Strategy Primer: Sustainable Improvers

Counterpoint Weekly 5–11 April 2021

Strategy primer: sustainable improvers Quintet’s sustainable investing philosophy comprises a toolkit of approaches and Melissa Spinoso Sustainability Strategist dedicated assets. In this primer we deep dive into the improvers approach – arguably the most innovative sustainable investing strategy. James Purcell Group Head of ESG, What you need to know Sustainable & Impact Investing — Improver strategies seek to invest in entities that are exhibiting positive environmental, social, Bill Street governance (ESG) momentum. Group Chief Investment Officer — Academic and industry evidence suggests that improver strategies can generate excess returns compared to conventional benchmarks. — Improver strategies can be applied to both equities and bonds. Typically, improver strategies utilise an active approach. Managers may attempt to catalyse the improvement through active ownership.

Section 1: What are improvers? Improver strategies seek to identify entities that are demonstrating positive momentum in addressing their environmental, social, governance (ESG) risks and opportunities. What is the investment thesis? Investors using improver strategies expect improved ESG performance to correlate to, or cause, improved operational performance. By identifying momentum ahead of other investors, they believe investee entities will deliver improved cash flows and may re-rate to a higher equity multiple, or a tighter credit spread. Investors may attempt to catalyse the improvement through active ownership; engaging company management through dialogue and voting in order to improve business practices and financial performance. How can improvers be identified? Improver identification can be the result of ESG data such as those provided by Sustainalytics and MSCI. This approach observes a trend in ESG headline scores during a defined period of time and, while easy to implement, relies upon third-party methodology, may struggle with data latency, and may oversimplify complex sustainability issues. Alternatively, an investor can identify improvers by assessing the change in individual material ESG topics, aiming to quantify the impact on revenue, risk and profitability. An investor may normalise these metrics by revenue or by gross fixed assets to improve comparability over time and to peers. For example, carbon intensity is important for the electric utilities industry, as it may indicate operational efficiency and potential risks. Figure 1 illustrates changes in carbon emission intensity.

Figure 1: Improver strategies may assess the change in individual material ESG topics CO2 equivalent emissions intensity, change 2017–19, selected utilities

60% 40% 20% 0% -20% -40% -60% -80% -100% Acciona SA Iberdrola SA Endesa SA Eneva SA Enel SpA Red Electrica Enel Avangrid Inc EDP Energy Corporacion Generacion Renovaveis Absolute PCL SA Chile SA SA Source: Goldman Sachs, Bloomberg, Thomson Reuters, Quintet

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How does one construct improver strategies? Improver strategies have been shown to support Improver strategies can be unconstrained and constructed without reference to sector or regional better ESG practices weights. Alternatively, improver identification can be implemented within sectors and regional peer groups, leading to smaller benchmark deviations but with a greater number of unintuitive selections, and may improve such as an improving base metal miner. investor returns Construction may consider where active ownership is most likely to catalyse ESG improvement. This can create factor biases such as a small capitalisation tilt, as engagement is more likely to have a material positive impact in smaller companies. Construction may also draw on elements of the leader strategy and combine absolute ESG improvement with relative peer-performance. For example, Goldman Sachs found that companies that had deteriorating ESG metrics and performed worse than peer average were more likely to underperform their regional sector peers1 (figure 2).

Figure 2: Strategy construction may combine improver and leader elements Percent of companies underperforming conditioned upon environmental and social (E&S) data, 2011–16, MSCI ACWI 62%

60%

58%

56%

54%

52% Negative E&S momentum Bottom half E&S performance Bottom half and negative momentum

Source: Goldman Sachs, Quintet past performance is not a reliable indicator of future returns

Section 2: Why invest with an improver strategy? Improver strategies have been shown to support better ESG practices and may improve investor returns. Why are improver strategies good for people and the planet? Improver strategies enable investors to align their investments with their preferences. By investing via an improver strategy, investors can signal the importance of good ESG practices and motivate entities to improve. Improver strategies have the most influence when combined with active ownership. Successful company engagement often entails specific metrics, benchmarking, well-defined targets and suitable verification, and can change business practices for the benefit of people, planet and profit. Are improver strategies good for your portfolio? Academic evidence suggests improver strategies are additive to risk and return. While past performance is not a reliable indicator of future returns, a seminal 2012 paper led by Cambridge University researchers with a dataset spanning more than 600 US companies between 1999 and 2009 found that successful engagement on environmental and social topics triggered a cumulative size-adjusted abnormal return of 7.1% over the subsequent 12 months2. The sentiment was echoed

1 Goldman Sachs. (2018). ESG Series: Momentum & Materiality – Building blocks for ESG integration. p.4. 2 Dimson, Elroy and Karakaş, Oğuzhan and Li, Xi, Active Ownership (August 7, 2015). Review of Financial Studies (RFS), Volume 28, Issue 12, pp. 3225-3268, 2015., Fox School of Business Research Paper No. 16- 009, Available at SSRN: https://ssrn.com/abstract=2154724 or http://dx.doi.org/10.2139/ssrn.2154724 2 — Quintet Private Bank — Counterpoint Weekly 5–11 April 2021 Strategy primer: sustainable improvers

by a study of almost 300 companies between 2005 to 2014, which found that value-at-risk was A Rockefeller study 20%lower for engaged firms compared to a control group3. covering US equities from 2010–20 concluded Practitioner evidence supports the academic findings. A Rockefeller study covering US equities from 2010–20 concluded that top-quintile improvers outperformed bottom-quintile decliners by 3.8% that top-quintile on an annual basis4. Goldman Sachs broadly supported the conclusion and found that companies improvers outperformed that began in the bottom ESG quartile at the beginning of a three-year period but ended the top bottom-quintile decliners half, combined with top-quartile momentum, outperformed by 1.2% on an annual basis5. Goldman by 3.8% on an annual Sachs researchers have since declared: "We find the strongest alpha signals in laggard-to-leader moves on environmental and social factors and vice versa"6 (figure 3). basis Figure 3: Some studies show improvers can deliver the strongest excess return Average annual relative return conditioned upon environmental and social data, 2014–17, MSCI ACWI 1.5%

1.0%

0.5%

0.0%

-0.5%

-1.0%

-1.5% Bottom quartile Staying in top quartile Staying in bottom Top quartile moving to moving to top half quartile bottom half Source: Goldman Sachs, Quintet

What portfolio characteristics do improver strategies exhibit? Improvers are making progress on the sustainability journey and may therefore exhibit value characteristics. When engagement is utilised, improver strategies may favour smaller companies as they are more likely to respond to stakeholder input and efforts by a single investor have the potential to make a major difference (figure 4).

3 Hoepner, A. G., et al. (2018). ESG shareholder engagement and downside risk, p.49. 4 Clark, C., & Lalit, H. (2020). ESG Improvers: An Alpha Enhancing Factor. Rockefeller Capital Management. https://rcm.rockco.com/insights_item/esgimprovers-an-alpha-enhancing-factor/ 5 Goldman Sachs. (2018). ESG Series: Momentum & Materiality – Building blocks for ESG integration. p.5. 6 Idem, p.6. 3 — Quintet Private Bank — Counterpoint Weekly 5–11 April 2021 Strategy primer: sustainable improvers

Improver strategies are Figure 4: Improver strategies may favour value most efficient when they Illustrative factor exposures are active, as identifying Large future and material improvements requires deep knowledge of a Leaders company’s Value Growth fundamentals, processes, management and ESG practices Thematic Improvers

Small

Source: Quintet

Are improver strategies typically active or passive? Passive improver strategies typically use quantitative ESG scores sourced from data providers such as MSCI or Sustainalytics. This creates challenges when attempting to identify momentum ahead of other investors, as passive improver approaches based on ESG ratings incorporate a large amount of backwards-looking published data. Improver strategies are most efficient when they are active, as identifying future and material improvements requires deep knowledge of a company’s fundamentals, processes, management and ESG practices. Active improver strategies achieve maximum impact when they incorporate active ownership. Figure 5 shows fund flows into active and passive engagement strategies for the last five years. Active funds have received more flows than their passive counterparts.

Figure 5: Passive vs active flows in engagement strategies Active funds have received more flows

Active Passive 40 35 30 25 20 15 10

Net inflows inflows (USDbillion) Net 5 0 2015 2016 2017 2018 2019 2020

Source: Morningstar, Goldman Sachs, Quintet

How can one invest in improvers?

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Improvers are an investment lens applicable to both equity and bonds. Improver strategies can be The risks of investing benchmarked to a conventional index, such as MSCI World or Barclays Global Corporate with an improver lens Aggregate, or a sustainable index, such as MSCI World SRI. Investors can deploy improver mirror conventional risks strategies in their portfolios via single instrument selection or fund selection (figure 6). Improver strategies are, arguably, the most innovative sustainable investing strategy, with numerous new such as credit, duration product launches. In 2021, Rockefeller Asset Management partnered with Bloomberg to launch a or equity. However, multi-factor ESG improvers index. Also in 2021, Amundi launched a new range of ESG improver there are some specific funds benchmarked to conventional indices. Both launches incorporate stakeholder engagement to risks speed up companies’ positive change. Figure 6: Questions to ask when building an improvers strategy Improver strategies can be deployed via fund or instrument selection

Source: Quintet What are the key risks? The risks of investing with an improver lens mirror conventional risks such as credit, duration or equity. However, there are some specific risks: — Improver strategies may focus on non-material ESG improvements that do not translate into enhanced financial performance. — Improver strategies may create unintended portfolio skews such as sector or regional biases, or a tilt to value or small capitalisation factors. — Improver strategies may seek to enhance the long-term performance of lowly ESG-rated companies, resulting in poor portfolio optics. — Improver strategies may create downside or reputational risks if investee entities do not improve and sustainable risks materialise. — When coupled with active ownership, improver strategies can be resource intensive, leading to additional operational fund costs.

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