Steve Chiavarone: Welcome again, Hear and Now Podcast from Federated Hermes. I'm Steve Chiavarone, Portfolio Manager and Equity Strategist. Today I'm joined via phone by Martin Jarzebowski, Director of Responsible Investing and Debbie Cunningham, Chief Investment Officer of Global Liquidity Markets. We're going to discuss ESG as it relates to liquidity and current events. But we'll also get Debbie's take on the change in investor sentiment when it comes to prime funds. In fact, let's start there, Debbie. We've noticed recent assets swings back into prime funds. What's your take on what's behind the change in investor sentiment here.
Debbie Cunningham: Thanks, Steve. And before I answer that question directly, I'm going to explain a little bit about the outflows that occurred at the end of the first quarter, specifically the second half of March from a prime fund standpoint, because that helps also explain the inflows then that were subsequent. At that point in time, liquidity in the market became very challenged.
Debbie: It was challenging across various sectors of security types. And with those challenges came concerns, especially within prime money market funds, that the weekly liquid assets number, which is a representation of liquidity within those portfolios, was getting too close to the 30% level that is mandated by the SEC for reviewing the appropriateness of liquidity in those products. Even though nobody got to that level for any of our products in the prime space, there was concern generally in the market.
Debbie: There were concerns that a fund liquidity breach might result in fees and gates. And as such, there was a broad exodus in the marketplace with about a third of the exodus that occurred at the end of March in prime funds being sort of normal flows - tax payments, ABS securitization outflows, payroll flows. But two thirds of those were definitely as a response to concerns about liquidity.
Debbie: Now back to the original question, which was on the inflows that have been subsequent to that time; there have really been four main reasons. Number one has been market liquidity restoration. The weekly liquid assets that I mentioned have been back up into the 40% to 50% ranges, not down in the 32% to 35% ranges where they were. To some degree, this was a function of the primary dealer credit facility and the money market liquidity facility that were brought out by the Federal Reserve at that point in time in March to aid in liquidity in the market.
Debbie: A second reason for the inflows is the NAVs on those products, the institutional prime products having a floating net asset. And those began to increase as spread started to decrease. As liquidity was returned to that marketplace, the four-digit NAVs started to go up again. So that was a positive for investors.
Debbie: A third reason for the inflows was just basically their overall yields. On a comparison versus government money market funds, which is where all the inflows went in March there was a spread versus those types of less risky products. And then, lastly, the fourth reason had a lot to do with diversification. People were full with some product types including government money market products. Investors were looking to diversify out of that product, not necessarily completely out, but to add additional product mixes to their investment alternatives.
Steve: Yeah, it sounds as though the progress here is really a story about normalization and feeling after the disruptions of February and March. And Martin, let's talk about that for a second. You and I have spent some time examining, thinking about, writing about some of the events that have affected global markets. The global pandemic, the social unrest, and how those really are at their core ESG issues and then how we can think about them from an investment standpoint. So if you don't mind, let's spend a minute or two discussing how ESG is kind of going macro here in a way.
Martin Jarzebowski: Oh, absolutely. So to start off with, I think we have to remember the COVID-19 and social injustice, they're both human crises and they're really shining a direct spotlight on the middle child of ESG, the social factor. So social factors have been historically viewed as soft and intangible in nature, but today we're seeing the widespread financial impact. And that's because a corporation is part of a broad human network of customers, suppliers, employees. We're all now part and operating as a one interconnected world.
Martin: So it's never been more important to understand how a company manages its human capital, its supply chain and protects its customers and employees in terms of health and safety. So it's no question that billions of brand value are at stake for companies who are prepared to adapt to this new virtual reality, which I think is going to stay with us long after COVID-19 has gone.
Martin: So the better question here is how do you practically apply this from an investing standpoint? Well, our fundamental credit team, they work side by side with our dedicated ESG engagement experts to really better understand how different sectors are adapting the purpose. So let me give you a couple of examples to crystallize that thought. Think of a retailer, specifically, a grocery store, what training and safety measures are they providing for their employees. How they increasing the hygiene in the store and in the checkout process? Or maybe a big technology company, are they ensuring strong data in cyber security to protect confidential information during work from home?
Martin: Right now, if you just take a step back and forget about the ESG acronym or the label, all of the examples that I just highlighted, they're just intelligent business practices, which will position a company who executes best as a long term secular winner. So as consumers, employees and investors, we all have very strong memories. And that gets exacerbated by very difficult and challenging economic times. So by directly engaging with these issuers on financially material, social factors, our investment teams, they just get a much more comprehensive understanding of both the risks and the opportunities that are presented in the marketplace today.
Steve: Debbie, I want to bring you into this conversation. I know at the macro level and at the prism asset allocation level, we're certainly looking at these factors in a more in depth way. Not just at the company level, but also when you think about macro factors, like what is the fiscal and monetary and health response to various governments and their ability to respond to some of these challenges. But I want to drill down here. When you think about these issues of ESG, the pandemic, social unrest, how do they impact your outlook, your strategy, and specifically the investment process in the liquidity space?
Debbie: Well, I can tell you that there are both positive and negative impacts. When we look at some of the exposures that we have to various issuers and we see pharmaceutical firms in there, that's a positive because they are seeking to find a cure for this virus. And they are undertaking extensive measures to get it out more quickly and more affordably than maybe would be the case were it not this type of a situation.
Debbie: You've got manufacturers like auto companies and consumer goods manufacturers who have completely shut down parts of their factories to make respirators or face shields, things that were necessarily not in their normal course of business. Those types of what I'm going to call qualitative factors are resonating quite well with our analysts and are helping to some degree to offset the negatives that are occurring from a quantitative standpoint.
Debbie: From that quantitative standpoint, some companies have had to take on more debt. Some companies are not earning as much. Yet you have some of these qualitative factors that can be put together with those quantitative to end up with a credit assessment that allows a fund to still continue using those firms. One of the most obvious entities that we deal with on a continuous basis is the US Treasury and US Government. We buy treasury bills, we buy treasury securities. And although their debt is increasing, their earnings on a GDP basis have decreased, their quantitative metrics as a sovereign are getting worse, what they have done from a standpoint of support programs for all types of entities, individuals, corporations, municipalities, state and local governments, nonprofits, universities, have been outstanding. That is something that helps us continue to be comfortable using them to the degree that we do in a lot of our portfolios.
Debbie: On the negative side, we have seen some firms, however, respond not as positively. Where you see as Martin was talking about the social side of the process being addressed, not all are equally treating their various types of employees. And from our standpoint that causes them to lose a little bit of the credibility factor when we're listening to what that firm's management is saying. And potentially what would have already been maybe a governance concern has now turned into a social concern. We're looking at revising our internal usage of those in a negative way.
Debbie: So it's not as if everything is all positive or all negative. It takes some of those positives and negatives and allows the portfolio mixture of the various firms to still conform to the requirements that we have to be the highest quality minimal credit risk products out there.
Steve: Martin as we begin to wrap up here, the overarching theme, I think, coming from Debbie, ESG factors are not separate from kind of traditional methods of analyzing a company. That by looking at how a company is acting from an environmental perspective, we're probably more acutely, and in recent months, a social and a governance perspective. It really is a window into how well these companies are run and how they're responding from a traditional business sense as well.
Steve: These are really interlinked. So perhaps the final word here, the final question is talk about how this ESG integration into liquidity management specifically, but in kind of investment management more really is a look into how companies are run and how they're responding to challenges.
Martin: Yeah, Steve, I like to think of our ESG integration approach as a natural extension of the primary research process that's been done by the liquidity franchise for decades. So in contrast to the majority of our competitors, who very simplistically outsource all of their ESG research to third party providers, our investment teams are equipped with proprietary data analytics on the issuer level, as well as the portfolio level.
Martin: And all of that is built and managed in house at Federated Hermes. So we don't approach ESG as a one size fits all. Rather, it's a clear focus on the ESG issues that are the most relevant and financially material for each sector and industry. Now there's no question that a key differentiator for our liquidity integration approach is active engagement. So at Federated Hermes, we have one of the largest in house teams of ESG subject matter experts who directly engage with a company's board of directors and C-suite to literally keep their finger on the ESG pulse.
Martin: So if you're engaging with thousands of companies per year, and you have a 15 year database housing all of these different engagements, our investment teams are equipped with a really unique understanding of a company's ESG trajectory and really getting a feel for where the puck is headed.
Martin: So a good example of an engagement is our relationship with one of the largest oil and gas companies in the world. So Hermes has been engaging with this super major for over a decade, and they regularly meet with the company's board and C-suite over 20 times per year. That's a very intensive engagement process. And what we've witnessed is positive ESG progress at the company over time on various material and relevant issues, such as emissions and employee safety related initiatives.
Martin: So because we've got a proprietary engagement database, we're able to quantify and measure ESG progress, not just for a particular issue, but also being able to roll that up to the portfolio level as a whole. So this advanced capability is something that very few money market funds can replicate because it's proprietary to Federated Hermes and to our liquidity franchise.
Steve: And if I may, I would suggest that it's an extension of what we at Federated Hermes do best, which is thoughtful research and active management. Which in this current environment where there is so much economic volatility and the gulf between winners and losers are greater now and likely greater going forward than they have been in the immediate past. That thoughtful research, that price discovery matters more.
Steve: You simply just can't own everything these days. You need to be able to choose the winners and the losers. I think we are up against time. So thank you, Martin and Debbie for joining, and thank you to our listeners. We look forward to you joining us again on the Federated Hermes Hear and Now Podcast. We invite you to subscribe to the Federated Hermes channel to get every Here and Now episodes. Plus our other series, Amplified and Fundamental for a global perspective on the issues, challenges and trends shaping the investment landscape.
Disclosure: Views are as of July 23rd, 2020, and are subject to change based on market conditions and other factors. These views should not be considered a recommendation for any specific security or sector. There is no guarantee that considering environmental, social and governance (ESG) risks will be a successful investment approach. An investment in money market funds is neither insured nor guaranteed by the Federal Deposit Insurance Corporation or any other government agency. Although some money market funds seek to preserve the value of your investment at 1 USD per share it is possible to lose money by investing in these funds. Federated Investment Management Company. 20-10125 (7/20)