SEPTEMBER 2016 EXPERT VIEW ESG IN CREDIT: APPLYING EXCLUSION CRITERIA TO INVESTMENT PORTFOLIOS

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1 FOR PROFESSIONAL CLIENTS ONLY. NOT TO BE DISTRIBUTED TO RETAIL CLIENTS. This strategy is offered by Insight North America LLC (INA) in the United States. INA is part of Insight Investment. Performance presented is that of Insight Investment and should not specifically be viewed as the performance of INA. Please refer to the important disclosures at the back of this document. SEPTEMBER 2016 EXPERT VIEW ESG IN CREDIT: APPLYING EXCLUSION CRITERIA TO INVESTMENT PORTFOLIOS > Many of our clients who invest in credit have asked us whether excluding particular stocks, sectors or activities from their portfolios will have a material impact on performance. Our analysis suggests that broad ethical screens are likely to have a minimal effect on long-term returns but more focused screens could have a larger impact. Photo credit: The Ocean Cleanup. Artist impressions by Erwin Zwart/The Ocean Cleanup.

2 WE ANALYZED HOW TWO SETS OF EXCLUSIONS THE SCREENS COMMONLY APPLIED TO ETHICAL EQUITY FUNDS, AND FOSSIL FUEL SCREENS AFFECT COMMON INVESTMENT GRADE AND HIGH YIELD FIXED INCOME PORTFOLIOS. THE RESULTS SUGGEST THAT APPLYING ETHICAL SCREENS IS LIKELY TO HAVE A MINIMAL EFFECT ON INVESTMENT PERFORMANCE OVER FIVE OR TEN YEARS BUT THAT FOSSIL FUEL SCREENS COULD HAVE A MATERIAL EFFECT, IN PARTICULAR IN HIGH YIELD PORTFOLIOS WHERE OIL AND GAS-RELATED COMPANIES CAN FORM A SIGNIFICANT PART OF THE INDEX. Pension funds, endowments and other investors often explicitly exclude (or screen ) sectors or issuers from investment mandates. Sometimes this is an exclusively financial decision, based on the view that these sectors or issuers will not perform well in the future. On other occasions, the decision may be driven by factors such as the organization s charter, regulatory requirements that prohibit specific investments, public or media concerns, and the view some activities are in some way unethical. One of the key questions for investors is whether and how applying exclusions will affect investment returns. There is a large body of research on the performance of screened (or ethical ) equity funds. However, very little has been written about the impact of exclusions on fixed income portfolios. This is surprising given the importance of fixed income as an asset class for most institutional investors. In this paper, we start to address this knowledge gap by analyzing how two sets of exclusions affect investment grade and high yield fixed income benchmarks over a full business cycle. We also discuss some of the practical implications for investors looking to apply these sorts of exclusions to their investment portfolios. Growing investor interest in screens on fixed income portfolios Many of our clients apply negative screens to their portfolios. Their motivations differ. For some it is because they are religious investors and they want to invest consistently with their values. For others, it is because there are market expectations of how they will invest. Examples include the common use of norm-based screens in the Nordic markets and the wide use of controversial weapons screens. More recently, we have seen much greater interest in fossil fuels. This has been driven by concerns about climate change and stranded assets, the demands for greater transparency about portfolio holdings, pressure from clients, beneficiaries and non-governmental organisations, and the very significant movements we have seen in oil prices over the last two years. Clients have asked us about whether they should exclude fossil fuels from their portfolios and what the investment implications of such a decision could be. Fredrik Werneman CFA, Business Development Director, Europe, Insight Investment Photo credit: The Ocean Cleanup. Artist impressions by Erwin Zwart/The Ocean Cleanup.

3 SCREENING IN PRACTICE Investment exclusions are used by many investors around the world. Eurosif, in its 2014 survey of the European responsible investment market, estimated that exclusionary criteria were applied to about 7 trillion of all professionally managed assets in Europe. 1 Within this, it is estimated that approximately 4 trillion had multiple exclusions, with most covered by some or all of the traditional ethical screens of tobacco, alcohol, gambling and arms/weapons. The concept of screening is straightforward; it is that the investor will not invest in defined sectors or activities. However, the practice is much more complex. Investors define exclusions in very different ways. The consequence is that two portfolios with ostensibly identical exclusionary criteria may actually be allowed to invest in very different issuers. To provide a simple example, a decision to exclude tobacco companies from a portfolio raises questions such as: Which tobacco and related products are involved? Is it just cigarettes or does it also include products such as cigars or electronic cigarettes (e-cigarettes)? Does the exclusion apply to all companies involved in the manufacture of tobacco products, no matter what proportion of their business this represents? Does the exclusion apply to companies that generate some of their revenue from tobacco and related products, e.g. supermarkets who sell tobacco? If yes, what is the threshold for including or excluding companies on this basis? Does the exclusion apply to service providers? For example, would the provision of catering services at a cigarette manufacturing plant breach the fund s screens? Would the provision of advertising services to the tobacco industry be seen as breaching the spirit of the fund s screens? Furthermore, investment exclusions evolve. A good example is that of controversial weapons. Most European governments have signed and ratified the Convention on Cluster Munitions (2008) and the Convention on the Prohibition of the Use, Stockpiling, Production and Transfer of Anti-Personnel Mines and on Their Destruction (1997), known as the Anti-Personnel Landmines Convention. This has been followed by an increasing number of institutional investors making commitments not to invest in companies that are covered by these conventions. 2 More recently, the growing pressure on investors to divest from fossil fuels has led to investors making commitments not to invest in companies involved in the mining of coal or tar sands. Some have gone further and excluded companies involved in oil and gas production. In total, it is estimated that nearly 500 institutional investors, representing over US$3.5 trillion in assets under management have made commitments to partially or wholly divest from fossil fuels. 3 Examples include Ap2 (Sweden), CalPERS (USA), Environment Agency Pension Fund (EAPF), Local Government Super (Australia), PKA (Denmark) and the Norwegian Government Pension Fund Global (Norway). We have seen much greater interest in fossil fuels driven by concerns about climate change and stranded assets, demands for greater transparency, pressure from clients, beneficiaries and non-governmental organisations, and the movements in oil prices over the last two years 1 See 2 For example, the 2014 Eurosif survey of the European responsible investment market estimated that approximately 5 trillion of assets were covered by cluster munitions and anti-personnel weapons-related screens. See european-sri-study-2014/. 3 Data from Bloomberg New Energy Finance, December 2015.

4 Investment perspective Fossil fuel companies are among the largest debt issuers in the market. Significant capital expenditures mean that these issuers have regular contact with the market to raise money and they represent a large part of many corporate fixed income investment portfolios. The high level findings from this research are to be expected. Fossil fuel companies form a significant part of the US dollardenominated indices and, when you have a large change in underlying commodity prices, this has a direct impact on the indices. The collapse in oil prices over the past two years has had knock-on effects both for the producers and for those companies in sectors that rely on the producers. It is important to recognize that the fact that these sectors have underperformed in recent years does not mean that they will continue to underperform. A future recovery in oil prices and sector fundamentals could well lead to bonds issued by fossil fuel companies outperforming over time. Cathy Braganza, Senior Credit Analyst (high yield, energy), Insight Investment A future recovery in oil prices and sector fundamentals could well lead to bonds issued by fossil fuel companies outperforming over time OUR ANALYSIS We started by identifying appropriate benchmarks. We chose two investment grade and two high yield indices (see Table 1), with one of each being euro (EUR)-denominated and the other US dollar (USD)-denominated. We chose these because they are broadly comparable mainstream indices, with multiple bond durations, maturities, quality and type. These benchmarks enabled us to easily apply Barclays sector classifications for relevant industry sectors and chart the results. Table 1: Fixed income indices used in Insight s analysis Index Name Currency Members 4 Principal ($/ bn) 5 Barclays Global Credit EUR 1, Euro Investment Grade Barclays Euro High Yield EUR Barclays Global Credit USD 5, USD Investment Grade Barclays US High Yield USD 2, We analyzed these portfolios using two distinct sets of exclusionary criteria: Ethical screens: We defined these as companies that fell into the following Barclays-defined sectors: Aerospace/Defence, Tobacco, Gaming, Beverage, and Food and Beverage (including companies that produce wine, spirits and beer) 6. Fossil fuel screens: We defined these as companies that fell into the following Barclays-defined energy sectors: Independent, Integrated, Oil Field Services, Refining and Midstream. These sectors are most likely to be immediately impacted by fossil fuel regulations and subject of calls for divestment. We included companies involved in pipelines as these would be highly likely to be affected by changes in fossil fuel production or consumption. We used Barclays Point (herein referred to as Point) to screen the four fixed income indices. The investment grade and high yield indices generally only contain corporate issuers, and so we did not modify the contents of these indices. Government-related issuers represent a small part of the overall investable universe and were excluded from our analysis. This ensured we analyzed a fairly representative client benchmark. For the 10-year period from July 1, 2006 to June 30, 2016, we generated three sets of performance data for each bond index: the benchmark itself without exclusions; the benchmark minus issuers covered by the fossil fuel screens; and the benchmark minus issuers covered by the ethical screens. The Point software automatically adjusts the weight of the portfolio to account for changes in the underlying composition according to market value. We used the tools available on Point to measure the unhedged total return performance on a monthly basis. 4 Number of bonds issued. Data as of December 31, Principal amount issued. Data as of December 31, Food and Beverage sector classification also includes manufacturers of soft-drinks and food products.

5 FINDINGS AND ANALYSIS The overall results of our findings for the ten years to end June 2016 are presented in Table 2. We draw two high-level conclusions. The first is that the ethical screens have a modest effect on the benchmarks studied. When looking at the European and US investment grade indices, underperformance of the indices with an ethical screen, relative to the unmodified indices, was 25 and 31 basis points respectively. We also found relative impacts were limited on an annual basis. The second is that the fossil fuel screens have a moderate effect on the two investment grade indices and on the high yield EUR-denominated index. This finding also applies on an annual basis. However, the fossil fuel screens did have a significant effect on the high yield USD-denominated indices. When we analyzed these data in more detail, we found that 302 basis points of the outperformance occurred in the period Q to Q2 2016, a period that saw a significant decline in the oil price. That is, the underperformance of companies in the fossil fuel sector (and the corresponding outperformance of indices excluding this sector) is not unsurprising. We also analyzed the index composition to determine if underperformance or outperformance was related to the proportion of the index covered by the screens. We found that the proportion of the indices for ethical screens excluded ranged from approximately 3.5% to 7.0%, and that the proportion of the European indices covered by fossil fuel screens was under 5.0%. Within US indices fossil fuel companies accounted for approximately 8.0% 11.0% of excluded issuers. The effects of screens are more pronounced for indices where a higher proportion of the index is excluded. However, the fact that the effect was more pronounced in the US high yield index (versus the European high yield index where it is not) points to the importance of paying attention to the individual constituents of indices; in this particular case, it is unsurprising that US high yield benchmarks are more vulnerable to specific shocks and to rapid declines in oil prices. Table 2: Annual performance of fixed income indices from Q to Q US High Yield Index Ethical screen Ex-fossil fuels Year Total return (%) 12m to June 30, m to June 30, m to June 30, m to June 30, m to June 30, m to June 30, m to June 30, m to June 30, m to June 30, m to June 30, Total US Investment Grade Index Ethical screen Ex-fossil fuels Year Total return (%) 12m to June 30, m to June 30, m to June 30, m to June 30, m to June 30, m to June 30, m to June 30, m to June 30, m to June 30, m to June 30, Total Euro High Yield Index Ethical screen Ex-fossil fuels Year Total return (%) 12m to June 30, m to June 30, m to June 30, m to June 30, m to June 30, m to June 30, m to June 30, m to June 30, m to June 30, m to June 30, Total Euro Investment Grade Index Ethical screen Ex-fossil fuels Year Total return (%) 12m to June 30, m to June 30, m to June 30, m to June 30, m to June 30, m to June 30, m to June 30, m to June 30, m to June 30, m to June 30, Total

6 WIDER REFLECTIONS Our research points to three wider conclusions. The first is that there are no practical barriers to applying ethical exclusions to fixed income portfolios. It is primarily a question of identifying the issuers that are to be excluded and then applying restrictions. There is often, however, some work required to ensure that the application of these exclusions aligns with the client s ethical and investment objectives, and to ensure that any potential conflicts are explicitly identified and discussed. The second conclusion is that the effect of traditional ethical exclusions (or screens) appears likely to be relatively modest. This is important because much of the literature on the investment effects of screening does not focus on the magnitude of impact but instead seeks to assess the direction of impact, and to answer questions such as whether the exclusion of specific issuers reduces event or other risk, reduces diversification, or reduces the likelihood of outperformance. While these are important questions, our analysis suggests that the impact in either direction is unlikely to be material. The third is that the direction of impact i.e., whether the exclusions lead to performance being better or worse than the relevant index cannot be predicted. This is particularly important for the fossil fuel sector. While our analysis suggests that the exclusion of fossil fuels would have significantly enhanced investment performance in US high yield portfolios over the past decade, this is a direct consequence of the fall in oil prices in particular over the past two years. However, looking forward, the reverse might also apply; a period of strong oil prices could lead to this sector materially outperforming rather than underperforming. Practicalities of implementing screening strategies in fixed income In recent years, environmental, social and governance (ESG) research providers have broadened the scope of the screening research they offer. There is now good coverage of most recognized investment grade indices, and it is reasonably straightforward to generate a list of investment grade issuers that do not meet standard ethical criteria. The situation is more complex in the high yield space. Research providers often only provide partial coverage of issuers. This means that there is often a need to conduct issuer-specific analysis to assess whether a specific issuer fulfils the criteria set out by the screens. The major challenge we face relates to the interpretation of clients exclusion lists. For example, if an investor doesn t want to make investments in a tobacco manufacturer, is it okay to include a company, such as a supermarket, that sells them? Similarly, if an investor does not want to invest in gambling companies, does this include television companies that allow them to advertise on their commercial breaks? It is also the case that the definition of ethical differs between countries. For example, while a number of our German clients explicitly exclude nuclear power from their investment portfolios, nuclear power tends to be looked upon favorably by our French clients. These variations mean we work with clients to ensure they clearly articulate their ethical and investment objectives. We frequently need to in a similar manner to the analysis presented here analyse the investment implications of the proposed screens and of the different ways in which these screens may be defined and interpreted. Joshua Kendall, ESG Analyst, Insight Investment Research providers often only provide partial coverage of issuers. This means that there is often a need to conduct issuer-specific analysis to assess whether a specific issuer fulfils the ESG criteria set out by a portfolio s screens RESPONSIBLE INVESTMENT IN CREDIT AT INSIGHT INVESTMENT David Averre Head of Credit Analysis Joshua Kendall ESG Analyst Rory Sullivan Strategic Advisor, Responsible Investment For more information on our responsible investment activities, please us at ri@insightinvestment.com.

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