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Gene Walden
Senior Finance Editor

FUND COMMENTARY

Putting the pieces together of a small-cap/mid-cap ESG ETF

12/20/2022
By Gene Walden, Senior Finance Editor | 12/20/2022

Part small-cap, part mid-cap, part ESG – the task of managing Thrivent Small-Mid Cap ESG ETF (TSME) is a bit like unscrambling a Rubik’s Cube.

“An important part of our investment process,” explains Chad Miller, Senior Portfolio Manager, “is analyzing the various ESG issues each company is involved with and the strategies that play into these topics – while also directly attaching this to our fundamental research analysis.”

Miller, along with Matt Finn, Head of Equities, limits the portfolio to a select mix of approximately 60 small- and medium-sized stocks with attractive valuations that have demonstrated a commitment to environmental, social, and (corporate) governance (ESG) initiatives and sustainable business practices.

Miller can lean on Thrivent’s experienced small- and mid-cap portfolio management teams to help shape the portfolio. “We're able to leverage the unique experience and knowledge that our investment team brings to the table – from our deep pool of investment analysts to our portfolio management teams.” (See: Could the small and mid-cap slump be a bounce-back buying opportunity?)

Investor interest in ESG has been growing quickly, with annual inflows into ESG-oriented funds climbing from $5 billion in 2018, to $21 billion in 2019, to $51 billion in 2020, to $70 billion in 2021i. At the end of 2021, ESG-oriented funds held more than $350 billion in total assets according to Morningstar.i

For Miller, bringing ESG standards into the mix adds a whole new dimension to managing the Fund. The lens under which stocks must be analyzed expands, while the universe of prospective holdings contracts. Adding to the challenge, ESG research data is still limited, particularly in the small- and mid-cap sectors.

“One of the biggest challenges with an ESG fund today,” said Miller, “is that the disclosure around ESG topics is still evolving and improving over time. And so, there are specific challenges on trying to figure out information we would love to know in our investment process.”

That’s another area where Miller believes Thrivent has an advantage as a long-term investor in the small- and mid-cap space. “Where there are ESG issues that might not be completely filled in from current disclosures, we can reach out and engage with the company to get a better understanding of the steps they may be taking that have not yet been picked up by the ESG reporting services. So, the ability to engage and partner with companies in deep, long-term, meaningful conversations is an advantage for us in making up for the lack of disclosures of ESG data.”

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Portfolio building

Purpose and positive impact are two elements Miller looks for in every company he considers for the portfolio. “We’re looking for companies that are having a positive impact on the communities they operate in, the employees in their workforce, and the consumers to whom they offer a great value proposition. And ultimately, we attach this to a goal of generating a strong financial return to this purpose-driven approach.”

Rather than selecting stocks for the portfolio that just happen to fall within the realm of acceptability by ESG standards, the Fund takes a close look at each prospective holding on a case-by-case basis. “We're really looking for the top companies that are doing a good job of addressing their material ESG issues across their business. We're analyzing the specific issues, and we're engaging with the companies to make sure we fully understand the issues that are arising.”

Miller doesn’t try to focus on companies within just one discipline of ESG but takes what he calls “a holistic approach.” “We do not use any sector exclusions.  But rather we put every company through the same investment process. This allows us to identify opportunities in the market place rather than avoiding specific sectors based on ambiguous exclusion criteria.”

Miller evaluates what companies are doing across the entire environmental, social, and governance spectrum. “We're looking for companies that can successfully serve the individual needs of their end stakeholders, while leaving some flexibility in our process to account for certain challenges and issues that these companies are currently working through to try to solve.”

He added: “The fund does not utilize any type of political, social or moral guidelines to select ESG investments.  But rather the fund is focused on identifying financially material ESG topics to improve the risk adjusted return profile of its investments.”

Miller believes that, as an actively managed portfolio, the Fund team has an advantage over passive ESG funds because of their opportunity to analyze companies from a complete 360-degree perspective. “We are able to engage with each company and talk through what they're doing, what they're seeing, and how they’re managing their business, because ultimately, they have a perspective that is important to consider. We believe that our ability to understand what's really happening on the ground gives us an advantage over the typical passively managed ESG index fund with 300 to 500 individual securities.”

Assessing ESG strengths

Sifting out promising ESG stocks takes a little extra effort, first to make sure the company is appropriately addressing ESG issues, second, to ascertain that the company has a viable business plan with solid prospects for growth, and third, that both of those pieces fit neatly together.

In his analysis, Miller breaks down each company’s ability to address what he considers to be the six primary stakeholders—the environment, employees, customers, suppliers, community, and corporate governance policies and procedures.

“This helps us identify potential opportunities in a business model and the specific points of differentiation,” explains Miller. “If our research indicates the company is doing a particularly strong job in any one or, ideally, several of these categories, this helps us formulate a picture of what their competitive advantage really is going forward.”

Once the Fund’s analysis is complete, adds Miller, “we're left with a better understanding of the company's risks and opportunities through their business ecosystem, which helps us make a better investment decision—while also engaging with those companies on the issues that we think are financially material from an ESG perspective.”

For instance, in the environmental area, Miller and his team assess each stock by paying particular attention to how the company is impacting the natural world around them—and what strategies it has to reduce that impact over time.

“We're looking for companies that can create emissions as efficiently as possible in the short-to-medium term and then ultimately reduce those over the long term,” Miller noted. “We're looking for companies that have a strategy to solve water scarcity challenges, consider biodiversity impacts, and then also invest in circular business models that create great efficiencies for the environment, as well as the individual companies.”

One example, Miller and team assessed a company in the health care industry in three key areas—improving outcomes, increasing coverage for underserved individuals, and maintaining strong data security and privacy standards. “If we believed they were improving outcomes and increasing coverage to underserved individuals who otherwise would have gone untreated, we could flow that through directly into our revenue forecast and into our profitability forecast to attach that to our estimate of long-term upside.

“But if we go through all of this,” adds Miller, “and determine that they're doing all these great things, but that’s already priced into the financial model, then we don't own that company in the Fund.”

Miller also believes it’s important that companies that are pursuing ESG initiatives are doing it for the right reasons. “We’re focused on those companies that are doing their best in human capital standards or setting aggressive environmental targets. And they're doing this because it feeds into the core vision of what they believe is the future path of that company, not because it's something that is subtracting from their end investment results or operating productivity as a company. Increasingly, we are seeing a growing body of evidence that those companies who do address these topics head-on, try to operate in a sustainable manner, invest in their employees, and tackle these material ESG issues are often able to outperform their peers.”

‘Unpacking social’

The Fund team addresses social topics related to ESG by utilizing a concept that Miller calls “unpacking social.” In the process, they break down their analysis into four social areas of ESG – employees, customers, suppliers, and the communities in which the company does business.

“That allows us to dive into the specific topics companies need to address to successfully serve these individual stakeholders, as opposed to just looking at it as one overarching bucket or looking at one element and trying to move on,” said Miller. “We can dive in with more granular detail and understand the individual elements that we need to assess to make an effective determination on these topics.”

Working with SASB

The Fund management team evaluates prospective holdings using criteria provided by the third-party ESG materiality framework from the Sustainability Accounting Standards Board (SASB). SASB has worked with stakeholders in various industries to help identify the most financially material ESG issues by industry.

SASB identifies several key areas of interest by industry, explains Miller, “next SASB indicates where they believe these concerns could show up in a company's financial statements – if they've properly addressed a particular category or if they’ve faltered in that category. We can tie this directly into our fundamental analysis of the company, and feed that into our financial model, and ultimately our assessment of the long-term valuation for the company.”

Within the governance category, the Fund focuses on accountability and alignment. “We're looking for an independent board; we're looking for effective disclosures,” noted Miller. “We're looking for ethical conduct, and we're looking for increased disclosures to help provide the information we want to see in making our investment decision.”

From an alignment perspective, the Fund analyzes areas such as pay practices, long-term investment decisions, and capital allocation. “We know the investments that these companies are making today ultimately become our returns in three to four years,” said Miller. “So, we really want to see companies that have a robust process around capital allocation and a right to win in the areas where they're making investments.”

Sustainability

ESG factors play an important role in investment management to help identify risks and opportunities. 

“From an opportunities perspective, we believe it is helpful to understand what companies are doing to position themselves as a part of the solution to various challenges,” explained Miller. “For example, the world is going through an energy transition driven by regulation, national security, and improved efficiency of more recent energy generation sources. Our ability to identify companies that can play a role in this transition and help other companies achieve required targets give us the ability to identify potential opportunities for investment.”

Can focusing on ESG stocks actually improve portfolio performance? While evidence is inconclusive given the brief period that ESG investing has been popular, Miller suggests that incorporating ESG factors in building a portfolio may contribute to strong investment performance for a couple of reasons.

“We know ESG topics are receiving significant attention from executives and board of directors in shaping company strategies for the coming years,” said Miller. “Based on this focus and implication on company strategy and investment, we believe having a system to engage and analyze the decisions companies are making today will be crucial to identifying opportunities over the coming years.”

He also points to a growing body of academic evidence to indicate that ESG topics may have an impact on stock performance (see table below).

Source: Governance & Accountability Institute, Inc. 2021

The Sustainability Thesis

Sustainability is an umbrella term that includes the integration of ESG factors. It means meeting our own needs without compromising the ability of future generations to meet their own needs. ESG factors allow us to consider sustainability issues in our fundamental analysis.

Our point of view

ESG focus

Understanding material ESG topics may reduce risk and increase long-term potential

Stakeholder analysis

Provides a window into the long-term viability of a company

Attractive return potential

Companies that successfully serve primary stakeholders have a greater chance of long-term success

Supporting evidence

Employee treatment matters

2-2.7% greater excess return per year for companies that treat employees best1

Materiality matters

3-8% greater annualized alpha difference between companies with good vs. poor performance on material sustainability issues2

Sustainability matters

Lower cost of capital found by 80% of studies for companies with strong sustainability practices3

1 “Employee Satisfaction and Long-run Stock Returns,” Financial Analysis Journal, Sept. 30, 2021

2 “Corporate Sustainability: First Evidence on Materiality,” Harvard Business School Working Paper, March 2015.

3 “From the Stockholder to the Stakeholder: How Sustainability Can Drive Financial Outperformance,” Whitepaper, March 15, 2015, Smith School of Enterprise and the Environment.

Dealing with risk

Miller believes that ESG factors play an important role in investment management to help identify risks and identify opportunities. 

While small- and mid-cap stocks can be volatile and may lose value, Miller believes that the Fund can mitigate some of that risk through its ESG analysis process while also identifying opportunities in the marketplace. “We use ESG topics to improve risk adjusted returns not due to any political, moral or social opinions.”

He added: “It's our belief that many companies who face challenges or potential scandals that wind up on the front page of The Wall Street Journal have issues that ultimately trace back to an ESG issue. It could be a disregard for the environmental impact the company has on its community, its customers or its employees that eventually causes problems in their business.

“Or it could be a social issue where those companies lack the proper ethics or investment in their workforce to create a structure where feedback can flow through the company and identify problems before they become too large,” Miller explained. “It could be a governance issue where companies don't have the correct policies and procedures in place to make sure risk is managed appropriately.”

Simply having a framework to analyze how companies are performing across the various ESG buckets helps the Fund identify potential risks in its investments. “But if we flip over to the opportunities,” stressed Miller, “it's our belief that those companies who can successfully and sustainably serve their primary stakeholders and their business ecosystem stand a better chance of being successful in the long run.”

(For more on Thrivent Small-Mid Cap ESG ETF, see: ETF offers features for small- and mid-cap ESG investors)

Source: Thrivent Asset Management, Investment Company Institute, U.S. Forum for Sustainable Investment


i Morningstar, “A Broken Record: Flows for U.S. Sustainable Funds Again Reach New Heights,” January 28, 2021

All information and representations herein are as of 12/20/2022, unless otherwise noted.

The views expressed are as of the date given, may change as market or other conditions change, and may differ from views expressed by other Thrivent Asset Management, LLC associates. Actual investment decisions made by Thrivent Asset Management, LLC will not necessarily reflect the views expressed. This information should not be considered investment advice or a recommendation of any particular security, strategy or product.  Investment decisions should always be made based on an investor's specific financial needs, objectives, goals, time horizon, and risk tolerance.

This ETF is different from traditional ETFs. Traditional ETFs tell the public what assets they hold each day. This ETF will not. This may create additional risks for your investment. For example:

 - You may have to pay more money to trade the ETF’s shares. This ETF will provide less information to traders, who tend to charge more for trades when they have less information.

 - The price you pay to buy ETF shares on an exchange may not match the value of the ETF’s portfolio. The same is true when you sell shares. These price differences may be greater for this ETF compared to other ETFs because it provides less information to traders.

 - These additional risks may be even greater in bad or uncertain market conditions.

 - The ETF will publish on its website each day a “Proxy Portfolio” designed to help trading in shares of the ETF. While the Proxy Portfolio includes some of the ETF’s holdings, it is not the ETF’s actual portfolio.

The differences between this ETF and other ETFs may also have advantages. By keeping certain information about the ETF secret, this ETF may face less risk that other traders can predict or copy its investment strategy. This may improve the ETF’s performance. If other traders are able to copy or predict the ETF’s investment strategy, however, this may hurt the ETF’s performance. For additional information regarding the unique attributes and risks of the ETF, see the Principal Risks section of the prospectus.

The ETF is newly formed and does not have any operating history. Small and medium-sized companies often have greater price volatility, lower trading volume, and less liquidity than larger, more established companies. The ETF’s value is influenced by a number of factors, including the performance of the broader market, and risks specific to the Fund’s asset classes, investment styles, and issuers. Markets may also be impacted by domestic or global events, including public health threats, terrorism, natural disasters or similar events. ESG strategies may result in investment returns that may be lower than if decisions were based solely on investment considerations. Because ESG criteria exclude certain securities/products for non-financial reasons, investors may forego some market opportunities available to those who do not use these criteria. ETFs trade like stocks, are subject to investment risk, and will fluctuate in market value. Unlike mutual funds, ETF shares are not individually redeemable directly with the Fund, and are bought and sold on the secondary market at market price, which may be higher or lower than the ETF’s net asset value (NAV). Transactions in shares of ETFs will result in brokerage commissions, which will reduce returns. The Adviser’s assessment of investments and ESG considerations may prove incorrect, resulting in losses, poor performance, or failure to achieve ESG objectives. The Adviser is also subject to actual or potential conflicts of interest. These and other risks are described in the prospectus.


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