ESG Materiality and Disclosure 2.5.3 ESG Materiality and Disclosure

momentum crash

A momentum crash occurs when those assets with recent overperformance (i.e., those assets with momentum) experience extremely poor performance relative to other assets.

dominate

A portfolio is said to dominate another portfolio if it offers a higher expected return with the same level of risk, a lower risk with the same expected return, or both higher expected return and lower risk.

risk bucket

A risk bucket indicates the amount of a particular type of risk that can be tolerated.

top-down approach

A top-down approach analyzes the macroeconomic environment and then determines the weights and the combination of industry sectors, countries, and so on that best meet the program objectives under the likely scenarios.

utility function

A utility function is the relationship that converts an investment's financial outcome into the investor's level of utility.

corpus

An endowment fund may have specific restrictions on the capital, restricted gifts, that may require that the university maintain the corpus, the nominal value of the initial gift, while spending the income generated by the gift to benefit the stated purpose.

restricted gifts

An endowment fund may have specific restrictions on the capital, restricted gifts, that may require that the university maintain the corpus, the nominal value of the initial gift, while spending the income generated by the gift to benefit the stated purpose.

naïve asset allocation strategy

An equally‐weighted, 1/N, or naïve asset allocation strategy refers to constructing a portfolio with an equally‐sized allocation assigned to each asset (or sector).

expected default frequency (EDF)

An important output from the KMV model is the calculation of the expected default frequency (EDF), which will measure theoretically or empirically the probability that loans of certain characteristics could default.

risk averse

An investor is said to be risk averse if his or her utility function is concave, which in turn means that the investor requires higher expected return to bear risk.

Adaptive Markets Hypothesis (AMH)

As first proposed by Lo (2004), the Adaptive Markets Hypothesis (AMH) is an approach to understanding how markets evolve, how opportunities occur, and how market players succeed or fail based on principles of evolutionary biology.

tradable assets

As its name implies, a tradable asset is a position that can be readily established and liquidated in the financial market, such as a stock position, a bond position, or a portfolio of liquid positions.

core-satellite approach

Broadly speaking, the core-satellite approach seeks to merge passive investing with active management in an attempt to outperform a benchmark.

cap and trade

Cap and trade is a government program regarding pollution or other externalities that specifies caps (allowances) on the activity for each entity but allows each entity to trade its rights (e.g., its allotment of pollution).

credit events

Credit events that give rise to credit risk include bankruptcy, downgrading, failure to make timely payments, certain corporate events, and government actions.

expected utility

Expected utility is the probability weighted average value of utility over all possible outcomes.

fundamental, style, investment, or dynamic factors

Fundamental, style, investment, or dynamic factors tend to drive equity returns within asset classes and include well‐known style factors such as value, size, momentum, quality, and low volatility.

funding liquidity risk

Funding liquidity risk arises when a borrower or investor is unable to immediately pay what is owed.

minimum volatility portfolio

Graphically, the minimum volatility portfolio may be envisioned in a mean‐variance framework as the leftmost point on a mean‐variance efficient frontier where the frontier is tangent to a vertical line.

greenwashing

Greenwashing occurs when investment promoters mislead prospective investors with overstated claims regarding the likely social impact of an investment opportunity.

impact investing

Impact investing is the inclusion of ESG and related issues in the asset allocation and security decisions of the investor with the goal of generating positive environmental and social influence alongside financial returns.

engagement strategy

In an engagement strategy, an investor with a long position in the stock starts a dialogue with the company with a specific agenda on how to improve the ESG standing of the company.

spending rate

In contrast to endowments, which typically have flexibility in their spending rate (which is the fraction of asset value spend each year. year), US law requires that foundations spend a minimum of 5% per year on operating expenses and charitable activities.

tragedy of the commons

In economics, the tragedy of the commons is the problem that individuals or entities will tend to overconsume or undervalue natural resources and other assets that are available for common use (i.e., shared or non-excludable) since the costs are borne by all.

utility

In the context of investments, we define utility as a measurement of the satisfaction that an individual receives from investment wealth or return.

resampling returns

In the context of mean-variance portfolio optimization (i.e., estimation of the efficient frontier), the method of resampling returns strives to reduce estimation error and typically is executed by: (1) repeated analysis of hypothetical returns simulated from the statistical parameters estimated from the original sample of returns; or (2) repeated analysis of new samples of returns generated from the original sample using draws with replacement.

shrinkage

In the context of mean-variance portfolio optimization, shrinkage is the process of implementing a statistical method designed to generate estimated statistical parameters (means, variances, and/or covariances of returns) that differ from those obtained from an unconstrained analysis of historical returns and that provide improved solutions with narrower confidence intervals.

negative or exclusionary screening

Investors focused on negative or exclusionary screening, choose not to invest in entire industries of publicly traded companies due to the firm's involvement in activities deemed objectionable, often based on the morals or religion of the investor.

macroeconomic factors

Macroeconomic factors drive asset returns throughout the entire economy and across asset classes, and include productivity, inflation, credit, economic growth, and liquidity.

market liquidity risk

Market liquidity risk arises when an event forces an investor to sell an asset that is not actively traded and there are a limited number of active market participants.

mission-related investments (MRI)

Mission-related investments (MRI) are investments viewed as offering a combination of ESG impact as well as financial return.

modern portfolio theory (MPT)

Modern portfolio theory (MPT) is based on Nobel Prize-winning economist Harry Markowitz's insight that because they have unique risk and return characteristics, less than perfectly correlated assets can be combined in a way that maximizes return for any given level of risk.

multi‐factor models

Multi‐factor models of asset pricing express systematic risk using multiple factors and are extremely popular throughout traditional and alternative investing.

negative externalities

Negative externalities are adverse consequences on third-party entities caused by contracts or transactions controlled by two or more primary parties and can include pollution, noise, congestion, and other potentially deleterious consequences to parties that did not have control of the contract or transaction.

satellite portfolio

Positions in the satellite portfolio are added in the form of actively managed and higher-cost investments.

The Six Principles for Responsible Investment (PRI)

Principle 1: We will incorporate ESG issues into investment analysis and decision‐making processes. Principle 2: We will be active owners and incorporate ESG issues into our ownership policies and practices. Principle 3: We will seek appropriate disclosure on ESG issues by the entities in which we invest. Principle 4: We will promote acceptance and implementation of the Principles within the investment industry. Principle 5: We will work together to enhance our effectiveness in implementing the Principles. Principle 6: We will each report on our activities and progress towards implementing the Principles.

program-related investments (PRI)

Program-related investments (PRI) are investments offering ESG impact and no financial return or offering a combination of ESG impact as well as a sub-competitive risk adjusted financial return.

proxy voting

Proxy voting is where shareholders vote on issues put up for election by management, typically focused on routine elections of board members and service providers.

betting against beta

Related to the volatility anomaly is the "betting against beta" anomaly, which has been documented with the observation that portfolios consisting of low‐beta stocks have outperformed the market in the past on a risk‐adjusted basis.

risk budgeting

Risk budgeting refers to a broad spectrum of approaches to portfolio construction and maintenance that emphasize the selection of targeted amounts of risk and the allocation of the portfolio's aggregate risk to those various categories of risk.

sin stocks

Sin stocks include firms profiting from products and services such as gambling, tobacco, or alcohol sales.

statistical factors

Statistical factors drive asset returns within an entire economy, asset class, or sector and are distinguished by having been identified purely on empirical characteristics rather than style or economic characteristics.

stochastic discount factors

Stochastic discount factors (pricing kernels) are used in asset valuation models to allow the present value of each cash flow (across each potential economic state) to be formed with potentially different discount rates rather than imposing that all potential cash flows be discounted with the same rate.

tactical asset allocation

Tactical asset allocation is the process of making portfolio decisions to alter the systematic risks of the portfolio through time in an attempt to earn superior risk-adjusted returns.

the Fama-French five-factor model

The Fama-French five-factor model adds two factors to the Fama-French three-factor model: robust minus weak, and conservative minus aggressive.

Fama-French model

The Fama-French model links the returns of assets to three factors: (1) the market portfolio; (2) a factor representing a value versus growth effect; and (3) a factor representing a small-cap versus large-cap effect.

Fama-French-Carhart model

The Fama-French-Carhart model adds a fourth factor to the Fama-French model: momentum.

G4 Materiality Principle

The G4 Materiality Principle asserts that: "[An ESG‐related] report should cover aspects that: reflect the organization's significant economic, environmental, and social impacts; or substantively influence the assessments and decisions of stakeholders."

The Global Reporting Initiative (GRI)

The Global Reporting Initiative (GRI) is a non‐governmental organization (NGO) that promotes improved reporting principles and disclosure of ESG‐related issues through the development of the GRI Standards.

Heston model

The Heston model is much like the classic Brownian motion (Weiner process) used for equity returns in the Black-Scholes model except that the volatility coefficient is itself a mean-reverting stochastic process.

KMV model

The KMV model is a structural credit risk model that uses Merton's model and estimates of the volatility and total value of the firm's underlying equity and assets to estimate the credit risk of the debt.

default trigger

The Merton model default trigger for the firm's total asset value is the face value of the zero-coupon bond, because it represents the asset value at which the firm would be on the brink of default.

Principles for Responsible Investment (PRI)

The Principles for Responsible Investment (PRI), formerly known as the UN PRI or United Nations Principles for Responsible Investment, is a non‐exhaustive set of six proposals designed to "provide a global standard for responsible investing as it relates to environmental, social, and corporate governance (ESG) factors."

SASB Materiality Map

The SASB Materiality Map analyzes ESG‐related issues along two major dimensions: ESG category (e.g., environment) and industry (e.g., consumer goods).

three characteristics of a program-related investment

The US Internal Revenue Service specifies three characteristics of a program-related investment: (1) 1. "The primary purpose is to accomplish one or more of the foundation's exempt purposes, (2) production of income or appreciation of property is not a significant purpose, and (3) influencing legislation or taking part in political campaigns on behalf of candidates is not a purpose."

Z-score model

The Z-score model focuses on a set of financial ratios that are based on a firm's financial statements as well as the market value of the firm's equity to generate a Z-score which is a relative rank of the likelihood of default.

endowment model

The asset allocation of major endowments and foundations, which typically includes substantial allocations to alternative investments and limited investments to listed stocks and bonds, has been called the endowment model.

assumed investor preferences

The assumed investor preferences are that most investors dislike variance, like positive skewness, and dislike kurtosis.

bottom-up approach

The bottom-up approach is based on fund manager or security specific research, in which the emphasis is on screening all investment opportunities and picking the perceived best.

conservative minus aggressive factor

The conservative minus aggressive factor is designed to distinguish firms by the rate of reported corporate asset investment (with conservative firms exhibiting a lower rate of investment in corporate assets).

degree of risk aversion

The degree of risk aversion indicates the tradeoff between risk and return for a particular investor.

distance to default (DD)

The distance to default (DD) is the number of standard deviations away from default and is approximately measured as the percentage difference between a firm's assets and its default trigger relative to the volatility of its assets.

efficient frontier

The efficient frontier is the set of all feasible combinations of expected return and standard deviation that can serve as an optimal solution for one or more risk-averse investors.

empirical approach to credit risk modeling

The empirical approach to credit risk modeling is based on the assumption that it is too difficult to model the company and its environment accurately.

default intensity

The higher the default intensity, the shorter the expected time to default.

hurdle rate

The hurdle rate is the minimum expected rate of return that a new asset (i.e., an asset not already included in a portfolio) must offer in order to be a beneficial inclusion in an otherwise existing optimal portfolio.

intergenerational equity

The investment goal of an endowment manager should be to maintain intergenerational equity, balancing the need for spending on the current generation of beneficiaries with the goal of maintaining a perpetual pool of assets that can fund the operations of the organization to benefit future generations.

liquidity penalty function

The liquidity penalty function reflects the cost of illiquidity and the preference for liquidity.

robust minus weak factor

The robust minus weak factor is designed to distinguish firms by a specific measure of their reported accounting profitability (with robust firms having exhibited higher accounting profits as a proportion of equity).

strategic asset allocation decision

The strategic asset allocation decision is the long-term target asset allocation based on investor objectives and long-term expectations of returns and risk.

three phases of the impact of adverse ESG events

The three phases of the impact of adverse ESG events: (1) In the emerging, or "pre‐financial" phase of an ESG lifecycle, a shift (subtle or overt) commences that ultimately has environmental, social, and/or governance consequences for a sector. (2) In the "transitional" phase, the ESG shift becomes increasingly visible, but neither its timing nor its ultimate financial impact are particularly clear. (3) In the ultimate phase of the lifecycle ‐ the "financial" phase ‐ the full financial impacts of the ESG event are felt.

community foundations

are based in a specific geographical area, concentrating the charitable giving of the region's residents.

independent foundations

are funded by an individual or a family. These foundations may be founded by a single gift, often by the senior executive of a large corporation who donates wealth in the form of stock.

individually managed retirement accounts

are no different from private savings plans, in which the asset allocation is directed entirely by the employee.

national pension funds

are run by national governments and are meant to provide basic retirement income to the citizens of a country.

foundations

are similar to endowments but tend to differ in a number of ways: (1) foundations are grant‐making institutions, whereas endowments tend to be funds established by educational, health‐care, or religious organizations; (2) foundations tend to be finite lived, whereas endowments tend to be perpetual; (3) foundations are more subject to minimum spending requirements; and (4) foundations are less likely to be funded from ongoing donations.

corporate foundations

are sponsored by corporations, with gifts provided by the corporation and its employees.

leverage aversion theory

argues that large classes of investors cannot lever up low‐volatility portfolios to generate attractive returns and that, as a result, low‐volatility stocks and portfolios are underpriced.

operating foundations

have the greatest similarity to endowments, as the income generated by an endowment is used to fund the operations of the charitable organization.

new investment model

investments are allocated with flexibility and in the explicit context of alpha and beta management.

constraint

is a condition that any solution must meet.

investment policy statement (IPS)

is a document that describes the primary goals for an investment program and lays out a framework to achieve those goals.

return target

is a level of performance deemed necessary to satisfy the goals of the owners or beneficiaries of the associated assets.

objective

is a preference that distinguishes an optimal solution from a suboptimal solution.

a common investment objective of endowments

is a return target X% above inflation, specifically connected to long‐term spending needs.

a common investment objective of pension funds

is a return target X% above the liability discount rate.

risk parity

is an asset allocation approach that identifies asset allocations based on balancing the contribution of each asset to portfolio risk without regard for expected return.

volatility anomaly

is the idea that low‐volatility stocks are underpriced and therefore offer higher expected risk‐adjusted returns and may be justified by market imperfections and the leverage aversion theory.

ESG materiality

is the property of being likely to be considered important (i.e., potentially having a substantial impact) from the reasonable perspective of stakeholders in the context of ESG principles.

external constraints

refer to constraints that are driven by factors that are not directly under the control of the investor.

internal constraints

refer to those constraints that are imposed by the asset owner as a result of its specific needs and circumstances and may be a function of the owner's time horizon, liquidity needs, and desire to avoid certain sectors.

credit score

A credit score is a measure that can be used to rank or assess the relative riskiness of firms or securities.

factor

A factor represents a unique source of return and a unique premium in financial markets such that the observed return cannot be fully explained by other factors.

positive screening

A later version of screening was positive screening, where an investor's portfolio was designed to focus on publicly traded firms that were judged to have operations that performed in an exemplary manner on one or more ESG issues.

enviropreneurship

Enviropreneurship is an emerging branch of entrepreneurship that deals with a mixed motive of profit-seeking and concern regarding ESG-related issues, specifically using entrepreneurship to address environmental issues.

Bates model

The Bates model treats volatility as a stochastic process much like the Heston model except that it includes a jump process for the underlying asset's price that permits price jumps at random time intervals and with random magnitude.

Coase theorem

The Coase theorem asserts that, in competitive and frictionless markets, economically efficient production and distribution will occur regardless of how governments divide property rights.

mixed approach

This method, called the mixed approach, either starts with a bottom-up strategy, to which increasing top-down optimization is added, or starts as an iterative short process cycle, in which bottom-up screenings are followed by top-down analysis and then by bottom-up screenings.

time-varying volatility

Time-varying volatility is the characteristic of a return series in which the asset's returns experience varying levels of true (as opposed to realized) return variation.

core portfolio

Typically, the core portfolio consists of passive and often low-cost investments that track the overall performance of an asset class.