Morningstar - Q1 2022 - 58

Investors
Yes, ESG adoption will create inflation in certain
industries and certain sectors. But it's too
early to expect that it will drive higher inflation
across the entire economy. Broadly, ESG
adoption is happening at a glacial pace across the
U.S. economy.
Risk Mitigation
Pacholok: ESG has become a different lens for
assessing risk. Has it changed the way that you're
looking at different asset classes?
Browne: Pretty much all our institutional investors
want to have a conversation about how
we think about ESG in the portfolio. Some want
explicit ESG monitoring. It started with
international investors, but increasingly we're
hearing it from U.S. investors as well.
We're doing a lot of work on stranded assets:
how ESG is going to affect the demand profile for
assets going forward, whether certain asset
classes are going to be stranded, or less investable,
in the future, and ultimately what that means
for valuations for those sectors.
Pacholok: Have you found asset classes that are going
to be stranded, as you put it?
Browne: Older commercial real estate properties
are going to require significant cost improvements
to get up to ESG-friendly condition. They
may not be stranded per se, but it will cost
a lot to bring those assets up to par. That's an
example in the private markets where some assets
may not be as valuable as they have been.
You couldn't have invested over the last 10 years
without having at least looked at the impact
of ESG on valuations in the energy sector. Certain
natural resources, whether because they're
considered dirty or because there are cleaner,
more efficient alternatives, may become stranded
or at least be devalued because of increasing
ESG adoption.
Lee: We have approached ESG integration from
the bottom up across our entire investment
process. It starts at the fundamental analyst level.
Our financial models incorporate those factors,
just like every other financial consideration. As our
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Morningstar Q1 2022
underlying portfolio managers are building their
portfolios, they can make trade-offs across
companies, sectors, and industries. Ultimately, that
gives us a perspective on how ESG is fully
integrated across our multi-asset portfolios.
The next question is how ESG affects the factors
around why we want to invest in different
areas of the marketplace. Commodities and energy
are the most obvious place to start. We're starting
to ask whether these will serve as good inflation
hedges going forward. If you have a world
potentially awash in oil because of growing
production, but a lot of the world is moving away
from petroleum-based energy sources because
of ESG considerations, will oil have inflationprotection
power? Those are the important
questions we need to ask as multi-asset allocators.
Green: ESG has definitely changed the way we
invest. One way to think about ESG is as risk
factors, which means you better understand your
exposures. We also spend a lot of time thinking
about ESG as an alpha opportunity. One example is
that we've found that diverse hiring policies
can lead to excess returns. We've also done
research on climate change and found signals that
help forecast excess returns.
Pacholok: Are there other risks out there that investors
may be overlooking?
Lee: One thing that doesn't get talked about
enough in the defined-contribution plan space is:
What is risk? There's short-term market risk,
like we saw in February and March of 2020. There
are inflation risks, like we're potentially feeling
right now. But there's also asset-accumulation
risk or, in retirement speak, longevity risk.
I don't think that gets enough attention from
plan sponsors.
In my perspective, there's been an overemphasis
on short-term risks and an underemphasis on
long-term risk. I deal primarily with retirement
investors, and they look at drops in the market like
we saw in the first quarter of 2020, and they
make a broad assumption that an event like that is
going to be ruinous for retirement. That ends
up leading people to invest too conservatively
because they underestimate the risk of not
compounding their wealth over the long term.
Browne: Inflation is the biggest risk that retirees
face at retirement. Most people focus on
wealth creation, while overlooking how to preserve
that wealth through inflation protection.
More broadly, the biggest overemphasis in
terms of risk is the use of VaR [value at risk] as the
singular metric by which portfolio managers
measure the risk in their portfolio. VaR is very
dependent on historical correlations, and
correlations can be spurious, particularly during
significant risk-off periods where correlations
break. I think there should be more of an emphasis
on more inclusive sources of volatility measures
and other ways to measure risk in order to
get a more complete and accurate picture of how
a portfolio will behave in left-tail events.
Green: The biggest risk is lack of imagination.
Stuff that we can't imagine happening happens.
A second risk is stuff that we might be able
to imagine but can't measure. COVID is a perfect
example. I doubt many people imagined there
would be a pandemic in their lifetime, and I doubly
doubt that anybody had any idea how to
measure the risk. A second example is the risks
around the pursuit of sustainability. What
kind of disruptions can we expect if the transition
doesn't go smoothly? What will happen to markets
and what will the impact be on individuals?
Geopolitical risk is another. How do you measure
the risks around the tensions brewing between the
U.S. and China? You can imagine a host of
scenarios, but how do you measure their impact
on capital markets?
Adding Alpha
Pacholok: When should investors consider an active
strategy versus a passive?
Green: A lot of people talk about active and
passive in terms of market efficiency. Emerging
markets are inefficient, for example, so do
active management there. I don't view the world
that way. My view is that active management
is a zero-sum game, so find a good manager and
go with them. It doesn't matter where they
are operating. If someone knows more than the
person on the other side of their trades, they
Morningstar - Q1 2022

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