Mike Hunstad, head of quantitative strategies for Northern Trust Asset Management, has watched socially responsible investing move way beyond negative screens that defined the space 30 years ago and he contends that investors “can have their cake and eat it too.”

In setting the strategy for one of the asset manager’s largest ESG funds, introduced three years ago, Hunstad put to work the fundamentals of a Northern Trust separately managed account that dates back to 2015. It made quality of a company’s balance sheet as important as its committments to ESG criteria. Together these priorities create a forward-looking ESG investment, he said.

Below he describes the investment picking priorities that make Northern US Quality ESG fund (NUESX), which has about $280 million in assets, different from its competitors, namely risk control, which is something he said other ESG-focused managers tend to overlook.

Liz Skinner: How did you start working in socially responsible investing?

Mike Hunstad: I’ve been at Northern Trust Asset Management for about nine years and essentially the entire period I have been involved with ESG investing. Prior to Northern Trust, I was with a couple of hedge funds, a proprietary trading firm, as well as a very large insurance company in their investment group. It was there that I was first involved in ESG and SRI investing, in that the insurance portfolios had certain restrictions that were put in place, negative screens essentially.

As a quantitative person, I always think about what are the risk and return implications of what we are doing, for everything. A lot of my thinking evolved from that experience. SRI is much more than saying ‘I don’t want to own a cross section of securities.’ It is potentially a form of independent risk, it is an independent form of potential returns. But how do you harness that in the best way possible?

LS: Can you describe what sort of risks you are referring to?

MH: If you have a portfolio of high ESG securities, you tend to have sector mis-weights like overweight financials and underweight to energy and materials, and there are others. You tend to have country biases as well. European companies tend to have higher ratings than North American or U.S. companies. So, in implementing your ESG views, you are also likely taking sector, country and region biases along with them. Those are the kinds of things that we were and remain interested in.

LS: What’s the strategy you put in place with NUESX?

MH: Just because ESG stocks or bonds are rated highly from an ESG or SRI perspective, that doesn’t necessarily mean they are of high financial quality. So we are keenly aware that there are some securities that rank very well from an ESG perspective, but may not necessarily be profitable, and they may have relatively poor balance sheets. From a perspective of having your cake and eating it too, we want to invest in those stocks that are the best of both worlds, higher ESG content, and that had a higher quality orientation like better financials, balance sheet, cash flows etc. so that we can sustain the portfolio.

You don’t want your clients or participants to divest in the strategy due to some unintended risk because that divestment typically happens at exactly the wrong time. Such as if you are overweight in financials, and financials do poorly, maybe because of an interest rate sensitivity, you don’t want that to influence the decision to divest. We believe that ESG should be independent of any of those other risk considerations.

LS: How are you providing investors with cake they can eat?

MH: We want not only negative screens from an ESG perspective, we want a substantial ESG uplift relative to a benchmark. We aren’t only screening out the worst of the worst, we are also promoting the best of the best, meaning we want the whole portfolio to tilt toward a higher ranking ESG securities and we also wanted to reduce the carbon footprint of the portfolio, so we have specific constraints on carbon emissions and reserves.

We also screen out any red flags, those companies that are involved in any ESG controversies. So on the ESG perspective, you get the carbon climate-change side, you get the headline risk mitigation and you get that considerably higher ESG content. But also you want to hold securities that are of high financial quality. Controlling the risk around all that is the area that’s not terribly well understood or widely recognized in the industry.

LS: Can you offer an example of how the strategy operates to control the risk?

MH: We are very diligent about controlling our region and sector country biases in the portfolio. We do not allow the portfolio to take material bets on sectors that classically have relatively poor ESG scores, like utilities, materials, things of that nature. We find the best of the best within each sector from an ESG perspective, so we don’t want to overweight or underweight any particular sectors as a result of their natural ESG orientation. That way we are controlling the risk and rewarding those firms within those sectors for having a good ESG posture.

We also don’t want to be completely void of any given sector. We prefer to hold that sector at that benchmark weight, but in those securities that have the highest ESG and quality content.

LS: What impact have you seen the pandemic and the Black Lives Matter events have on the ESG investing space?

MH: They highlight the need for strategies like this. I should mention we do a lot of business outside the U.S., in Europe and Australia, where ESG is much further along than in the U.S. But the U.S. has been catching up to these other countries in the last few years and I think the pandemic, as well as Black Lives Matter, accelerated this trend and more or less put a spotlight on the issues that are central to ESG. They have spurred a lot of interest and investments in ESG strategies for the right reasons.

LS: Have these events changed the fundamental way you look at companies?

MH: We have always been measuring things like access to healthcare, and equality of pay, things that were put under the spotlight with recent events. The Biden administration has expressed a lot of environmental concerns that have clearly been a part of the strategy from its inception as well. So not so much changed the strategy, but we are very well positioned for recent events.

Two years ago, the discussion was much more about climate change and today the discussion is about climate change but some of these other social issues are really coming to the forefront. Having a robust social pillar as part of our ESG strategy not only helped in terms of the performance but also is attractive to investors who are concerned about these issues today.

LS: What expertise do the fund’s two managers bring?

MH: Peter Zymali is our foremost ESG expert. Jeffrey Sampson has been doing a lot of our quantitative factor investing throughout his career. We are melding these two together, ESG on one side and our quality factor on the other side, and so you have representation from both angles.   

LS: What’s unique about this ESG fund compared to competitors?

MH: One is its higher quality orientation. We are very different from competitors who don’t think about the financial side of things. We also think about the sustainability of the portfolio where the investor is satisfied and wants to remain in the portfolio for the long term. We call it sustainability of the user experience. The risk management aspect is also very much a differentiator. We see that a lot of ESG portfolios, in addition to the biases I’ve outlined, tend to have a lot of macroeconomic risks associated with them.

We want to have very precise risk management. I think it’s a subtle thing, that’s hard to appreciate, but its something we don’t do enough of as an industry. NUSEX does a great job of controlling those unintended risks, like interest rate exposure in the financials, and commodity price risks in the energy stocks, which you don’t own but are still a source of risk for the portfolio. It also can be country biases if you are in an international flavor of ESG portfolio. For a lot of ESG portfolios in 2020, the performance of the strategy was dominated not by the ESG exposure but by these unintended bets.

LS: Do you anticipate a time when ESG screens and policies are applied across all investing strategies?

Absolutely, we are already doing it in the fixed income space. It’s a little bit more difficult to do in some of the alternatives and other types of asset classes. But I have no doubt that we are moving in that direction.

[This post ran first on InvestmentNews’ ESGClarityUS.com]

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