ESG investing is fundamental investing

Why more view ESG criteria as integral to their process

The use of environmental, social and governance (ESG) considerations is now a vital part of managers’ fundamental securities analysis, , the pursuit of -term risk-adjusted returns, as well as the fulfullment of investors’ fiduciary responsiblity. Combining traditional securities analysis with ESG data and metrics and tangible corporate engagement is essential in order to address the limitations of static datasets and the importance of understanding positive and negative changes in the risk profile of an investment.

Key points We believe companies emphasizing fi nancially material sustainability practices generate the opportunity for better risk-adjusted returns over time.1 Due to a number of drawbacks in static ESG data and metrics, it’s important to evaluate both the investment risks as well as the potential effect ESG factors can have on future investment returns. The integration of ESG criteria and fundamental analysis is essential in investment-decision making as well as fulfi lling fi duciary duty. The effectiveness of management and strategy cannot be assessed and potentially infl uenced without ongoing corporate engagement.

Investment management is based on an asset manager’s duty to invest the entrusted to them carefully and effi ciently as if they were their own. This “prudent man” rule underpins fi duciary duty in the U.S. and is arguably a major principle of around the world. While some aspects of investment management originated in the U.S., asset management has a global history stretching back hundreds of years to sovereign lending in Europe and the early exchanges. Thus, it’s not surprising that major innovations in investment management—and specifi cally in the fundamental securities analysis that drives much of it globally—is coming from global institutional investors and asset managers. One specifi c global trend in the past decade is the incorporation of ESG considerations in the investment process. In this paper, we will demonstrate why ESG, far from being a passing fashion, is a very real and permanent part of fundamental investing and the tools of equity and credit selection. We defi ne whatESG means in the context of different types of investment management, defi ne some key concepts to understand and debunk a few falsehoods. We also analyze the development of what is considered modern fi duciary duty, the limits of fundamental analysis, and what is likely to drive real change in . Finally, we contend that ESG investing is a natural evolution of the investment process, capital allocation, and the identifi cation of long-term investment value.

The road traveled from “sin ” and “negative screening” There’s a substantial amount of discussion and debate in the investment management industry when it comes to ESG considerations. Largely driven by governments, institutional investors, asset managers, investment consultants around the world, the topic of ESG can be overwhelming to some and, coupled with a prodigious amount of data, can quickly devolve into the “noise” of an investment fad that everyone talks about but can not be easily defi ned. ESG, though, is anything but a fad. The assets involved alone give pause for thought. The asset management signatories to the United Nations Principles for Responsible Investment (PRI) now oversee approximately $90 trillion. Sustainable invested assets globally stood at $30.7 trillion in 2018, according to the Global Sustainable Investment Alliance. The most recent study in 2019 from the Global Impact Investing Network found that the number of asset managers offering ESG strategies in the past 20 years had grown more than 400% and that $35.5 billion was invested in more than 13,000 impact investing deals in 2018.2

ESG investing is not new, but it has gained signifi cant in the past 10 to 15 years. According to a 2019 report by Cerulli Associates, 88% of total U.S. public assets are linked to a UN PRI signatory.3 For years, U.S. religious-affi liated institutions, as well as some university endowments, have avoided “sin stocks” (e.g., tobacco, gaming, alcohol, fi rearms) or fossil fuel investments in their portfolios, a process known as negative screening, as well as divestment from certain companies after pressure from stakeholder groups in the institution. Positive screening took off with the development of ESG datasets, which are mainly designed to isolate ESG risks (e.g., climate-related, labor relations, independent corporate boards), and have now spawned a cottage industry with dozens of data providers. Today, there is global momentum behind ESG integration in investment processes partly driven by investors’ expectations. Additionally, depending on an institution’s specifi c goals, ESG integration is leading some to pursue impact investing or defi ned as the implementation of investment strategies that result in some measurable long-term environmental or societal return in addition to a fi nancial return. This is often accomplished, in part, via stewardship.

Not FDIC Insured • May Lose Value • No Guarantee The road to impact investing and stewardship Depending on an ’s overall goals, ESG integration and corporate engagement could be used for impact investing or to help realize long-term value in portfolio investments.

Engagement

ESG Negative ESG Positive Impact investment Stewardship screening integration screening investing themes

The key concept in all this evidence is how sustainability is intertwined with Myth #1: To do “good” fi nancial the concept of materiality. Sustainability in fi nance is when a company’s returns must be sacrifi ced business practices work with, and not against, the long-term profi tability and success of the organization and, ultimately, the economy as a whole. While government pension plans and some offi cial institutions in Europe and However, the caveat is how fi nancially important (or material) specifi c risks Australasia have developed solid track records in ESG and impact investing, and outcomes of the company’s business practices are to that future success. a continuing question for investors globally has been whether or not fi nancial For example, a large consumer bank’s CO2 emissions are probably not as returns must be sacrifi ced in order to invest with ESG considerations in mind. fi nancially material to their future as is the bank’s fair lending standards or its Although evidence can be very time-period dependent, investors can point board composition. to years, i.e. in 2011 and 2016 where not owning energy or mining stocks, for example, showed underperformance of benchmark indexes.4 Additionally, materiality is important in analyzing companies in the same industry. Yet without fundamental investment analysis, the consideration of These objections are now being addressed by a growing body of academic materiality only goes so far. In an October 16, 2019, Institutional Investor evidence in the past decade indicating that actual ESG integration (as article, several Harvard Business School academics summarized the limits of opposed to the notion of so-called greenwashing, or the process of materiality in their advocacy of the concept of shared value in ESG criteria: conveying the false impression that a company’s use of capital is environ- “A materiality analysis of ESG metrics may help investors identify industry mentally sound) can be consistent with strong fi nancial returns over time. For laggards or measure, analyze, and price risks that protect portfolio value. Yet example, a well-known 2015 meta study (a study that compiles results of this approach is insuffi cient to identify companies that are truly innovating by hundreds of underlying studies) demonstrated that companies with “robust” creating shared value through the use of social innovation to drive superior sustainable practices had “better operational performance” and “have long-term economic results.”7 a positive infl uence on investment performance,” which “ultimately demonstrates that responsibility and profi tability are not incompatible, but in fact wholly complementary.”5 U.S. domiciled asset management AUM More recent work shows that with ESG incorporation, 2018 companies that make tangible Since 2012, there’s been substantial growth in the total value of assets efforts in sustainability measures devoted to sustainable investment strategies. There’s a growing often become solid investments. body of academic Writing in the Accounting Review, $12,000 evidence showing researchers showed that that ESG integration companies with “good ratings on material sustainability issues $10,000 can be consistent signifi cantly outperform” those with strong fi nancial with low ratings—specifi cally, these returns over time. investments generate * of between 3% and 6% per annum.6 $8,000

In a June 16, 2019, article in the Financial Times entitled “Future $6,000 Leaders Take Note: Finance and Sustainability Go Together,” two London Business School researchers summarized an analysis showing that “genuine” ESG adopters outperformed 1 $4,000

non-adopters by 4.8% annually over the past 18 years. In other words, assets (USD billions) Total emphasizing the ESG criteria that is integral to the future economic value of the company and its industry is what really moves the needle from an investment analysis standpoint. $2,000

$0 2005 2007 2010 2012 2014 2016 2018

Source: US SIF: The Forum for Sustainable and Responsible Investment Foundation. Myth #2: ESG is only about Considerations in ESG data evaluating risks ESG risk factors, however, are sometimes not as easily quantifi ed and data can lack in consistency among companies in a single industry. Therefore, Even for those investors and asset managers who have integrated ESG both quantitative and qualitative securities analysis is required to understand considerations into their investment process, an inordinate amount of how ESG risk factors may be changing (because they are dynamic, not static) attention is given to the type of risks ESG analysis spotlights. Of course, and what that might hold for the future. As noted, studies show that blind issues of sustainability in areas such as climate change, labor standards or adherence to ESG risk data without the consideration of materiality adds corporate governance practices are important, but a great deal of time is little or no investment value.8 spent analyzing and quantifying those risks, while too little time is devoted to understanding the future economic value that might be created (or destroyed) In fact, there’s decided downside to a singular dependence on data without in an investment. Put differently, the focus on present ESG risks is only half thought as to how changes in ESG factors can affect the future state of a the equation without consideration of potential future economic returns. company or its investment value. Federated Hermes believes there are several aspects of sustainability ratings and data that investors should keep in mind: One explanation for the focus on ESG risks, from an investment Data consistency/standardization: Many academic studies have standpoint, is increasing investor highlighted different results in similar ESG datasets, for the most part The focus on awareness of general risk and risk due to a lack of standardization of materiality data. One famous present ESG risks factors, especially in the context example of this divergence is that of a leading electric car company, is only half the of multi-asset investment which had a strong rating from one data provider and a weak rating from another vendor. equation without portfolios. With the and asset drawdowns of the global consideration of Transparency: While ESG data providers’ methodologies are usually fi nancial crisis still top-of-mind readily available, the areas where they generate proprietary estimates potential future even more than a decade on, and assumptions—where reported data isn’t available—aren’t easily economic returns. investors are analyzing the understood. This also applies to how certain factors are weighted in imbedded risk factors in their a company’s rating or score. In other words, every provider weights portfolios—value, momentum, various inputs differently. carry, liquidity, etc.—and trying to isolate and those risks. The preponderance of information: Which data provider does an investor This work has underpinned a secular change in strategic asset allocation listen to when there are more than 125 vendors offering insights on undertaken by major institutional investors in the past few years. Additionally, climate and emissions, corporate governance and social impact one outgrowth of awareness is that investors (both institutional statistics? Is one provider better than another for the same type of data? and individuals) are utilizing risk-factor-based strategies often as a core of a multi-asset-class portfolio. As noted, true sustainability is key to identifying a potentially outperforming investment. By way of example, intrinsic to its process, Federated Hermes looks for improving sustainability and companies’ progress toward those goals—all of Impact investing capital invested and number of which is reinforced by a rigorous process of corporate engagement. investments, 2014 and 2018 In four years, there was double-digit growth in both the dollar value of impact investing capital committed as well as the number of investment opportunities. ESG integration with securities analysis Investors and the asset management industry are increasingly viewing the 8,000 $15 incorporation of ESG considerations in their investment process as inherently $13.6b part of fi duciary duty as opposed to be something outside of a fi duciary remit. 6,617 Even in recent years, trade groups such as the Council of Institutional Investors Impact capital invested (USD billions) have questioned if seeking to mitigate ESG impacts goes against their duty $12 of striving for investment returns of their stakeholders. This view is changing 6,000 (and, again, driven from outside the U.S.) by governmental and regulatory guidelines such as the European Union’s Markets in Financial Instruments 4,396 $9 Directive (MIFD) II regulation which, in part, requires that asset managers must $7.5b ensure that ESG factors and risks are part of their investment process. 4,000 Additionally, there is the recent EU “taxonomy” of classifying green invest- ments and asset managers overseeing those investments. The United $6 Kingdom’s Stewardship Code (implemented in January 2020) requires that managed capital has a long-term value that refl ects “sustainable benefi ts for Number of investments 2,000 the economy, the environment and society.” $3 It’s clear that regulatory guidance will eventually affect global invest- ment management because many 0 $0 institutional investors and asset 20182014 Investors are managers operate on a global ■ Number of investments increasingly viewing basis. Therefore, it would be ■ Impact capital invested (USD billions) ESG incorporation nearly impossible to invest by one Source: Global Impact Investing Network set of standards in the U.S. as as inherently part of opposed to those utilized abroad. their fi duciary duty. Securities analysis depends on reporting and corporate disclosures under accounting standards. For its part, ESG metrics have come a long way in recent years, though, more needs to be done. Independent organizations such as the Global Reporting Initiative (GRI), and its GRI Sustainability Reporting Standards as well as the Sustainability Accounting Standards Board have done much to create standardization of corporate sustainability The value of engagement reporting in order to assess the economic impact of corporate actions. We’ve established that ESG considerations are a vital part of an investment Interestingly, however, it’s only recently been proven that companies’ process and that change occurring at a company with regard to these valuations benefi t from more sustainability disclosures, according to a metrics is more valuable to understanding than the static metrics themselves. Harvard Business School working paper.9 Additionally, sell-side analysts have Studies have shown that real change (and, therefore, real value creation) fi nally curtailed their historic practice of downgrading their ratings doesn’t happen without strong management and the effective implementa- on public companies with high corporate social responsibility efforts.10 tion of a corporate strategy. The effectiveness of management and strategy cannot be assessed and potentially infl uenced, however, without ongoing Because the standards of ESG disclosures are a work in progress, ESG engagement. Engagement is about enhancing and protecting the value of considerations must be intertwined with traditional fundamental securities portfolio investments. For all types of investors, that means a constructive, analysis for assessing the future value of companies’ earnings, the discounting long-term dialog with portfolio companies that goes beyond the traditional of future cash fl ows or the ability to service debt. As sustainability practices of periodic meetings with corporate management—in other words, real companies have major consequences to the economy and society in general, long-term stewardship. they directly affect the long-term economic value of the company. Therefore, the integration of ESG criteria and fundamental analysis is inherent in the Effective engagement is integral to an investment research process that exercise of investing in general, i.e., the allocation of capital to the companies incorporates quantitative and qualitative elements (ESG elements in addition that create the most economic value over time. Stated another way, if an to growth, profi tability, , etc.), risk assessment and evaluation investor is looking for companies with so-called moats or decided competitive of corporate behavior. All of which creates actionable investment ideas and advantages then ESG criteria, which goes directly to a company’s long-term the potential to realize long-term value in an investment. competitive advantage or disadvantage, must be fundamental to the investment process. Federated Hermes pioneered stewardship and engagement as a service, establishing Equity Ownership Services—or EOS—in 2004. We believe engagement is a pragmatic, iterative process, taking into account High-net-worth and multi-family-offi ce company-specifi c and market-specifi c circumstances. To understand the incorporation of ESG criteria, 2019 scope of an engagement program, EOS may engage about 400 companies at a time in deep-level engagements that can take years. HNW investors and institutions are increasingly integrating ESG considerations in their investment process. We believe a rigorous engagement program differs from traditional investment management interaction with companies because engagement offers: 35% A long-term, dynamic process that goes beyond typical management presentations and proxy voting procedures, 30.0 30% Encouragement in practical measures for companies to take or disclosures to surface, 25% An advisory role in providing cost-benefi t analysis for different material 22.0 concerns around corporate governance, climate, labor standards, gender equality and myriad other factors as applicable. 20% 19.019.0

Federated Hermes also utilizes a proprietary system called ESG Dashboard, 15% which is incorporated into investment teams’ existing fundamental selection process. ESG Dashboard combines proprietary information, data 10% from many of the third-party providers, as well as engagement information 7.0 from EOS.

5% 4.0 Putting it all together 0% Even for the most fi nancially sophisticated private-equity-style impact ESG Negative Positive Impact OtherSustainability- integration screening screening investing themed investing programs, the measure of success always comes back to investing achieving investment goals. Investment goals—whether it’s risk-adjusted returns or positive societal objectives or a combination of both—drive any Source: Cerulli Associates investment process. Incorporating ESG criteria into fundamental research will be crucial to reaching any type of investment goals in the future. Investors’ consideration of ESG factors in their investment processes is relatively new by historical standards, but has advanced rapidly in the past decade. Depending on an investor’s overall objectives, ESG integration and corporate engagement should be used to better realize long-term value in portfolio investments. *Alpha: This measures an investment strategy’s risk-adjusted performance. It represents the difference between an investment strategy’s actual returns and its expected performance, given its level of risk as measured by (see defi nition of Beta). This difference is expressed as an annualized percentage. Beta analyzes the market risk of an investment strategy by showing how responsive the investment strategy is to the market. The beta of the market is 1.00. Accordingly, an investment strategy with a 1.10 beta is expected to perform 10% better than the market in up markets and 10% worse in down markets. Usually the higher betas represent riskier investments. 1 https://www.ft.com/content/54f96d4e-82ec-11e9-9935-ad75bb96c849 2 “Annual Impact Investor Survey 2019,” Global Impact Investing Network 3 https://www.institutionalinvestor.com/article/b1j1161j66t61g/Asset-Managers-Say-They-re-Into-ESG-Their-Product-Descriptions-Say-Otherwise 4 Morningstar Direct, MSCI All Country World Index NR USD v MSCI All Country World Index /Energy NR USD 5 Clark, Gordon L. and Feiner, Andreas and Viehs, Michael, From the Stockholder to the Stakeholder: How Sustainability Can Drive Financial Outperformance (March 5, 2015). Available at SSRN: https://ssrn.com/abstract=2508281 or http://dx.doi.org/10.2139/ssrn.2508281 6 Mozaffar Khan, George Serafeim, and Aaron Yoon (2016) Corporate Sustainability: First Evidence on Materiality. The Accounting Review: November 2016, Vol. 91, No. 6, pp. 1697-1724. https://doi.org/10.2308/accr-51383 7 https://www.institutionalinvestor.com/article/b1hm5ghqtxj9s7/Where-ESG-Fails 8 Ibid 9 Ioannou, Ioannis and Serafeim, George, The Consequences of Mandatory Corporate Sustainability Reporting (May 1, 2017). Harvard Business School Research Working Paper No. 11-100 . Available at SSRN: https://ssrn.com/abstract=1799589 10 Ioannou, Ioannis and Serafeim, George, The Impact of Corporate Social Responsibility on Investment Recommendations: Analysts’ Perceptions and Shifting Institutional Logics (July 1, 2015). Strategic Management Journal, Volume 36, Issue 7, pp. 1053-1081, July 2015. Available at SSRN: https://ssrn.com/abstract=1507874 or http://dx.doi.org/10.2139/ssrn.1507874 The MSCI ACWI is a weighted index designed to provide a broad measure of equity-market performance throughout the world. MSCI All Country World Index/ Energy provides a measure of the energy sector’s equity market performance throughout the world. Views are as of March 16, 2020 and are subject to change based on market conditions and other factors. These views should not be construed as a recommendation for any specifi c security or sector. Past performance is no guarantee of future results. There is no guarantee that any specifi c investment strategy will be successful.

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