Federated Hermes, Inc. (FHI) Earnings Call Transcript & Summary

Good afternoon. It's Mike Cyprys, Morgan Stanley's Brokers and Asset Managers analyst, and welcome to our final session of the day at Morgan Stanley's Day 1 of the Financial Services Conference. Before we get started, I've been asked to read -- direct your attention to some important disclosures on the Morgan Stanley Research Disclosure website at morganstanley.com/researchdisclosures. If you have any questions around the disclosures, please do reach out to your Morgan Stanley sales rep. So with that out of the way, for our final fireside chat of the day, we have Federated Hermes, and we're excited to welcome and have with us Chris Donahue, President and CEO and Chairman. Chris has been in his current role since 1998. And we also have with us Ray Hanley, President of Federated Investors Management Company and responsible for Investor Relations. As many of you know, Federated Hermes is a leading asset manager with over $600 billion of client assets and is one of the top players in the money market fund industry. The company manages assets across the spectrum, including equity, fixed income, alternatives and multi-asset. Federated also has one of the leading ESG engagement management businesses in the world, which is a key aspect of their transformational acquisition of Hermes in 2018, U.S. at Federated Hermes Engagement business was started 15 years ago and today represents about $1.1 trillion in assets for engagement purposes, mostly from third-party asset owners. So with that, Chris and Ray, welcome. Thanks for joining us today.

Thank you for having us.

Great. So I'll kick off with some questions -- kick off the discussion here with some questions, and then we'll leave some time for investors to ask questions via the web portal. So feel free to submit questions here on the webcast. So why don't we start with the current environment, Chris and Ray? Can we talk about how your business is holding up here today? Imagine most of your workforce is still working remotely. How is that working out for you guys? And what do you have to do differently to manage a business entirely remotely in this sort of backdrop?

Well, it's been a fascinating time, and we are very well positioned here in the current environment. With our focus on active management and sustainable investing, we've eaten our own cooking because our employees' response demonstrates their resiliency and their dedication. And we're really quite proud of the fact that for the years of technology investments, buying extra monitors, business continuity plans, that we were fully ready to go operational without being in the office and we've been fully operational the whole time. And as of now, we have in excess of 95% of our people, U.K., Pittsburgh, New York, Cleveland, Boston, Texas, all over the world, operating properly and fully remotely. So we're quite happy with that. And in the meantime, they've adjusted the trading and the portfolio of people do a lot more activity and a lot more volatility in the marketplace. We added some new things to the call systems so that the calls can quickly and efficiently be moved to call receptionists and call takers very, very efficiently. And you say, "Well, what's different about trying to manage this?" Well, we value very highly a culture and community. And the fact that we have good culture and good community means that we can withstand some of this for many months. But in the end, you want to get back to that. So what we've told people is that we're going to encourage you to stay home into September, through the summer, and that's for the lot of the standard reasons that everybody knows about. But we've still found that we've been able to collaborate and get some of the advantages of community and culture. You can imagine all the meetings that are going on and things like that. We've even been able to onboard new employees and even onboard new clients, especially in the EOS area that you mentioned at the outset. So we're pretty happy with where we are.

Great. Maybe we could shift over to your clients. Just curious what you're hearing from your clients during these unprecedented times, and how do you see their needs evolving, if at all?

Well, their needs have been evolving a lot. As I said, a lot of volatility on the trades and a lot more activity. But I think to think that they have looked to us for -- that has been the most successful has been our thought leadership, where the amount of articles, webinars, conferences over the phones, remote, Zoom, et cetera, have just been very, very well received. One little fact is that all of our website traffic has increased by 30% compared to the same time last year, and we're measuring much longer engagements throughout this time, the engage up almost -- the time is up almost 60%. And believe it or not, even though our regional consultants and institutional sales forces can't travel, they're staying very, very close to the clients. And here's a little footnote on oligopolization. It's hard to get in when you can't even knock on the door, but we're already in. So that's a plus. So basically, our clients are looking for information to talk about performance and market conditions. We've given the market minutes every morning, outlooks. And in addition to that, the performance has been excellent across the board. So our clients are still looking for solutions and we've been able to offer them, and that has worked out to both parties' advantages.

And as you look across your business today, what are some of the recent flow trends? And has anything changed material at all?

Well, the money market growth so far here in 2020 is $80 billion, which is about 20%. And as you know, money markets tend to shine when things are unsettled. But we've noticed that money market funds do well in higher rates, too. And our whole history is a history of higher highs and higher lows. And we have that slide on Page 13 in our booklet. And if you look at flows on the equity side, the flows through June 5 in the second quarter here are negative $1.8 billion on equities as compared to negative 8 -- an 800 -- $0.8 billion in Q1. On the fixed income, however, we're positive at $2.6 billion here in the second quarter as compared to a minus of $1.8 billion, which, as you will note, for the quarter, puts us in positive flow land on variable net asset value funds. So we're pretty happy with that. The leaders on the flow charts would be the Kaufmann Group, especially the small-cap fund; the Hermes Global Equity ESG fund and our MDT All Cap Core fund. The strategic value dividend still remains negative flows, but they've been jumpy because in February, we were almost breakeven than outflows in March and April and significantly less outflows in May. And we always like to comment on this fund. Remember, it does what it says it does, pays a dividend and looks for that type of approach. And on that basis, the fund's 5% gross yield ranked it in the top 2% of Morningstar. And when you look at the performance compared to dividend tiers, not to its regular Morningstar category, but its dividend tiers, we're about plus 600 basis points through the end of May. So that's a pretty good picture of the flows. And we had, interestingly, in equity funds, about 14 funds that were positive during the second quarter on flows. So you had a lot of the Hermes funds with positive flows, even though some of them are small. Now in fixed income, I already talked about the gyrations from negative flows to big positive flows. And the leader in the clubhouse here would be high-yield on the positive side, and corporates and governments were up as well. Ultrashorts were positive, and so is the total return bond fund. So all in all, the flow situation is a lot better than I would have expected in these kinds of turbulent times.

So strong flow picture, it sounds like -- just to make sure I heard you guys correctly, so equities were out by $1.8 billion, fixed income was positive $2.6 billion inflow. So that nets to about $800 million or so inflows so far in the second quarter, and that's firm-wide across retail and institutional?

Yes, sir. Believe it. That's SMA and funds. The institutional is separate.

And we don't tend to look at the institutional until the end of the quarters. But we've also had similar trends there, although equity has not really had outflows, but we've had some good inflows on the institutional side of fixed income as well.

Got it. So it sounds like the institutional side would be more or less additive to that SMA and fund flow picture?

Yes. Yes.

Okay. Okay. Great. And then money funds as well, I imagine that does not -- that those numbers, so that would also be additive if we can look at the Morningstar numbers there?

Yes. Well, the numbers that I gave were on money markets generally. So that include our LGIP pools and everything. If you want to talk about the funds in particular, we can do that, too.

Got it. Okay. Maybe just shifting over to -- we talked a little bit about money funds. We saw during the recent crisis over $1 trillion of inflows across the industry into money funds, most of it into institutional govie funds. Is that mostly pension fund clients? Just curious what the top client sets you saw driving the surge of inflows across the industry. And from your perspective, what would need to happen to see this sort of -- I mean a large degree flow out the door, if at all? I mean, $1 trillion in a very short period of time is quite significant.

Well, on the last point first. As I mentioned with respect to our assets, we've seen higher highs and higher lows. So yes, the money goes in ebbs and flows. And in specific answer to your question, we would say about 90% of our growth came from institutional clients and that includes wealth management, Bank Trust, corporations. And the other 10% would be retail, broker-dealer sweep and things like that. But remember that whichever category it's coming in, there's a bunch of that money that's CARES money that's PPP money, and that money was designed to come in and go out and get forgiven. And so you would expect some of that to have that kind of a character. Not all of the money was a pure flight to safety-type money, and that's an important thing to consider. Now when you say, "Well, gee whiz, what would it take to have all this flow out?" Well, I already told you about some of the money that's being used. That's what happens with cash. We think that if rates are all higher, that sure helps the money funds. And in past cycles, with rates going up, if that's what's in store, the money funds will get there sooner than the bank deposit rates because the bank deposit rates are always a lagging indicator. But of course, as rates rise, the spot rates available for some clients, where they can go direct better, they can go there. So it's pretty tough to say. Our house view is that the Fed isn't going to do anything to rates anyway, and we're going to be living in this type of environment. But we have seen things like our repo rates go up 1 basis point or so over the last day or 2, little wee things like that.

Great. And then just on the prime money funds, notwithstanding all the inflows into the govies prime funds saw $150 billion outflows during this past crisis with the Fed, then stepping in to provide backstop hardily, perhaps similar to what we saw in 2008. So just curious to hear your perspective on what transpired there? And what are the implications here for the future of money funds and potential for regulation?

Well, in terms of going back to '08, the reality is that in both cases, there was a need for liquidity in the system, which is peculiarly the Fed's province, and that's what happened in both cases. And that is all that the funds ever asked for, and that was all that was ever needed was liquidity in the system. And so it was similar to what we did in '08 but dissimilar. There was no insurance this time. There was no breaking a buck and nobody's laying any blame at the foot of the money market funds for the COVID. I mean there's a lot of politics on who caused it, but it didn't get blamed on money funds this time. And so we think that overall, the Fed has recognized that they want the muni market. They want the commercial paper market to actually function. And all a money fund is, is the shortest tip of the spear of that marketplace, and the Fed has recognized that that's supposed to function well. And one of the things that made the problems a little more challenging a little sooner was a rule they put in that said you had to maintain 30% of your portfolio in weekly available cash or you had to make a public disclosure that you had to go to your Board to consider what action, if any, to take. So it created a whole new hurdle way earlier in the system that basically was the trigger for the issues. And all of these money funds had no credit problems and any of the money funds are even buying paper back still had in the high 20s percent of their assets in weekly liquidity. So in both situations, the Fed was concerned about substantial corporate issuers being able to issue debt or to roll, and they came in with the liquidity, and I think that was the right step to and that's the right role of the Fed in these circumstances.

Thanks for the clarity there. On the fee waiver side, that's often a topic now coming up in the context of this low-rate backdrop and in the money fund industry. LIBOR levels also having come in a bit here as well. I guess, just what's the reinvestment rate and the mix looking like today? And how should we think about the implication here for fee waivers?

Well, we are not going to change what we said at the other conference and at the quarter end, which was we estimated $3 million of reduction in Q2 operating income from what we call money market fund minimum yield waivers. So we're staying with that. That's based on our investment team's outlook and the asset level and the mix at the time. Ray can comment on the other part of your question.

Yes. In terms of the reinvestment rates, you're right. I mean we've seen LIBOR come in concurrent with the actions that the Fed took in that market. And you can see the rates that are out there. There -- we can go out in a money fund out beyond 1 year, 397 days. But of course, much of the portfolio is very short. So we're just under 20 basis points in terms of 1-month LIBOR and a bit more going out to 3. On the government side, where we've seen the bill rates edge up a bit and as Chris mentioned, so we're up into the teens on 3 and 6 months mid to upper teen levels. And on the repo rates, which is where a lot of the portfolios are -- need to be to provide liquidity, we've seen a couple of basis point improvement there over the last week or 2. And so we're seeing 6 to 11 basis points on different types of repo, treasury, MBS and muni -- weekly muni.

And as you think about the potential for waivers, looking out the next couple of years, does anything look different today, whether it's the business, the industry, around the potential for waivers versus the last time we were in a zero-rate backdrop? And how might this result in a better or worse outcome for fee waivers out the next couple of quarters or years?

Well, yes, it's always a multifaceted calculation. It's a function of both the rates and the volume and what kind of funds. In our case, it also is determined on -- a big factor is the distribution expenses. So today, our assets are higher than they were in '08. We are more concentrated in government money funds compared to prime and munis than before. The government funds basically have lower yields. And so they could run into minimum yield waivers faster. But they -- we also have many, many more -- much more assets at lower fee levels, which means they run into waivers later than the last cycle. And there were a lot of funds that we had before that were in sweep vehicles, which are now in bank deposits, and those ran into waivers earlier in the cycle. And it's just very, very difficult to try and build a model to take care of all of these factors to come up with an estimate. So there are a lot of differences, but the money fund remains a very, very solid cash management vehicle.

Great. And maybe shifting gears a bit. As you approach the second anniversary here of the closing on the Hermes transaction, how is the integration and the growth relative to your expectations?

Well, okay, expectations. So when we did this deal with our colleagues in the U.K., we wanted an excellent management team, a workforce. We wanted principles that were consistent. We wanted evidence of strong growth. We felt investment performance was critical, a distribution footprint, cultural compatibility probably led the parade. We are committed as our friends in the U.K. are to active management. And we got and looked for an ESG integration effort and an engagement effort, which we've commented a little bit on, with the EOS. And perhaps the best indicator of whether we got those things is the fact that we changed our company name to Federated Hermes, Inc. and our symbol to FHI. And this is a rate branding effort, and it shows our willingness to state clearly that sustainable investing is the way to wealth. And we have 90% of our teams integrated with ESG using the EOS methodologies and information. And we think this is a very, very important thing. If you look at how it's gone, one thing I would mention is that the engagement service, EOS, has increased from $400 billion when we bought the firm to over $1.1 trillion today. And that group is engaging with over 1,000 companies last year and has 18,000 companies in their records, and this is all very good information. Some of the other things we've done is to create the 5 funds, which we've talked about before, seeded them with $30 million, and they're up to between $75 million and $80 million. And combined with the acquisition from PNC, our colleagues in Cleveland, which added a 5-star fund and 2 other funds, we now have, adding to our New York funds, a good family of 9 international funds, and this is a important growth platform. We recently added a -- our first U.S. Hermes institutional strategy, and we have on the drawing boards the first Hermes SMA strategy. And as I think most of you are aware, we did complete 2 more acquisitions, where we already own various pieces of things. But this is the real estate business and then the private markets private equity and infrastructure business from the pension scheme. So overall, I think we've gotten the things that we've looked for. And I think from the Hermes people's viewpoint, it's fair to say that our colleagues are better understanding the importance of having a franchise for all seasons when you see how the money market fund business does during a rather challenging times.

Certainly. I want to dig in on ESG. But maybe just on the Hermes piece. You picked up the -- a more international and a global franchise with Hermes. Can you talk about your aspirations to grow outside the U.S.?

Once we're allowed to travel again, this will be something that will be more current. But pending that, we still talk to clients, et cetera. But one of the great features is exactly like you pointed out. We view this as complementary distribution, very low overlap in clients and distribution strength. So it was additive in both cases. We put our Asia Pac team together with the Hermes team, and we put the German sales force into the Hermes team. And initially, we were focused and are focused on bringing various U.K. Hermes strategies to the U.S. And on the reverse, we expect money markets, trade finance, Kaufmann, strategic value, high yield to be some of the ones that would be considered overseas by others. And it's just that at this particular time, it's hard to -- when you can't get in front of the clients, it's hard to make those things happen, as we had expected them to happen.

Sure. Maybe just digging in a little bit on ESG. There's some debate in the marketplace around performance of ESG. Just curious your perspective on what the magnitude of relative performances in your view of ESG strategies. And more recently, it does seem like performance has picked up across the industry in ESG, but there's also a debate there around whether it's just been more sector allocation because of underweight to cyclical, such as the oil and gas and autos. So curious to your views as well on what drivers of long-term outperformance of ESG can be from here?

Let's talk about some of our internal studies to begin with. On the G side, the studies that we've done have demonstrated that the bottom decile of companies with rankings of poor governance do substantially worse. And just by missing them, you enhance performance. And the same kind of thing on social ranking. And this is based on our evidence from having engaged with companies to evaluate where they're going and how they're going there. And it's a very similar kind of thing that if you miss out on the bottom 10% of who we evaluate, you have enhanced performance. And the second thing I would mention, in addition to the facts like that, is that our approach is quite different in that we're not just using labeling and saying, "Oh, we're integrated, and that's great." This is based on 15 years of experience with all of the engagements that I spoke about earlier. We have 30 engagers who have a different perspective than a regular analyst, which is what a lot of companies do and declare them to be engagers. The level of knowledge and understanding of our people includes PhDs, scientists, accountants, industry expert, bankers, people that really know the industry and have a perspective of long term, meaning more questions and approaches in the 5 to 10-year sequence than analysts who may be looking at a shorter time frame, 1, 2, 3 years and things like that. And so this whole approach is different. Another aspect of the different approach to engagement is that the EOS group is a group of about 55-or-so clients, 3 of which were onboarded during corona time, getting together and deciding who to engage and what to engage on. And this has been going on for 15 years. And this history, this data and these approaches just can't be replicated by new players. And we work with these teams, and we think this gives us a very powerful advantage, especially for active managers. And it's interesting that what we're beginning to hear from clients is that they're talking about active management and trying to miss out on owning the companies that aren't going to make it or are on the bottom of the heap. Now this is not a way to say, "Oh, well, the trends in passive or over or anything else like that." It's just to say that people are becoming a lot more aware of the efficacy of making decisions on owning companies for good, sustainable investment reasons.

And Mike, just to your question about the energy sector specifically. What we found is, for example, oil and gas is less than 4% of the S&P 500 weighting at the beginning of the year. And most of the conventional non-ESG funds were actually allocating less to that sector. If you look into the ESG funds broadly, they're, on average, overweight on industrials and materials, and those are highly cyclical and really aren't thought to be green sectors either. What we find is it's much more a question of security selection and the orientation toward characteristics that are indicative of higher quality for fundamental analysis. So things like lower volatility, more consistent profitability, lower credit spreads. In effect, ESG is emerging as the new measure of quality, a new quality factor, and it's really just a natural extensions of what investors have been looking at anyway to signal higher quality. So certainly, Hermes has found that, over time, using the ESG factors and analysis has led to better risk-adjusted returns over time. And we're in the process of educating and working with Federated clients to convey that the ESG integration is an additional tool set for portfolio management. It's not -- these are not exclusionary strategies. It's another tool in the tool kit to identify risk and to help them help our teams generate better long-term and sustainable investment results.

Great. And we're just about out of time, but I'm going to just try and squeeze one last one in here, just around the demand that you're seeing for ESG. So if you think about -- and maybe we've answered this from a U.S. client perspective, how would you characterize as demand today for ESG strategies versus, say, a year ago across your different channels in the U.S.? And are these sort of numbers you're able to share with us around how much this has contributed to flows or how many new clients?

It's really hard, Mike, to see how -- where the flows are. We don't get a breakdown that we can really do that. However, when you look at the money markets and the flows there and the fact that that's fully integrated, and we talk to clients about it, and they think it's important, and then we gain assets and gain market share, it gives you confidence that it's working. So we're seeing a lot more interest in it from both broker-dealer type and institutional type. We won our first institutional mandate, which I mentioned, and we're just not as far along in this country as they are over in Europe or for that matter, in the U.K. But when you look at movements in the U.S. and as Ray talks about it as a quality effort as well, we are seeing things that this is an important ingredient of the future. And for Federated, this was an important ingredient in doing the acquisition with Hermes in the first place. And we think that our responsible investing office has done an excellent job of integrating our products and our goal here with the name change and with this integration is that hope people see the Federated Hermes, Inc. brand as a brand that includes ESG baked in the cake.

Great. Well, I'm afraid we're out of time. We'll have to leave it there. Chris and Ray, thank you so much for joining us today.

Thank you.

Thank you, Mike.

And everyone, thank you for joining us for Day 1 of Morgan Stanley's Virtual U.S. Financials Conference. We kick off Day 2 tomorrow morning at 8:00 a.m. Hope to see you then. Thank you.