Emma Rapaport: Hello and welcome to Morningstar. I'm Emma Rapaport. Australia's sustainable investing sector is growing at a blistering pace. Joining me today is Morningstar's ESG strategist Christopher Franz.

Chris, thanks for joining us.

Christopher Franz: Thanks for having me, Emma.

Rapaport: So Chris, you recently published the Morningstar Sustainable Investing Landscape, for the last quarter, can you tell us what the biggest takeaway from that report was?

Franz: Yeah, I think you alluded to it in the intro, that blistering pace, and we're just seeing a massive continued positive trend in Australia, when it comes to investor interest in sustainable funds. And specifically the flows in the second quarter are just right around AUD3 billion, which was, you know, a record in Australia, by a significant margin. And I think even looking globally, we just put a global paper out, you know, Australia was one of the few bright spots around the world that had continued positive momentum and trends with investor appetite and flows. Looking at that landscape, fund launches were a bit softer in the second quarter, only three strategies launched in the first quarter. But even going back over the past four or five years, we're talking double digit fund launches. So just, you know, that continued investor appetite and demand is there. So, at a high level, that's the main takeaway is that there's still interest here, and that's continuing to grow.

Rapaport: It's a sector that's been around for quite some time, but it's really in the last few years, especially in the last year or so we've really seen quite a big pickup in the pace of flows. Why do you think investors at the moment are more interested in this sector than they have been before?

Franz: Yeah, I think it's just the attention that's being paid towards sustainability not only in the finance space, but just I think, broadly in society is continuing to grow. And investor appetite is certainly matching. You know, taking a step back, certainly the events over the past couple years, even dating to the bushfires of late 2019, early 2020. And everything that happened, you know, with COVID, it's just, I think, more awareness of ESG issues. And not just on climate, even thinking about, things on the societal side, there's been a lot of conversation about, labor practices and corporate governance, and I think there's just more of a microscope put on sustainable investing. And as I'm sure we're going to talk about thus far investors haven't had to sacrifice return for that. So I think all of this just points to the fact that there is more interest, there's more demand, not only from the top down, from the government on down, but even at that bottom level for people just talking about this in their lives. And certainly, we're seeing the dollars chase that demand.

Rapaport: Yeah, so at the top level we're seeing enormous flows into this industry, but are there particular sectors or parts of the industry that are seeing more flows, you know, active or passive, are there particular fund managers that have more flows than others? How does the industry sort itself out with these big flows that are coming through?

Franz: Yeah, that's a good question. And as you might expect, it's long been kind of pointed towards equity managers, and somewhat split between active and passive. We can get into some of those large players. But, you know, think of the Vanguards of the world, BetaShares is another really large player here that are also doing kind of exclusionary strategies. So, take an investment universe, whether that be, the ASX 200, or some sort of a global universe and kind of omit the bad companies. Whereas there's other types of ESG strategies, which are more integrated in their approach, which not only, kind of kick out the bad actors, but try to highlight and engage with positive actors.

You know, interestingly, in this past quarter, equity took the silver metal to use an analogy, the Olympics just ended and balanced allocation funds were quite popular. And specifically, there was a pair of strategies from Pendal, which were gaining quite in prominence, and then the other large player was Australian Ethical. And I think it's important to note that Australian Ethical they manage over $5 billion locally now. They've been a local leader doing this since the late 1980s. And really the sustainable investing landscape locally is dominated by them and Vanguard, you know, roughly, they have 20% market shares each and I think it's interesting, because they somewhat have different approaches to sustainability.

If you think about Vanguard, you know, offering passive products, it's more or less track an index, which tries to promote the best ESG players. Whereas Australian Ethical is kind of on a different end of the spectrum, really identifying companies that are going to be aligned to their ethical charter, aligned to the sustainable development goals provided by the UN. And really being truly integrated and engaging. So, it's interesting that the demand is on both sides of the spectrum. But I think there are other actively managed strategies that are gaining share, if you look at the local landscape, Alphinity, Ausbil they have local Australian equity strategies that are actively managed and integrated, which are growing. But I think you're still seeing, the large amount of flows on the equity side still going to passive providers and players.

Rapaport: Yeah, so can you just describe quickly for us the state of the industry. You mentioned quickly the, I guess, the biggest or the most popular funds are the ones that are applying exclusionary screens, but they're not the only sort of fund that's out there. So what kind of funds do investors have open to them? And are there certain areas of the market that just haven't seen a lot of product proliferation or a lot of options for investors.

Franz: Yeah, sure. And I think you're spot on. Starting quite simplistically with exclusionary strategies. And you can largely place most passive products here. And these are just, you know, taking a set of securities and excluding the bad actors, or maybe on their ranking methodology, they're trying to overweight areas that are being more sustainable per their methodology. Kind of in the middle, you have integrated strategies, which are not only excluding bad things, but trying to highlight, companies that are more sustainable or contributing to a more sustainable future. And there, we see a large, broad swath of active strategies, you can think some of the Ausbil and Alphinity that I had mentioned.

And kind of on the other side of the spectrum a more thematic or impact or integrated strategies. And those might be more singularly focused, whether it be on a climate issue, whether it be on something like green bonds. And I think if you look at the local landscape, you know, there aren't as many fixed interest options as there are with equity or even multi asset. And within that fixed interest, it tends to be concentrated within a few players. Encouragingly there have been a few launches of impact strategies. So you know, whether it be there's a Regnan strategy, which just launched. You know, there's a green bond strategy Affirmative, which we think is doing a quite a good job.

And again, those impact or green bonds within fixed interest, they're tying their dollars to specific issues, which go towards, a green initiative or something that's tied specifically to an SDG (UN Sustainable Development Goals). And this is following what we're seeing from offshore. So I think it's encouraging that there are more options, specifically with fixed interest where I think, you know, traditionally a lot of investors think of equity strategies when it comes to ESG. Just the rights that they have as an equity holder versus fixed interest. But it is encouraging to see more and more product come online there. But that's probably the area where we'll see more continued growth in the future.

Rapaport: Yeah, and I guess it will lead to more multi asset ESG products, which is something that we've seen a little bit of, but sort of a lot of them come with equity ESG, but not necessarily the bond ESG part on the other side. So it'd be interesting to see that happen. One thing that investors obviously focus quite heavily on is the performance of sustainable funds. And in your report, you talked about how just over half of the sustainable investing funds have outperformed their benchmarks or sorry you'll have to correct me was it their benchmarks or was it their peers.

Franz: This is kind of peer relativity, but you're right it is kind of a broad 50-50 split.

Rapaport: So why are we seeing outperformance in this particular sector? Is it to do with what they're investing in, is it to do with some of the strategies that are under management? Why are investors seeing this outperformance?

Franz: Yeah, it is a broad ranging kind of spectrum, right. So if you think about things, like allocation funds, for example, if certain allocation funds within that cohort are more skewed towards equities, and I think some of the growth oriented sectors here, be it technology, be it health care that would have better ESG scores intuitively than something like energy names, there has been outperformance there. Certainly within Australian equities, you're seeing that technology skew, I think the Afterpays of the world which I think on an ESG screen would would do a bit better. But interestingly, there are some local managers which are investing in some materials names and some minerals names, names like OZ Minerals, like Lynas Rare Earths, you may think, you know, how do they fit within a sustainable portfolio. But these are companies that, are involved in that transition to the green economy. So maybe they're involved in minerals, like copper, nickel, lithium, and these are really integral for things like battery technology going forward. And so I think it is interesting, kind of peeling that back and seeing where that performance has been.

Rapaport: So just closing out. We've seen ASIC, in the last couple of months come out with a segment, they are going to run a greenwashing review. Can you quickly explain to our viewers what greenwashing is? And if you're seeing any evidence of it in the funds that are under Morningstar's coverage?

Franz: Yes. So simplistically greenwashing is asset managers kind of, taking advantage of this trend and saying that their product might be more green or more sustainable than it actually is. And to what we've seen from ASIC, what we've seen from offshore, which is, governments and regulatory bodies are now announcing formal reviews. I think sustainability has been, a broad topic that there hasn't been a lot of, not only regulation on but uniformity, so it means a lot of things, to lot of different people. So we're really encouraged by the local review, which they announced in July, and we'll see that take place over the years to come, which should add a bit of uniformity and a bit of more disclosure to see actually who is doing what. And Morningstar also has a metric, in the manager research team, we have our ESG commitment level, which is meant to not only highlight managers, and strategies that we think are really truly incorporating ESG, but also calling out, those that might not really be true to label or perhaps those that, you know, aren't really engaging with companies to the degree that they might or even disclosing. So that's certainly an area to watch going forward. A lot of this is coming from what's happening offshore, particularly in Europe. So, you know, Australia's been a bit of a laggard to that, but we're encouraged on what we're seeing.

Rapaport: Yeah. So as somebody that spent a lot of time reviewing ESG funds, over the last year or so, what would you describe as best class ESG? Who is doing the best job in this space?

Franz: So, that's a great question. And you know, obviously the aforementioned Australian Ethical, we think they do a really good job on our ESG commitment level methodology. They are awarded, a leader standpoint, and the scale goes from leader down to advanced, basic, and low. Another group to highlight locally is Stewart Investors, specifically the sustainable funds group, which has an office here in Sydney. And this is another team that has invested like this for several decades. They tie all of their holdings to specific sustainable development goals, they're really interested and involved in stewardship, you know, how a company can be involved sustainable future and they kind of use sustainability as an offshoot of quality and kind of view them one and the same. So they're really standouts locally. In addition, Affirmative I had mentioned, their green bond strategy, we think it's really good in terms of incorporating ESG and disclosing to the investors what they're doing. So, you know, certainly there's quite a lot of passive providers in the space as well. So I think it comes down to investor interests, kind of what you're trying to do if you're just trying to get broad ESG exposure or if you want to go a little bit more specifically. Then you know, certainly the Stewarts and the Australian Ethicals of the world are worth a look.