FNCE 254 - SRI/ESG

SRI portfolio AUM (Jan 2018)

-$12 trillion professionally managed (vs. $46.6 trillion total AUM in US) -26% of all professionally managed assets in US are SRI portfolios -Since 2005, SRI has grown more than 400% -91% of institutional ESG assets are managed by public funds and insurance companies -$3 trillion from individual investors, which traditionally are a keystone of SRI, but the additional growth really came from institutional investors

How have MSCI KLD 400, MSCI World SRI, and MSCI Global Environment performed against their benchmarks (list which benchmark)?

-20 years vs MSCI USA: +5 bps annualized SRI performance -8 years vs MSCI World: +44 bps annualized -7 years vs MSCI ACWI: -179 bps annualized

Envestnet Study (returns dispersion)

-2014 study - researchers at the investment platform Envestnet compared the performance of SRI and non-SRI funds at the outer ends of all the dispersion of returns to find if "there exist economically and statistically significant and persistent differences in performance between SRI and non-SRI funds when comparisons are made at the quantiles away from the median, differences that increase deeper in the tails of these distributions" --> Found these differences create a substantially different risk exposure profile for SRI funds in aggregate -Results show that SRI funds had better alpha during bear markets/market shocks, the opposite happened during bull markets

Sin stock investing

-Also known as the shorting impact -Small market for investors who want to "short" impact -Sin stocks supposedly beat the market during recessions

Turnover

-Amount you buy/sell your portfolio investments per year -ESG has lower turnover (patient capital, window dressing)

History of MSCI Indices

-Amy Domini created the Domini 400 Social Index in 1990, now known as the MSCI KLD 400 Social Index; consists of 400 primarily large-cap US corporations, designed to be like the S&P 500 except including SRI screens, US companies exclusively -MSCI acquired KLD 400 Index, spurring a creation of a large family of SRI indices for both equity and fixed income

Role of pension plans in global investing

-As of Jan 2018: US retirement plan assets were $28.2 trillion --> 61% of US investment assets -$40 trillion in pension assets in the OECD -Need to care about legal duties the DoL imposes on US pension plan managers -A lot of economic power given size!!!

Negative Screening

-Constrain security selection to those which avoid a defined negative social impact -Why? --> brand image, not aligned with values, market has not priced in negative externalities, divestment (pressure) notion, systematic risk lower, negative investments are costly -Examples: alcohol, tobacco, gambling, nuclear power, firearms, abortion, usury, porn

Perceived costs of ESG (Geczy-Stambaugh-Levin)

-ESG more expensive b/c harder to find investments and buy the data -Compensation for utility (lower sharpe ratio but higher utility)

Load

-Entrance/exit fees -Traditionally, promoted lower turnover -ESG more expensive

Positive screening

-Favor, or constrain selection to, those securities which meet defined criteria for inclusion in the SRI portfolio -Why? --> consistent with preferences, diversifications, have a vote -Examples: firms who use/invest in renewable energy, community involvement, diverse board

ERISA (Employee Retirement Income Security Act)

-Federal law that sets minimum standards for pension and health plans in private industry to provide protection for individuals in these plans (every decision has to be solely in the interest of planned beneficiaries) -Enforced by Department of Labor (DoL)

Interpretive Bulletin 2015-01

-Gave ERISA fiduciaries wider latitude for social investments

Adjusting for risk: four factor model (Geczy-Stambaugh-Levin)

-HML (high to low; value - growth); ESG is negative, meaning more growth than value (not significant) -SMB (small - big) - beta on the return that longs small stocks and shorts big stocks; ESG has strong tilt towards small stocks (b/c often looking for pure-plays), Non-ESG has weaker tilt towards small -MKT - ESG significantly greater than non-ESG -MOM - momentum (price continuation); ESG follows price trend -Delta (alpha) - extent to which we get the model wrong; holds risk constant, no significant error; shows that overall, ESG is NOT ANY WORSE than non-ESG investments

Main options for measurement or indexing of SRI investments

-MSCI Indices -MSCI IVA -Dow Jones Indices -Calvert Indices -FTSE Indices

Intangible Value Assessment (IVA)

-MSCI's methodology for generating company scores on various SRI/ESG measures to qualify or disqualify a company (or bond) for index inclusion; also sold as a separate product -Partly subjective Formerly known as KLD Stats until 2009

Universities' attitude toward SRI investing

-Only 16% of university endowments apply some form of ESG criteria to investments (NACUBO STUDY) -Many boards have voted to exclude responsible investing considerations (b/c of costs associated), but many third-party stakeholders want meetings regarding responsible investing considerations

Expense ratio

-Proportion of fees to AUM -ESG funds have higher fees because of lower supply, perceived high effort, greater demand, higher return, etc.

The Boston Foundation - SRI

-Starts with investment policy; emphasis on environment, community engagement, diversity, good corporate governance -Active commitment to ESG (mission-related investment)

FTSE4Good Index Series

-Subsidiary of the London Stock Exchange Group; FTSE 100 is the LSE analogue to DJIA -4/9 indices are tradable, other 5 are benchmarks -FTSE4Good tradable indices - global, European, US, UK (cover largest 50-100 companies in associated benchmark index) -FTSE4Good benchmark indices - same regions as tradable indices but adds Japan; can't invest in a benchmark

Trump administration attitude towards SRI

-Tapped the brakes on SRI in ERISA plans -Trump DoL guidance in 2018 (Field Assistance Bulletin No. 2018-01) reaffirmed Obama approach, including use of ESG factors as part of expected economic return, but cautioned: "fiduciaries must not too readily treat ESG factors as economically relevant"

TNA

-Total net assets -ESG has lower TNA (b/c newer)

Socially Responsible Investing

-Type of security selection in which positive and/or negative screening constraints exist to achieve social as well as investment returns

Examples of screens that are both positive and negative

-animal rights -labor relations and workplace conditions -diversity -environment -human rights

Examples of fiduciary duties

-duties of care and loyalty -duty to act in good faith -duty of disclosure -duty to monitor (investment performance) -have reasonable basis for investment advice -avoid conflicts of interest

Costs of SRI/ESG

1. Diseconomies of scale - funds tend to be smaller 2. Need more information to make more complex decision; costly to acquire 3. Technically a cost to give up some amount of return to achieve social impact From Geczy Study: 1. Expense ratios higher for SRI funds 2. Load (sales percentage) tends to be higher for SRI 3. Cost varies with amount allocated to SRI funds

Examples of Public Pension Plans looking to divest

1. Fossil fuel investments are targeted the most, such as San Francisco pension plans' divestment from coal companies; some UK pension plans divest from fossil fuels 2. NYC pension plans divestment plan and committed to "engagement" - but shareholder cannot both divest and be an activist 3. CalSTRS and a Chicago pension plan divested from gunmakers in 2013

Three key things to look at when activating SRI portfolio (Katherine Klein mentioned)

1. Intentionality -Identify SRI across the portfolio -Have to mean what you invest in (be intentional about impact) 2. Additionality -SRI has to actually add something new to the portfolio, distinctive, doesn't conflict/overlap with other investments 3. Measurability -Measuring via ratings, standardized ESG principles

Conclusions from the Geczy-Stambaugh-Levin mean-variance construction of an optimal portfolio

1. On an aggregate basis, the SRI constraint does not tightly bind for a typical optimal equity mutual fund investor seeking the highest ex ante reward-to-risk tradeoff 2. In the case of market index investors, the expected SRI cost appears low for reasonable parameters 3. the SRI constraint has expected costs when one believes that a) style matters or b) fund managers have skill or c) pricing models in the industry have flaws

Some trends in SRI investing

1. of the ~$8B SRI investments in 2016, $3B were investment funds, mostly mutual funds and alternatives 2. Mutual funds invested mostly in G, then S, then E criteria in 2018 (but all basically even) 3. ESG funds grew drastically post-2008 financial crisis 4. No. of SRI Mutual Funds increased by 10 times in the last decade

Bush administration attitude towards SRI

2008 additional guidance (IB 2008-1) requiring documentation of an analysis of SRI investment showing that it does indeed have competitive risk/return with non-SRI investments; many thought of it as "waving off" plans from SRI investment

ESG trend in SRI currently

32% of SRI assets are managed within funds incorporating ESG factors, and institutional assets subject to ESG screens increased 33%, 2014-2016

Calvert Social Index

675 components, market cap-weighted index, value calculated daily -Universe: 1,000 largest US companies in Dow Jones Total Market Index -Calvert performs a "social audit" on each company about its products, environment, workplace, and integrity

Fiduciary duty

A legal duty to act solely in another party's interests; the strictest duty of care recognized by the US legal system -Regulated by common law, the Investment Advisers Act of 1940, and ERISA

Calvert Investments

Asset manager, mutual fund family with proprietary index; separate foundation promotes SRI & Corporate Social Responsibility

SRI and Non-Profits

Charitable boards may have duty to consider SRI

Leading ESG issue considered by money managers

Climate change (b/c of preferences and measurability) - ~$2.9 trillion

Investment Advisers Act of 1940 (Advisers Act; 40 Act)

Common law that defines, regulates, and enforces investment fiduciary duties, is enforced by the SEC

Leading ESG criteria for University Endowments

Conflict risk (terrorist or repressive regimes)

Example of shareholder activism

Engaging management on executive pay, to commit to sustainability

"E" in ESG

Environment - includes climate change mitigation, sustainability, and other consideration of company policy and outcomes relating to the environment

US Department of Labor's view on SRI investments in pension plans (1998)

Every investment necessarily is at the expense of another. You need to consider the returns of alternate SRI investment and compare your SRI investment to it as far as return goes -But, SRI was first addressed in 1994 (IB 94-01)

"G" in ESG

Governance - "good corporate governance" includes management/board transparency and accountability to shareholders, reasonable compensation structures, etc. -Lately, G has come to include specific corporate policies to promote social goals such as board diversity, CSR, and disclosure of money spent on politics

Perception of SRI to investors

Investors interested in: -Ex ante maximization of the Sharpe Ratio (quadratic investor) -Using mutual funds only (allows us to define the problem narrowly enough to provide an answer) but has opinions about: -manager skill -how good the style adjustment model is

Dow Jones Sustainability Indexes

Launched 1999, 1st global sustainability benchmark; include only companies that fulfill certain sustainability criteria better than majority of peers; no sectors excluded; custom indices can be created Examples: Dow Jones Sustainability Index World, Europe, North America, etc.

Main reasons institutional investors report considering ESG

Mission and social benefit

Business Roundtable

Non-profit whose members are CEOs of major US companies, such as Jeff Bezos and Larry Fink

Trend of SRI in pension plans in Europe

Over the past several years, European governments and pension plans have moved decisively to integrate SRI into investment policy -For example: Norway Oil Fund ($1T) documented 66 companies it divested from due to their carbon emissions levels; France became first country in 2015 to mandate ESG reporting by institutional investors

DoL's view of SRI

SRI is consistent with fiduciary duty if risk/return of the portfolio is competitive with alternatives; however an ERISA fiduciary is always required to act in the interests of plan beneficiaries only.

"S" in ESG

Social - any consideration of a social return factor which is not E or G

MSCI World SRI Index

Target highest ESG-rated companies making up 25% of market cap in each sector of underlying index (targeting 25% instead of 50% of the parent index = more rigorous screening) Examples: MSCI World SRI Index, MSCI ACWI SRI, MSCI EM SRI, MSCI KLD 400 (US only) -Also: MSCI Global Environment, MSCI Global Climate Fixed Income Barclay's MSCI Indexes

MSCI Global Sustainability Indexes

Target highest ESG-rated companies making up 50% of market cap of the underlying index Examples: MSCI World ESG, MSCI EM ESG, MSCI USA IMI ESG and MSCI ACWI (all country world index) ESG indexes

Greenwashing

The practice of making statements that make an investment (or fund) appear more serious about ESG than it actually is. It tends to have no meaningful impact other than positive PR

Obama administration attitude towards SRI

Thomas Perez (US Secretary of Labor 2015) had friendliest language (tolerant) toward SRI; another change is that ERISA fiduciaries analyzing investments are now free to consider policies of companies as potentially improving risk/return