by natural gas, nuclear energy, and oil)
Generally, “best-in-class” energy leaders are companies where pro-transition management factions have won the internal battles, and have successfully pivoted their roadmaps towards a net zero economy. But such strategic shifts can be fragile.
Consider NRG, an enormous American power company, whose CEO, David Crane, wrote to shareholders in 2014: “The day is coming when our children sit us down in our dotage, look us straight in the eye … and whisper to us, ‘You knew … and you didn’t do anything about it. Why?’”
NRG announced it would cut its carbon dioxide emissions by 50 percent by 2030 and 90 percent by 2050, and began its transformation. But just three years later, Elliot Management, an activist hedge fund unhappy with its financial performance, was able to reshuffle the board, depose the CEO, and begin to sell off NRG’s renewable energy assets.
One could argue that the climate movement is better served, if the David Cranes of the world not only get control, but stay in control. Elliot was able to reverse the transition while holding just 6.9% of NRG’s shares. If climate-conscious capital held enough of the rest, and used that perch to fight, Crane could have survived.
At a systemic level, divestment and engagement are complementary—the stick for companies core to the problem, and the carrot for those who may be part of the solution. Each message has value, and your investments can express both. However, for these messages to actually reach their intended recipients, how you implement these investing strategies becomes important.
A globally diversified portfolio calls for exposure to thousands of individual stocks and bonds. Buying index funds, rather than the individual securities directly, is not only the cheapest and simplest way to get this exposure. For most climate-conscious individual investors, it’s also by far the most effective path to have their dollars contribute to the systemic change they want to see.
A detour into some general investing plumbing may help to appreciate why.
The Power of the Index
While passive investing had been steadily gaining popularity over active stock-picking for decades, the 2008 global financial crisis served as an inflection point. Complex strategies seeking to beat the market came under suspicion, and then continued to lose credibility during the relentless bull market that followed.
With each year, a transparent buy-and-hold strategy proved harder and harder to beat, particularly net of fees. The spotlight shifted away from chasing alpha, towards lowering expenses, making the continuing rise of passive index fund investing a textbook flywheel in action, where growth begets more growth.
Falling fees mean more inflows, and more assets mean more scale, which allows for another round of fee reductions, which pulls the next cohort of fee-conscious investors into the fold. The big fund managers have been engaged in a decade-long “core war”, led by Vanguard, whose flagship equity fund (found in Betterment’s core offering), has ballooned to over a trillion in assets, with its expense ratio down to 0.03%.
These pooling dynamics have had an underappreciated second order effect—the anointment of index providers to new heights of authority in global markets. The trillions may be flowing into Vanguard, Blackrock, and State Street, but the investing decisions have been largely delegated to FTSE Russell, MSCI, and S&P DJI. In 2017, the Economist dubbed them “finance’s new kingmakers: arbiters of how investors should allocate their money.”
However laborious the process behind constructing and maintaining an index, the finished product is little more than a list of companies, with assigned percentages that add up to 100%. The index-makers take pains to emphasize the rules-based, non-discretionary nature of their work. Nonetheless, because trillions of obedient dollars promptly and faithfully replicate every bureaucratic tweak, these glorified spreadsheets are imbued with at times eye-popping power.
Being added to a list has no bearing on a company’s business, and under an efficient markets hypothesis, should have no impact on share price. Yet it is conventional wisdom that membership in the S&P 500 provides some price support. Thus, joining this iconic club can be cause for fanfare befitting a coronation, while removal can be tantamount to a “humiliation”, a symbol of irreversible decline.
Some allegedly “rules-based” decisions are inevitably discretionary, and impactful enough to threaten a geopolitical crisis. A rumor that MSCI was considering reassigning Peru from its flagship Emerging Markets Index, to its less prestigious Frontier Markets Index, put the finance minister, leading a senior delegation, on an emergency flight to NYC to avert the demotion.
The gradual inclusion of Chinese “A-shares” into the major indexes was a highly political, contentious process with far greater stakes. In early 2019, MSCI announced it would quadruple its exposure, which is estimated to steer $80 billion of investment into China. Throughout the process, MSCI has at times functioned as a quasi-regulator, at one point delisting several Chinese companies that had violated its internal governance standards.
Such examples are myriad, ably outlined in a recent paper on “the growing private authority” of index providers. It’s hard not to come away in agreement with the authors, that this backoffice corner of global finance would benefit from more transparency and accountability. But there’s another takeaway: These mechanical, ostensibly value-neutral switchboards for capital have untapped potential as agents of change.
But Make It Sustainable 🚀🚀🚀
What would it mean for sustainability-focused indexes to wield this kind of power? Is it crazy to imagine a future in which getting booted from a major ESG index for failing to hit sustainability targets is viewed as irrefutable evidence of corporate management malpractice? Or is that future more likely than not, if we observe the patterns already in motion, some new, some familiar, and play them forward to their logical conclusion?
As of Sept. 2020, the top ten equity indexes were directly tracked by over $3.5 trillion. Of course, there is no hint of ESG anywhere near the top, but there are compelling reasons to believe that a secular shift is already in progress, and that the rate of change will be non-linear.
None other than the head of ESG at MSCI believes that its sustainable indexes will eventually overtake its traditional offerings, and that trends suggest that the shift will happen “more quickly than most people would expect.” Indeed, while the absolute numbers are relatively small, sustainable funds are seeing scorching, exponential growth. In 2020, investors poured in $50 billion; double that of 2019, and ten times that of 2018.
Meanwhile, we’re on the cusp of the greatest generational transfer of wealth in history, to a demographic that bodes well for only more acceleration. According to Morgan Stanley, “nearly 95% of millennials are interested in sustainable investing, while 75% believe that their investment decisions could impact climate change policy.”
This story is genuinely new, but one level deeper is a more familiar one. Sustainable investing, until recently still largely the domain of active management, is catching up with the broader industry, and shifting towards passive.
2020 marked the first year that passive sustainable funds (i.e. ones that fully replicate an ESG index) handily beat active sustainable funds. Passive took in 2.5 times more inflows than active, whereas the split was 50/50 just in 2019. Not surprisingly, ETFs, predominantly passive, and favored by investors for their tax efficiency, dominated mutual funds by similar margins.
In other words, the defining capital allocation shift of the last two decades is just now starting to play out within the nascent field of sustainable investing, and we know where it leads—the elevation of the index as a behind-the-scenes nexus of power.
Neither retail nor institutional investors are likely to reverse course towards more complexity, less transparency, and higher fees. Sustainable or not, investors have been trained to be laser-focused on low fees. We know how the flywheel turns. How do we harness this unstoppable force as a tailwind for real progress on sustainability, and ensure that there’s more to this reallocation than greenwashing deck chairs on the Titanic?
“Index Activism”: A Theory Of Change
“Index activism”, as any theory of change, faces serious challenges, addressed below. But the structure of index fund investing, as compared to investing in companies’ stocks directly, is uniquely suited to aggregate and amplify the impact of tens of millions of individual portfolios. It represents a form of “collective bargaining”—putting aside lesser differences in favor of progress towards a greater common cause.
Index funds will always entail a trade-off between personalization and the benefits of scale. For some investors, trading the underlying securities for a portion of their overall exposure, will make more sense. However, when it comes to effecting broad, systemic change, the prospect of a robust sustainable index fund ecosystem is hard to beat.
We can rely on the asset gathering flywheel to carry funds tracking sustainable indexes to the mainstream. Yet asset inflows alone won’t magically teach the passive asset allocators to be the active shareholders that we need them to be.
After all, active ownership is a demanding full time affair, requiring specialized expertise. Most of us already have jobs, and ideally, we would empower a team of experts with our dollars, not only to decide what shares to buy, but also how to then leverage those shares in furtherance of a sustainable agenda.
What might it look like, if fund managers acted as stewards of sustainable business, pushing their portfolio companies towards a net-zero economy, standing ready to oppose activist shareholders like Elliot, who seek to undermine progress?
Boutique managers who have long specialized in shareholder advocacy can offer a glimpse. In 2020, Green Century, which manages ~$1 billion across three mutual funds, used the shares of Procter & Gamble it holds on behalf of investors to introduce a resolution, calling on the company to step up efforts to mitigate deforestation in its supply chain. P&G’s board recommended that shareholders vote “Against”.
It passed anyway, with a resounding 67% of votes cast—the first ever deforestation proposal to do so, receiving twice as many votes as any such prior attempt in all of corporate America. Experts believe it will spur other companies targeted with deforestation resolutions in coming months to engage with shareholder proponents.
The Work Ahead
Now for the reality check—both Blackrock, with 43% of all passively managed sustainable assets, and Vanguard, with 21%, could learn a thing or two from tiny Green Century, to put it mildly.
When it comes to steering capital flow, where their expertise is unparalleled, the giants’ commitment to sustainability is tangible. In January 2020, Blackrock made its first ever addition of a sustainable fund, its flagship ESGU, to forty of its non-ESG model portfolios. As a result, ESGU captured nearly a quarter of the $26 billion of net new money that surged into sustainable strategies through August 2020.
Yet, there is no denying that active engagement is not in their DNA.
That Larry Fink, the head of Blackrock, would call for every corporation to develop a plan for a net zero economy, as he did in his 2021 “Letter to CEOs”, would have been hard to believe just five years ago. Activists may see more posturing than substance to these proclamations, and the facts don’t exactly refute the accusation.
While support for shareholder resolutions relevant to climate change from fund managers was generally on the rise in 2020, Blackrock and Vanguard, the perennial largest and second largest shareholder of any major U.S. corporation, were dead last, voting in favor of just 12% and 15% of such resolutions, respectively.
Even basic issues of transparency reflect an unacceptable status quo. For instance, how did these giants, who together control about 15% of Procter & Gamble, vote on Green Century’s deforestation resolution? For now, only they know. Blackrock only recently began to disclose their votes on a quarterly basis, and Vanguard may not announce its votes until August 2021.
Reading Fink’s letter in a vacuum, one could get the impression that Blackrock confidently leads on environmental and social issues, and corporations are somewhat compelled to actually listen. At best, that model “is not so much true, as it is in the process of becoming true”, as Matt Levine generously put it.
As investors, and as citizens, we can and should demand that managers of sustainable funds act like sustainable fund managers.
However, one need not infer bad faith. It’s hard to overstate the banal power of inertia. An active posture towards their portfolio companies runs directly counter to decades of institutional muscle memory. Reorienting the highly coordinated efforts of tens of thousands of people will require its own theory of change.
At Betterment too, our work is just beginning.
Our Climate Impact offering is as much a process, as it is a product. We see it as a continuation of a conversation with our customers, who told us in no uncertain terms, that climate change matters to them. We set out to integrate this mandate alongside the rest: diversify globally, keep costs low, optimize for after-tax return, and automate as much as we can. It’s the framework we’ve been refining for a decade, and continuing to make it better is all we know.
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