Encouraging companies to adopt best-in-class ESG practices. Active ownership drives responsible investment stewardship
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1 Encouraging companies to adopt best-in-class ESG practices. Active ownership drives responsible investment stewardship February 2018 This marketing document is exclusively for use by Professional Clients, Financial Advisers in Continental Europe (as defined in the important information) and Ireland as well as by Qualified Investors in Switzerland. This document is not for consumer use, please do not redistribute. Please read the Risk Warnings that appear on page 6. Environmental, social and governance (ESG) issues in investing have strongly grown in importance for investors across the globe and are now considered a mainstream consideration. ESG considerations are incorporated in a variety of ways, including active ownership as an overlay, which has become a very effective mechanism to drive responsible investment and strong investment stewardship, and encourage the companies in which we invest to adopt best-in-class ESG practices. At the same time, research indicates that performance is generally on par and in some cases can deliver stronger returns and reduce volatility. By Bonnie Saynay, Global Head, Proxy Governance and Responsible Investment, Invesco and Dr. Henning Stein, Head of EMEA Institutional Marketing, Invesco Application of ESG criteria. Investing in accordance with ESG principles involves the consideration of environmental, social and governance issues when selecting companies and countries in which to invest. There has been a proliferation of ESG vendors in this space including MSCI, Sustainalytics, and Vigeo Eiris. ESG criteria can cover many different aspects of corporate behaviour, with as many as 250 different criteria assessed by EIRIS (Ethical Investment Research Services) 1. Taking these factors into account is certainly not a new phenomenon. They have been evident at the country, corporate and sector level for many years. In the 1970s, selective disinvestment from South Africa because of the apartheid system became a global phenomenon. Other countries have been subject to divestment pressures and investment boycotts, including Sudan, Iran and Russia. There are around 150 countries with stock exchanges, but about half of them are omitted by all the major index providers 2. Many faith-based charities have long-prohibited investment in areas such as gambling, armaments, alcohol and tobacco. And corporate governance issues have been a focus of many active fund managers for a long time; in particular, the attention that companies pay to the interests of their shareholders. 1 Source: EIRIS global sustainability ratings, EIRIS-global-sustainability-ratings-2015.pdf 2 Source: Credit Suisse Responsible Investing: Does it pay to be bad? Credit Suisse Global Investment Returns Yearbook, /157815/Credit+Suisse/0c0ceeb5-c5af-464d-be00-fb1378cb0412 1
2 Shareholders in a company share in the responsibility for the firm s actions and so are complicit when errors are made. Defining moment in ESG evolution voluntary to statutory requirements Recently, however, there has been a growing view that owning shares or bonds in a company or investing in a country implies complicity with the actions of the company or country. A defining moment in the evolution of this idea was in 2003 when a committee that the Norwegian government appointed to propose ethical guidelines for the Government Petroleum Fund advised that owning shares or bonds in a company that can be expected to commit gross unethical actions may be regarded as complicity in those actions. The reason for this is that such investments are directly intended to achieve returns from the company, that a permanent connection is thus established with the company, and that the question of whether or not to invest in a company is a matter of free choice. 3 In this view, shareholders in a company share in the responsibility for the firm s actions and so are complicit when errors are made. There are also opportunity costs to consider when constraining your investment universe. 4 Voluntary exclusions may disrupt your ability to deliver strong client returns. Adjusting for poor ESG factors is an important part of active portfolio management. Active ownership provides an opportunity to change unsatisfactory behaviour. Today, one indicator of the increasing awareness of ESG issues is the growing number of institutional investors that are signatories to the United Nations-supported Principles for Responsible Investment (UN PRI), as figure 2 shows. Invesco became a signatory to the UN PRI in According to PRI, the assets under management of its signatories have grown from less than US$7 trillion at PRI s launch in 2006 to more than US$73 trillion as of April 2017, more than three-quarters of the global asset management industry s assets 5. Clients/investors demand consideration of ESG issues. Fiduciary obligations and ESG risk The motivations are manifold, as a recent survey by CFA Institute indicates 6 : the primary reason for taking ESG issues into account is that it helps to manage investment risks, for example, business risks such as a drop in a company s asset value or earning ability as a result of a breach of ESG standards. The second highest-ranked reason was the fact that clients/investors demand consideration of ESG issues. What approaches to ESG investing are used? In recent years a seven-way classification of ESG strategies, set out by the Global Sustainable Investment Alliance (GSIA), has become generally accepted 7 (figure 3). Does ESG investing lead to weaker performance? One concern that many investors have in adopting ESG strategies is that they may compromise investment performance. Partly because there is a wide variety of different ESG criteria and an equally wide variety of ways in which they can be reflected, the empirical evidence on the question of whether ESG investing leads to weaker performance is mixed and results can vary by region. However, we are encouraged by evidence that an emphasis on governance has been associated, in the past, with stronger returns. Perhaps the most comprehensive assessment of the link between ESG criteria and corporate financial performance (CFP), produced recently 8, found that the business case for ESG investing is empirically very well founded. Roughly 90% of studies find a non-negative ESG CFP relation. More importantly, the large majority of studies report positive findings and that the positive ESG impact on CFP appears stable over time. Looking at the link between ESG and stock market performance, a recent analysis by TIAA (Teachers Insurance and Annuity Association of America) 9 of leading ESG equity indices over the long term (from 1990) found no statistical difference in returns compared to broad market benchmarks, suggesting the absence of any systematic performance penalty. 3 Source: Graver Committee The Report from the Graver Committee Norwegian Ministry of Finance (2003). 4 Source: Jan Trinks, Pieter & Scholtens, Bert. (2015). The Opportunity Cost of Negative Screening in Socially Responsible Investing. Journal of Business Ethics /s Source: 3 Boston Consulting Group Global Asset Management 2016: Doubling Down on Data. 6 Source: CFA Institute, as at 7 November The results are from the survey of CFA Institute members on ESG issues on 26 May ,131 members who are portfolio managers and research analysts were invited via to participate in an online survey. The survey closed on 5 June 2015; 1,325 valid responses were received. 7 Source: 8 Source: Friede, Busch & Bassen ESG and financial performance: aggregated evidence from more than 2000 empirical studies Journal of Sustainable Finance & Investment, Source: TIAA Responsible Investing: Delivering competitive performance April
3 Figure 1: Performance of selected ESG indices World Equity Indices ESG approach years 5 years ACR 2 10 years 10 years ACR DJSI World Index net total return 1 S&P Golbal BMI Index net total return FTSE4Good Global Index total return FTSE Developed World Index total return MSCI ACWI ESG Universal Index total return MSCI ACWI Index total return Best in class: top 10% of the largest 2,500 companies in the S&P Global BMI bases on ESG criteria Parent index for DJSI World Index Exclusion of tobacco, controversial weapons and coal Parent index for FTS- E4Good global index Universal owner approach. Tilts towards those companies demonstrating a robust and improving ESG profile, using minimal exclusions from the MSCI ACWI index. Parent index for MSCI ACWI ESG Universal index. Includes large and mid-cap stocks in 23 developed markets and 23 emerging markets n/a n/a n/a n/a Sources: Thomas Reuters Datastream and MSCI; data as at 27 February Unless specified all indices returns are stated in US $. 1 Net total returns are after the deduction of withholding taxes, using (for international indices) a tax rate applicable to non-resident institutional investors who do not benefit from double taxation treaties. 2 Annual Compound Return. A number of ESG-based market indices have been developed. The variety reflects the different approaches, discussed above, to ESG assessment. Here we have mixed results compared to the respective parent indices (figure 1). Focussing just on corporate governance issues (the G in ESG) over an 18-year period from , a Harvard study 10 concluded that high-sustainability companies outperformed lowsustainability ones in terms of both stock market and CFP measures. The annual above-market average return for the high-sustainability sample was 4.8% higher than for their low-sustainability counterparts and with lower volatility. The high-sustainability companies also performed better as measured by return on equity and return on assets. Looking ahead, ESG investing may be capable of mitigating the risks of adverse outcomes. There is also evidence of the integration of ESG criteria in investment selection reducing downside risk. One study of 1,500 firms from 26 developed countries found that, from , integrating corporate environmental criteria into pension fund investment processes substantially reduces downside risk of pension portfolios 11. Equally, however, companies with a poor ESG record can still be good investments if they have the desire to change. Evidence on engagement with companies on ESG issues shows that excess returns can be generated. One study 12 found that, over a 10-year period from , corporate social responsibility engagements generated a cumulative size-adjusted abnormal return of +2.3% over the year following the initial engagement. 10 Source: Eccles, Ioannou and Serafeim The Impact of a Corporate Culture of Sustainability on Corporate Behavior and Performance Harvard Business School Working paper May 9th, Sample comprised 180 US companies Source: Hoepner, Rezec and Siegl Does Pension Funds Fiduciary Duty Prohibit the Integration of Environmental Responsibility Criteria in Investment Processes? A Realistic Prudent Investment Test (2011). abstract= Source: Dimson, Karakas and LI, cited in Credit Suisse Global Investment Returns Yearbook, Sample comprised of US companies only. 3
4 The important note of caution with all of these measures of performance is that they do, of course, relate to past performance. Looking ahead, one of the most important aspects of ESG investing is that, as it sets a higher standard for investment selection, it may be capable of mitigating the risks of adverse outcomes. Aiming for strong returns In our view, the importance of good corporate governance does not rely on empirical evidence for support. Strong and accountable boards, high-performance cultures, strong risk frameworks, diverse boards: these good corporate governance factors are bound to lead to strong financial results. And generating robust returns for clients that exceed expectations is our prime mandate. Given this, we have been actively involved in the ESG approach for over 30 years. We currently manage US $57bn in sustainable investments across ten investment centres, 19 different investment strategies and various ESG integration approaches. We are a PRI signatory and a Tier 1 signatory of the Stewardship Code of the UK Financial Reporting Council (FRC). Plus, we developed a highly flexible proprietary voting platform that enables our fund managers to take well-informed, thoughtful and independent proxy investment decisions in a democratised manner. Figure 2: Growth of PRI signatories AO AUM (US $ trillion) Number of AOs Assets under management (US $ trillion) Number of Signatories (US $ trillion) (Number ) Apr 06 Apr 07 Apr 08 Apr 09 Apr 10 Apr 11 Apr 12 Apr 13 Apr 14 Apr 15 Apr 16 Apr 17 Source: 4
5 Figure 3: Size of various sustainability strategies (US $bn) Negative/ exclusionary screening 15,023 Positive/ best in class screening Normsbased screening Integration of ESG factors Sustainabilitythemed investing Impact/ community investing Corporate engagement/ shareholder 10,369 8,365 6,210 1, Source: Global Sustainable Investment Alliance Global Sustainable Investment Review ESG investing is a mainstream consideration Fund managers have long considered implications around board governance, labour relations, and environmental regulations. ESG investing is a holistic framework for risk assessment that is becoming an ever-more important theme in investment management. There is broad acceptance of the need to take such criteria into account, as evidenced by, for example, the widespread adoption of the PRI principles. It is an approach that regards us not as shareholders of companies but as business owners. The approach taken in our active equity funds has always placed a strong emphasis on governance. It is an approach that regards us not as shareholders of companies but as business owners. As stewards of good governance, our fund management teams frequently engage with and visit portfolio companies, challenge boards, and drive for change where and when it is appropriate. In fact, we believe that active ownership is the single most effective mechanism to drive responsible investment and strong investment stewardship. 5
6 Contact Amsterdam Brussels Frankfurt Madrid Milan Paris Vienna Zurich Risk Warnings The value of investments and any income will fluctuate (this may partly be the result of exchange-rate fluctuations) and investors may not get back the full amount invested. Important Information This marketing document is exclusively for use by Professional Clients, Financial Advisers in Continental Europe (as defined below) and Ireland as well as by Qualified Investors in Switzerland. Data as at , unless otherwise stated. This document is not for consumer use, please do not redistribute. By accepting this document, you consent to communicate with us in English, unless you inform us otherwise. This document is marketing material and is not intended as a recommendation to invest in any particular asset class, security or strategy. Regulatory requirements that require impartiality of investment/investment strategy recommendations are therefore not applicable nor are any prohibitions to trade before publication. The information provided is for illustrative purposes only, it should not be relied upon as recommendations to buy or sell securities. Where individuals or the business have expressed opinions, they are based on current market conditions, they may differ from those of other investment professionals and are subject to change without notice. Further information on our products is available using the contact details shown. This marketing document is not an invitation to subscribe for shares and is by way of information only, it should not be considered financial advice. As with all investments, there are associated risks. This document is by way of information only. Asset management services are provided by Invesco in accordance with appropriate local legislation and regulations. For the distribution of this document, Continental Europe is defined as Austria, Belgium, Luxembourg, Finland, France, Germany, Greece, Italy, Portugal, the Netherlands, Spain, Sweden and Switzerland. Germany, Austria and Switzerland: This document is issued in Germany by Invesco Asset Management Deutschland GmbH, An der Welle 5, D Frankfurt am Main. This document is issued in Austria by Invesco Asset Management Österreich Zweigniederlassung der Invesco Asset Management Deutschland GmbH, Rotenturmstrasse 16 18, A-1010 Wien and in Switzerland by Invesco Asset Management (Schweiz) AG, Talacker 34, CH-8001 Zurich. Belgium, Finland, France, Greece, Italy, Luxembourg, Netherlands, Portugal, Spain and Sweden: This document is issued by Invesco Asset Management S.A., rue de Londres, Paris, France. Ireland: This document is issued in Ireland by Invesco Global Asset Management DAC, Central Quay, Riverside IV, Sir John Rogerson s Quay, Dublin 2, Ireland. Regulated in Ireland by the Central Bank of Ireland. EMEA1482/2018 Read more articles from the Euro Zone News: Centrally or locally? Finding an optimal mix will be the winning formula for Europe s future in a fractured world, says Bernhard Langer. Bull or bear case? Europe is a special case in the QE to QT debate, argues Arnab Das. Out with the old? Taking a deep look into the notes on ECB Governing Councils can be worthwhile, observes Jeff Taylor. How long can this go on? There is reason to think the strong economical development of the Eurozone will continue, says Paul Temperton. Are investors ignoring the balance of risks? The risks to the consensus view of Eurozone inflation are increasing, observes Mark McDonnell. 6
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