A Differentiated Approach to ESG Investing

Transcription

1 Topic Paper April 9, 2018 A Differentiated Approach to ESG Investing PERSPECTIVE FROM TEMPLETON GLOBAL MACRO Michael Hasenstab, Ph.D. Executive Vice President, Portfolio Manager, Chief Investment Officer Templeton Global Macro Sonal Desai, Ph.D. Senior Vice President, Portfolio Manager, Director of Research Templeton Global Macro Julie Moret Head of ESG, Director Performance Analysis Investment Risk Franklin Templeton Investments Vivian Guo Research Analyst Templeton Global Macro Introduction Information, data and research are the fuel for investment decisions. Over the years, as new information has emerged and evolved, investors have found innovative means to harness additional insights to help inform their decisions. Today, forwardlooking investors are turning to environmental, social and governance (ESG) analysis to complement existing research efforts. ESG factors have always been integral to our research process, but we have more recently established a rigorous scorebased framework for its analysis. This paper outlines what ESG is, our ESG methodology and how ESG is incorporated into our overall investment model. What Is ESG? Across the asset-management world, interest in ESG has soared since the launch of the Principles for Responsible Investments (PRI) in As of March 2017, 1,741 signatories, representing US$73.5 trillion in assets under management (AUM), have signed on to the principles, committing to integrate ESG considerations into their investment decision-making, ownership practices and reporting (see Exhibit 1). AUM under PRI Have Grown Consistently Since Its Inception Exhibit 1: Growth of AUM Using the United Nations-Sponsored PRI USD Trillion Number of Entities $90 $80 $70 $60 $50 $40 $30 $20 $10 $ Asset Owners* AUM (LHS) Total AUM (LHS) Number of Asset Owners (RHS) Number of Signatories (RHS) *Asset owners are entities that manage their own assets. Source: United Nations Principles for Responsible Investment, as of March Not FDIC Insured May Lose Value No Bank Guarantee

2 ESG Market Trends: Growth in Client Demand Exhibit 2: ESG Growth by Region 2014 and 2016 North America $9,809 Europe $12,040 Asia-Pacific $1,042 $7,301 $10,776 $200 34% Increase % Increase % Increase Source: Global Sustainable Investment Alliance, 2016 Global Sustainable Investment Review. Client appetite for ESG-informed investing has clearly been on the rise as well. In its 2016 review, the Global Sustainable Investment Alliance estimated that assets under management that incorporate ESG criteria reached US$22.89 trillion globally, representing a 25% increase since 2014 (see Exhibit 2). This increase has occurred across all geographic regions. Institutions today view integrating ESG criteria into the investment process as a measure of investment excellence and as an effective risk management tool for assessing long-term sustainable performance. Some of the key drivers behind growing client interest have been the increasing relevance of sustainability challenges like extreme weather, terrorism and migration risks. Shifting demographics and changing investor preferences from millennials have also driven the increased interest in ESG-informed investing. Government policy and regulatory pressures are similarly contributing to the growing relevance of incorporating deeper ESG research into investment decision-making. Templeton Global Macro considers ESG analysis an integral component of our investment process. Looking through a sovereign investment lens at currency, interest rates and credit, ESG considerations are critical to macroeconomic issues impacting asset values, providing an additional tool for both managing downside risk 1 mitigation and uncovering sources of upside opportunity. 2 While analysis of ESG factors has long been a critical component of our team s research process, we have recently formalized how we communicate our ESG process with investors. We have developed a rigorous and systematic approach that quantifies ESG inputs and enables comparisons across a broad spectrum of countries. The output from this process is our proprietary Templeton Global Macro ESG Index (TGM-ESGI). 1. Downside risk is a measure of how much a security or a portfolio may lose in value given specific risk scenarios in the market. 2. Upside opportunity is an estimation of how much positive investment return a security or a portfolio may achieve. A Differentiated Approach to ESG Investing 2

3 Environment, Social and Governance Scores by Country (TGM-ESGI) Exhibit 3: TGM-ESGI Scores by Country As of February 2018 TGM-ESGI Score Venezuela Nigeria Ecuador Kenya Egypt Zambia Uganda Turkey Russia Greece China Serbia Thailand Chile Italy Malaysia Hungary Poland Spain Korea France Japan UK Netherlands Ireland Germany Australia New Zealand US Sweden Norway Canada Singapore Switzerland Denmark Source: TGM-ESGI. Our ESG Methodology Combining and quantifying inherently fluid ESG factors represents a complex challenge, but we have taken a rigorous approach. Our team scores countries from 0 10, with 0 being the lowest and 10 being the highest, in 13 ESG subcategories that we determined to have significant impact on macroeconomic conditions. The index is constructed by overlaying the view of our research team onto a benchmark created by global indexes. We attain initial scores from representative and credible sources like the World Bank and the United Nations. Our analysts then adjust those benchmark scores based on their proprietary research and assign projected scores in anticipation of how we think these conditions are likely to evolve in the medium term. 3 Final composite current and projected scores are attained with a weighting of 40% for governance, 40% for social and 20% for the environment. Exhibit 3 shows a representative sample of these ESG scores. Our methodology differs from many others in its forward-looking component. Rather than focusing solely on the overall level, which is closely related to income for countries, our team places greater emphasis on the change in ESG, or the difference between projected and current scores (see Exhibit 4). We believe that this change is more illustrative of the direction in which a country is headed and a more effective tool for analyzing economic and investment performance. A detailed explanation of the TGM-ESGI methodology is available in the Global Macro Shifts (issue 9) paper dedicated to our ESG process. TGM-ESGI Projected Scores by Country Exhibit 4: TGM-ESGI Scores: Projected Current As of February 2018 Change in TGM-ESGI Score Poland US Italy Germany Hungary Malaysia Singapore Spain Turkey Venezuela Japan Uganda Netherlands Russia Ecuador Nigeria Korea China UK Canada Australia New Zealand Norway Denmark Sweden Switzerland Ireland Zambia Greece Egypt France Kenya Serbia Chile Thailand Source: TGM-ESGI. Our medium-term projections are for the next three years. 3. We define medium term as three years. A Differentiated Approach to ESG Investing 3

4 The Role of ESG in Our Investment Process Exhibit 5: ESG Factors and Economic Analysis Inform Investment Decisions ESG Factors Macro Conditions Governance Effectiveness Policy Mix Corruption Institutional...Strength Business...Climate Social Social Stability Infrastructure Human Capital Labor Demographics Economic Analysis Environmental Unsustainable...Practices Extreme...Weather Risk Resource...Scarcity Growth and Growth Potential Volatility and Resilience Productivity Consumption Domestic Investment Inflation Credit Financial Depth Fiscal Policy and Debt Competitiveness Trade Capital Flows Foreign Reserves Asset Price Valuation Credit Spreads Risk Premium Exchange Rate Valuation Interest Rates It is important to note that consideration of ESG factors has long been embedded in our research process. TGM-ESGI represents an effort to explicitly quantify these issues and generate a framework for their discussion rather than a fundamental shift in our approach. As a result, ESG is a fully integrated component and, together with macroeconomic analysis, forms the foundations of our team s investment methodology (see Exhibit 5). Inclusion of ESG is not intended to imply that we are forming value judgments regarding individual governments, social structures or environmental policies. ESG simply serves as an additional tool to be used in formulating investment decisions based on financial considerations. ESG in Templeton Global Bond Fund and Templeton Global Total Return Fund ESG inclusion aligns well with our longer-term investment horizon, and our portfolios reflect the inclusion of these considerations. Our current investment strategies target countries with improving or unchanged scores. 4 The following exhibits display the sovereign bond positions in two of our flagship funds, 5 Templeton Global Bond Fund and Templeton Global Total Return Fund, 6 and the expected change in ESG scores of these countries. Exhibits 6 9 show that as of December 31, 2017, nearly 100% of both funds held investments that overwhelmingly had either improving or neutral ESG scores. However, there will be times, as these exhibits illustrate, when our funds hold countries with deteriorating scores due to the transition period between a change in views and the exiting of a position. While Templeton Global Macro is always seeking longer-term, sustainable opportunities, we must also consider economic performance and asset prices. ESG improvements, current and expected, often significantly impact our decision to invest. Examples in our flagship funds include and, two countries which show strong, positive changes in the TGM-ESGI. In, we are expecting the current administration to reverse much of the poor economic choices and government corruption that held back the country for over a decade. In, we believe a strong push for structural reform, including reduction of bureaucracy and improvement of the business environment, 7 could unleash some of the country s economic potential. 4. We define unchanged as any improvement or deterioration in the range of to 0.05 in recognition that the qualitative nature of the methodology does not allow for absolute precision in scoring. 5.. Sovereign bond positions excluding cash, cash equivalents, derivatives, forwards and supranational, corporates and de minimis holdings (de minimis holdings are minimal or largely immaterial market exposures in a portfolio). Cash equivalents include short-term US Treasury bills and agency bills. 6. Templeton Global Total Return Fund holds corporate securities, while Templeton Global Bond Fund does not. 7. Additional information on and, as well as other examples of our ESG thought process, can be found in Global Macro Shifts (issue 9). A Differentiated Approach to ESG Investing 4

5 Investments Show Almost Entirely Improving or Unchanged ESG Scores Exhibit 6: Templeton Global Bond Fund: ESG Scores Projected Current of Holdings Change in TGM-ESGI Score Exhibit 8: Templeton Global Total Return Fund: ESG Scores Projected Current of Holdings Change in TGM-ESGI Score Serbia Source: TGM-ESGI. Our medium-term projections are for the next three years. Kenya Canada South Korea South Korea Exhibit 7: Templeton Global Bond Fund: ESG Ratio Projected Current of Holdings 33% 33% 3% 3% 64% 64% Improving Unchanged Deteriorating Exhibit 9: Templeton Global Total Return Fund: ESG Ratio Projected Current of Holdings Improving Unchanged Deteriorating ESG concerns have also frequently been sufficient to spur departure from previously favored positions. Two more-recent examples are Poland and Malaysia. Table 1 displays the dates of maximum percentage of exposure 8 to each country in the flagship Templeton Global Bond Fund, as well as the dates when we exited the positions. The table also shows that ESG scores for each country are projected to deteriorate. Weakening institutions have strained Poland s relations with the European Union, and we have become concerned by the direction of macroeconomic policy and brewing social tensions in Malaysia. We are always aware of the risks that poor ESG can create. While Venezuela is an extreme example, disastrous politics in Caracas have created a humanitarian crisis in addition to an economic one, eventually leading to a collapse of asset prices and sovereign default. ESG Concerns Have Led to Position Departures Table 1: Select Holdings Data of Templeton Global Bond Fund As of February 2018 Maximum Allocation Date of Maximum Allocation* Date of Exit Projected Change in ESG Scores Poland 11.1 Q Q Malaysia 11.4 Q Q *Over the last 10 years. Source: TGM-ESGI. Our medium-term projections are for the next three years. 8. As percent of the whole country portfolio. A Differentiated Approach to ESG Investing 5

6 The above information is meant to give investors a sense of how we currently employ ESG; it is not only an interesting thought exercise, but also a powerful tool for investment decisions. We wish to note that while we have chosen these baseline standards, we are open and enthusiastic about working with clients to tailor ESG portfolios for their specific needs; our rigorous scoring methodology gives us flexibility to accomplish these modifications. Stewardship and Active Engagement through a Sovereign Lens Stewardship and active engagement to encourage improving governance, social and environmental practices have traditionally been viewed as applicable only for equity investors. We believe that engagement in ESG issues is equally important for fixed income investors. Our longer-term investment horizons and our strong track record of investing alongside countries have established Templeton Global Macro as a valuable partner for governments aiming toward stronger economic management. These shared objectives often provide unique opportunities for open communication with policymakers regarding best economic practices. Such dialogues are significant, both for our ability to best serve clients, and for policymakers seeking valuable perspectives on capital markets. Taken together, we expect our rigorous approach to ESG and its full integration into our investment process to enhance the conversation. WHAT ARE THE RISKS? All investments involve risks, including possible loss of principal. Derivatives, including currency management strategies, involve costs and can create economic leverage in the portfolio which may result in significant volatility and cause the fund to participate in losses on an amount that exceeds the fund s initial investment. The fund may not achieve the anticipated benefits, and may realize losses when a counterparty fails to perform as promised. The markets for particular securities or types of securities are or may become relatively illiquid. Reduced liquidity will have an adverse impact on the security s value and on the fund s ability to sell such securities when necessary to meet the fund s liquidity needs or in response to a specific market event. Foreign securities involve special risks, including currency fluctuations (which may be significant over the short term) and economic and political uncertainties; investments in emerging markets involve heightened risks related to the same factors. Sovereign debt securities are subject to various risks in addition to those relating to debt securities and foreign securities generally, including, but not limited to, the risk that a government entity may be unwilling or unable to pay interest and repay principal on its sovereign debt, or otherwise meet its obligations when due. Investments in lower rated bonds include higher risk of default and loss of principal. Bond prices generally move in the opposite direction of interest rates. As the prices of bonds in the fund adjust to a rise in interest rates, the fund s share price may decline. Changes in the financial strength of a bond issuer or in a bond s credit rating may affect its value. These and other risks are discussed in the fund s prospectus. IMPORTANT LEGAL INFORMATION This commentary reflects the analysis and opinions of the authors as of April 9, 2018, and may differ from the opinions of other portfolio managers, investment teams or platforms at Franklin Templeton Investments. Because market and economic conditions are subject to rapid change, the analysis and opinions provided are valid only as of April 9, 2018, and may change without notice. The commentary does not provide a complete analysis of every material fact regarding any country, market, strategy, industry, asset class or security. An assessment of a particular country, market, security, investment, asset class or strategy may change without notice and is not intended as an investment recommendation nor does it constitute investment advice. Statements about holdings are subject to change. Statements of fact are from sources considered reliable, but no representation or warranty is made as to their completeness or accuracy. Investors should carefully consider a fund s investment goals, risks, sales charges and expenses before investing. To obtain a summary prospectus and/or prospectus, which contains this and other information, talk to your financial advisor, call us at (800) DIAL BEN / or visit franklintempleton.com. Please carefully read a prospectus before you invest or send money. For Exhibits 4, 6, 7, 8 and 9 and Table 1 there is no assurance that any estimate or projection will be realized. Franklin Templeton Distributors, Inc. One Franklin Parkway San Mateo, CA (800) DIAL BEN / franklintempleton.com franklintempletoninstitutonal.com Copyright 2018 Franklin Templeton Investments. All rights reserved. 4/18