Can Your Portfolio Make an Impact and a Profit?

MIKE TOWNSEND: Investing in its most elemental form has always been about accumulating wealth, about making a profit by investing in companies that continue to grow and succeed.

But millions of investors are trying to do more than just profit—they're trying to use their investments to support causes and principles they care about, to make statements about the kinds of businesses they want to back, to advocate for policies that address the world's most complex issues, maybe even to change the world. Investors today have a dizzying array of options to use their investing to send a message. 

They're using what's known as ESG investing—which stands for "environmental, social, and governance" and applies to investing strategies that factor in issues like how a company treats the natural world, how it treats people inside and outside of the company, and how the company is run.

But does it work? Can an investor make solid returns while investing their conscience?

And does it matter? Do ESG investors really have any ability to affect outcomes or force change?

Welcome to WashingtonWise, an original podcast from Charles Schwab. I'm your host, Mike Townsend, and on this show, our goal is to cut through the noise and confusion of the nation's capital and help investors figure out what's really worth paying attention to. 

In just a few minutes, my colleague Michael Iachini will join me to talk about the state of ESG investing today, whether you have to sacrifice profit to invest your principles, how to identify companies that share your values, and how Washington policymakers are trying to shape the future of ESG investing.

But first up, let's take a quick look at some of the latest headlines coming out of the nation's capital.

At the top of the list is the passage of the $1.2 trillion infrastructure bill after a crazy week of negotiations among Democrats on Capitol Hill last week. The bill passed the House by a 228-206 margin just after midnight on Saturday morning. It was already approved by the Senate in August and will now be signed into law by the president, giving the White House a big first win in its two-part domestic agenda. 

The legislation includes $110 billion for roads and bridges, $66 billion for rail, $65 billion for upgrading the nation's electrical grid, $65 billion for expanding broadband access to rural areas, $39 billion for public transit, $25 billion for airports, and more. President Biden said over the weekend that he expects "shovels in the ground" on projects across the country within two to three months. That may be a bit optimistic, but it's reflective of the White

House's desire to get this money working as quickly as possible—especially with midterm elections now less than a year away.

There were countless times last week when it seemed like a House vote on the infrastructure bill would be delayed yet again. House leaders had missed two self-imposed deadlines for a vote—one in late September and another at the end of October. The hang-up was never about the substance of the infrastructure bill. Rather, it was about the timing of the vote and how it related to the second economic bill, the $1.75 trillion Build Back Better Act, which focuses on climate change and strengthening the social safety net. 

House Speaker Nancy Pelosi began last week trying to get both bills passed by the end of the week. But it became clear that moderates were reluctant to vote on the Build Back Better Act without more details about its budget impact. And progressives were reluctant to vote for the infrastructure bill without a guarantee that moderates would back the second bill. 

After hours of negotiations among Democrats, an agreement was finally reached. Progressives would allow a vote on the infrastructure bill only once moderates agreed to a specific timeline to vote on the Build Back Better Act next week. The vote moved forward, and, in the end, 13 Republicans joined with all but six Democrats to pass the bill. 

But while the infrastructure bill is now the law of the land, the second package still has a bumpy road ahead before it reaches the finish line. The $3.5 trillion in the original plan was reduced to $1.75 trillion to secure support from moderates in the Senate. To get there, they had to jettison entire programs that were really important to lots of Democrats.

Even if the House passes the bill next week, it still has to go to the Senate, where Democrats still do not have firm commitments from all 50 of their members to support it. It's likely that the Senate will revise the bill yet again. If the Senate makes changes and passes a modified version, it must go back to the House for another vote. Given the back-and-forth, plus the approaching holidays and the looming deadlines for a government shutdown and another debt ceiling battle in early December, it's highly unlikely that the Build Back Better Act will pass Congress until mid-December at the earliest. And some observers think even that may be optimistic. The drama on this bill is far from over.

A couple of things for investors to note about the newest iteration of the bill. The first is that after months of talks, Democrats in the House agreed to raise the cap on the state and local tax deduction. In the 2017 tax law, the so-called "SALT" deduction was capped at $10,000, a figure that disproportionately impacted people in high-tax states, like California, Illinois, Massachusetts, New Jersey, and New York. Lawmakers from those states have been advocating for a repeal of that cap, or at least a significant increase. 

Last week, they got the latter. The cap was increased to $80,000 beginning in 2022 and running through 2031. But the provision is seen by many as a gift to the wealthy, so whether or not it can pass the Senate remains to be seen.

The other notable development was the return of several retirement-related provisions that were stripped out when the bill was reduced in size. 

Included in the current version of the bill are provisions that would end so-called "backdoor" Roth conversions at the end of this year and would also prohibit wealthier filers from converting their traditional retirement accounts to Roth accounts, beginning in 2032. 

The bill would also implement significant new rules on individuals who have large balances in their retirement savings accounts. Any individual with more than $10 million in savings across their 401(k) account, their traditional IRA, a Roth IRA, and any other retirement accounts would be prohibited from contributing any more dollars to those accounts. And they would be required to take minimum distributions from their account regardless of their age. Individuals with more than $20 million in savings would have even more stringent withdrawal requirements.

But anyone impacted by these changes will have plenty of time to plan as they won't go into effect until 2029.

Amidst all these changes, here's the key thing to know: More change is probably coming. At this point, not much in this bill is a certainty, and with votes in the House and the Senate still pending, expect further changes before it reaches the finish line.

On my Deeper Dive, I'm really pleased to welcome Michael Iachini, managing director and head of manager research at the Charles Schwab Investment Advisory. Michael is a 17-year veteran of Schwab and focuses an increasing amount of his energy on the ESG investing landscape.

Welcome to the podcast, Michael.

MICHAEL IACHINI: It's great to be here, Mike.

MIKE: Well, let's begin by talking about what, exactly, we mean by ESG investing, which seems to bring together under one umbrella several different ideas—green investing, sustainable investing, socially responsible investing, for example. How do you define ESG investing, and what differentiates it from, say, socially responsible investing?

MICHAEL: Yeah, so ESG is the umbrella term that we've decided to use at Schwab, very commonly used in the industry, to describe any type of investing where your goal is not just purely financial risk and return, but some other factors that you want to make a difference with your portfolio. So, specifically, ESG, of course, stands for "environmental, social, and governance," which are three of the common factors that investors are thinking about beyond the financial metrics.

Socially responsible investing (or SRI) is part of this umbrella, but, typically, SRI refers to an older type of investing, been around since at least the 1980s, that usually refers to excluding certain sectors or industries or just certain types of companies from your portfolio, which is one way to go to get rid of polluters or companies that you don't like. But there's other ways you can think about ESG investing beyond just SRI. So you might, instead of excluding industries, you might, instead, focus on buying shares of companies whose practices you want to change via proxy voting, for instance, to try to make them better companies. Or you might focus on owning shares of companies that maybe aren't perfect, but they're better than their peers, rather than completely excluding them. All of these approaches fit within that broad ESG umbrella.

MIKE: Well, it seems like the popular word in the media these days on this topic is "exploding," as in, "Interest in ESG investing is exploding." So what are the trends in this area?

MICHAEL: ESG asset growth around the world has been growing tremendously, especially in just the past few years. So one of the ways we look at this is with mutual funds in the United States. And Morningstar collects data on mutual funds, and they report over $300 billion in what they call sustainable funds as of June of 2021. And that is nearly double the $159 billion they saw in such funds just one year prior. So almost doubling in a year is tremendous growth.

Now, if you take a broader view of what is ESG beyond just mutual funds, there's a different organization called the USSIF Foundation. They have a 2020 report where they look at all sorts of money managers for foundations, and endowments, and individuals, and so on, and in their report in 2020, they showed a little over $17 trillion in what they called sustainable investing assets, and that was up from 9 trillion that they found in 2016. So nearly doubling in about a four-year period, up to 2020. 

Beyond just the dollars, we're also seeing a lot more choices for investors. There's been a very large number of new mutual funds and ETFs with an ESG bent launching in just the last few years.

MIKE: That's an amazing amount of choice in this space, and what incredible growth in the last years.

Well, from the investing standpoint, it feels like there's a long-held view, maybe it's a myth, that in order to be an ESG investor, you probably have to sacrifice a little return. That you can either make a lot of money investing, or you can feel good about investing in, say, environmentally friendly or socially responsible companies, but you can't do both. But now more and more companies seem to be embracing ESG because it's good for their bottom line. So if that's the case, then are there ways to grow your portfolio while feeling good about the companies you invest in?

MICHAEL: Yes, we think you definitely can grow while still feeling good about the companies. And, really, we've done research on this topic, and our research has found that ESG investing is neutral when it comes to performance, in general. So that means we don't think that ESG investing means you're going to have to give up the possibility of good returns and we also don't think that ESG investing automatically means you're going to get great returns.

So, to do this, we looked at mutual fund data that Morningstar flags as sustainable investment, overall―that's our ESG fund universe. And we looked at these funds across all different asset classes—U.S. stocks, international stocks, taxable bonds, etc. And to figure out if ESG funds were doing better or worse than non-ESG funds, we looked at how their performance ranked against their peers that have similar broad investment objectives. So if ESG was really hurting funds, you would expect their ranks to be very low, near the bottom of the peer group, and if ESG were really helping funds, you would expect them to be very high, near the top of the peer group. 

What we found when we looked at all of these ESG funds across these asset classes and across time, is that, in general, ESG funds tended to rank right around the middle of their peer groups very consistently. So what that means is investors don't have to expect poor returns just because they want to go with an ESG fund, and it also means that they shouldn't count on great returns just because they picked an ESG fund.

Now, I'll note that, in general, this has been the case over time that ESG funds have been in the middle, but we have seen in the past few years, the last three to five years in particular, that stock funds with an ESG approach have actually been doing better than their peers, on average. And that's great news for those investors who have bought those ESG funds. 

In the long run, though, we think it's smarter to not count on outperformance in the future as your reason for ESG investing. We think it makes more sense to go with ESG if that's what matches with your values.

And, finally, I do want to note with all this performance numbers, we're talking about a lot of different funds out there. There's a lot of choice, as we noted, and that does mean that in any given time period, you're likely to see some funds with an ESG approach doing really, really well and some funds with an ESG approach doing really, really poorly. There's a lot of variety of funds out there. But, on average, we found that ESG investing is pretty neutral when it comes to your performance expectations.

MIKE: Well, let's talk about that variety for a moment. I think this space can feel a little bit overwhelming to investors. So what advice do you give to investors who want to start investing in ESG funds? Can one dip their toe in ESG investing, or is it something you really have to be committed to with your entire portfolio?

MICHAEL: With ESG, we think a toe dip is completely fine. So, really, for us, we see ESG investing on a spectrum. On one side of the spectrum, you are all out—you don't care about ESG issues at all. And on the other side of the spectrum, you are all in—ESG is the most important thing. These environmental or social or governance issues are perhaps even more important to you than your risk and return that you're getting from your portfolio. But those are the extremes of the spectrum, and we think that most investors are probably going to end up falling somewhere in between. 

So if you're not doing anything with ESG today, but you're interested in maybe wading in very slowly, we think it's completely reasonable to find a single fund―maybe it's a mutual fund or an ETF that has an ESG approach and that you like, and you add that to your portfolio for one small piece of it while leaving the rest of the portfolio alone. So that's a very toe-dip, slow approach in, and that's completely OK. You don't have to go whole hog.

Now, I think that if you want to go farther and have more funds that are ESG-focused and build your portfolio around it, you can. But I'd say, specifically, let's say you're going to take a stock-based approach and research individual companies, you want to make sure you continue to think about being well diversified because what you might find is, "Hey, here's an ESG-positive company that I like, and here's another one, and a few companies that all seem really strong from an environmental or social perspective." And it turns out they're all in the same industry or just a couple of industries, and you build your portfolio around that, and now you're not very well diversified. So just because you want to be ESG tilted doesn't mean that you can ignore diversification—that is still important to diversify across sectors. 

So, ultimately, on the spectrum from all-out to all-in, any degree of ESG involvement in your portfolio can be accommodated as long as you're willing to put in the work.

MIKE: Well, that work is an interesting question because environmental, social, and governance issues are non-financial metrics for a company. You won't find them in typical financial reporting as of now. So how does an investor find the right fund or the right company to invest in to make both a solid return and feel good about what they're investing in?

MICHAEL: Yeah, ESG standards are hard to come by right now. There are a few people out

there in the industry, a few groups, that are trying to make it a little better, and we think that's going to improve, but it is a challenge. 

So where things stand today? There are a few groups that are trying to set out standards for companies to disclose ESG information in a consistent way. And so a few of these to know about are the Sustainable Accounting Standards Board, or SASB; the Global Reporting Initiative, GRI; or the Task Force on Climate-Related Financial Disclosures, TCFD. For all of these, they have guidelines for companies to voluntarily follow to share information about their ESG operations in their companies, but none of this is as robust, nor is it as required, as financial standards and accounting standards that companies follow today.

When it comes to funds, the CFA Institute has recently published some proposed ESG standards that investment managers, like mutual fund or ETF managers, could follow, but, again, these are completely voluntary and they're brand new. And then you also have approaches that some companies are taking where they're providing ratings for different companies or funds on ESG metrics. So MSCI and Sustainalytics are a couple of examples here where they might provide rating information. So that's another resource for investors to consider.

Ultimately, the trouble is there's no one single answer that will work for everyone. And that's, in part, because everybody's preferences are different. Something that matters a lot to one investor that's environmental might not matter as much as somebody else who is focusing on social issues, and so on. So, ultimately, we investors are left to gather the information we can about potential investments and then determine which of them are best aligned with our own values and priorities.

MIKE: Well, Michael, this discussion of standards is a great segue to what's going on here in Washington with regulators and, really, with regulators around the world. They are really wrestling with how to define or standardize what it means to be a green fund or a sustainable fund. 

Just last week, SEC Chairman Gary Gensler said that he has asked his staff to prepare recommendations that would require funds to disclose the underlying criteria and data that they use to make a claim about the fund—that it is green, or sustainable, or low carbon. I think the goal, ultimately, is to have a clear set of definitions that will make it easier for investors to understand what those words mean and make it easier for investors to compare funds to each other, maybe a bit like having nutrition labels on foods. Is that something you'd like to see?  Is it a realistic goal, or is this always just going to be a moving target?

MICHAEL: Well, getting the government to mandate disclosure and consistency about how funds report these things—that is realistic, in my opinion. And if we had that, it could go a long way toward having high quality information that you can use to compare across different funds with their different ESG approaches. This can also apply to companies, too, and what they disclose about ESG-specific information. But that said, while it would be nice to have a rule, once you have a rule in place, you need to be prepared for companies or funds to do what they can to look good within the rule, even if what they're doing isn't really super environmentally friendly or socially conscious, but, instead, just makes them look good. And that's something that investors have to watch out for. 

Now, regulations can adapt over time to account for such things, so it's going to be a moving target, but regulators can try to move with it. And in my opinion, ultimately, having the information is better for investors than not having it.

MIKE: Well, your comment about how companies may try to make themselves look better I think is something that's happening a lot, where ESG investing has kind of become caught up in a broader political battle. I think it has particularly played out over the last couple of years in Washington, where, for example, during the previous administration, rules were approved that made it really difficult for retirement plan sponsors to offer ESG funds as investment options in their plan. But that rule is in the process of being overturned by the new administration. If investors commit to incorporating ESG factors in their portfolio, do you think they have to worry that we'll be flipping back and forth on these issues, depending on which party is in power in Washington?

MICHAEL: Well, I'm not too concerned about any individual fund being prohibited from investing in an ESG manner, for instance. So if you find a fund that you like—it aligns with your values—the free market probably means that you'll be able to keep investing in it. There's assets there, and the manager finds it to be worthwhile. So I wouldn't worry too much about administrations changing individual fund objectives. 

But what you noted about retirement plans, that is one where the government has some say in what can be offered within a retirement plan. And I think it is possible that you would see the availability of how many ESG choices or whether there are any ESG choices in your retirement plan could be affected by changes in administrations, as the Department of Labor shifts around and modifies their rules.

Now, that said, I think that if investors decide they really like ESG—and with all the asset growth we've seen, it seems that investors are going in that direction—and they own a lot of dollars in ESG funds in retirement plans as they become more widespread, I think it becomes less and less likely that a future administration would change that rule and take those investment options away. Investors have voted with their dollars, and the government is, to some degree, responsive to what investors and the public are telling them they want. So if ESG becomes really cemented in retirement plans, I think you'll likely see those assets be allowed to stick around in those plans.

Now, on the state level, we have seen some areas where individual states might be trying to make ESG investing a little more difficult. And one example there is a recent rule in Texas that prohibited their state agencies from doing business with companies that are divesting from oil and gas. So this meant that, you know, certain companies that might underwrite municipal bond issuance from state agencies or municipalities might not be allowed to if they were doing this divesting. So that's a possibility where, if not at the national level, maybe ESG issues would be impacted at the state level.

But, ultimately, I think that there's just going to be a lot of choice out there. Some investors are not going to want ESG investing at all, and that's completely OK—they don't have to. At the same time, I think a lot of other investors do want environmental, social, and governance factors to play into how they invest their money. And I think they typically will be allowed to do that, as well, and it's fine.

MIKE: Well, this has been a great discussion, Michael. Final question: As we record this podcast, the U.N. Climate Change Conference in Glasgow, Scotland, is entering its final few days. Do you see any investing opportunities based on what's been announced and agreed to, or are these such slow-moving issues that it will be a long time before we really see any change?

MICHAEL: There don't seem to be any obvious ESG investment issues that are immediately affected by any of the announcements and agreements that we're hearing coming out of Glasgow. But that said, I think seeing world leaders coming together and making general climate-friendly statements, that does signal that there will be a good welcoming in the world when it comes to ESG-friendly investing. So that's a good sign for investors who like ESG as an investment approach.

What I think will have a bigger impact on ESG investing will be any firm rules or requirements that follow up from these international gatherings like we see in Glasgow. So general statements, I don't think, are going to matter too much, but any firm changes to regulations, those are going to matter. 

So, for me, I'm keeping a closer eye on regulations and also any ESG-related government spending and taxation changes that we see here at home in the United States.

MIKE: Well, Michael, you've given us a lot to think about and about a topic that I know a lot of investors are interested in. So thanks so much for making the time to join me today.

MICHAEL: It's been my pleasure, Mike.

MIKE: That's Michael Iachini. You can follow his work on the Insights tab of schwab.com.
Finally, on my Why It Matters segment, I like to note something interesting that is happening in Washington that may have been below the radar screen and explain why I think it's important. 

Last week, financial regulators in Washington released a report on stablecoins, a specific type of cryptocurrency that is designed to maintain a stable value relative to a national currency and is being increasingly used as a form of payment. The New York Times reported last week that there are more than $130 billion in stablecoins in circulation, up from just $28 billion in January, an increase of more than 350%. The financial regulatory agencies, however, said in the report that stablecoins pose "significant concerns from an investor protection and market integrity perspective." The report called on Congress to quickly pass legislation that would subject issuers of stablecoins to bank-like regulation.

Why does this matter? Well, it's the latest entry into the rapidly expanding debate in Washington around cryptocurrency regulation as they continue to explode in popularity. SEC Chair Gary Gensler has been saying since he took office earlier this year that he's concerned about protecting investors from fraud, scams, and abuse in the cryptocurrency space. But just last month the agency approved the first Bitcoin futures exchange-traded fund, a new way to give ordinary investors the opportunity to dabble in cryptocurrency. 

This new report was jointly authored by all the major financial regulators, including the SEC, the Federal Reserve, the Treasury Department and the Federal Deposit Insurance Corporation, or FDIC. And they said that Congress needs to move quickly to limit stablecoin issuance to only insured depository institutions. "Failure to act," the report said, "risks growth of payment stablecoins without adequate protection for users, the financial system, and the broader economy."

Members of both parties on Capitol Hill welcomed this report, though not necessarily because they agree on what the approach should be. They did agree, however, that the first steps to creating a sensible regulatory environment for cryptocurrencies must be taken by Congress.

Given all that's going on in this space, this looks like another sign that cryptocurrency regulation is going to be on the front burner in 2022. Investors interested in cryptocurrency should keep an eye on developments as they unfold next year.

Well, that's all for this week's episode of WashingtonWise. With the Thanksgiving holiday approaching, we'll be off for the rest of November. But we'll be back with a new episode in early December. Please take a moment now to follow the show in your listening app so you don't miss that episode—or any of our future episodes. And if you like what you've heard, leave us a rating or a review—that really helps new listeners discover the show.

For important disclosures, see the show notes or schwab.com/washingtonwise, where you can also find a transcript.

I'm Mike Townsend, and this has been WashingtonWise. Wherever you are, stay safe, stay healthy, have a great Thanksgiving later this month, and keep investing wisely.