IMPACTONOMICS Impact Investing: The Long-Term View

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1 IMPACTONOMICS Impact Investing: The Long-Term View GWIM CIO IMPACT INVESTING COUNCIL MARCH 2018 SUMMARY While some investors may believe that in order to create a positive societal or environmental impact with their investment, they may need to give up return or take on additional risk, a deeper analysis of impact investments shows that this may not always be the case. While impact investments may have different risks than their traditional counterparts, in general they are no riskier and in many cases, offer attractive risk-return profiles. 1 Many investors now believe that taking into account environment, social and governance (ESG) factors while also investing with a longer-term investment horizon when evaluating investments may contribute to a more holistic approach to investment selection. ESG factors may furthermore be a powerful tool in helping investors both identify risks and opportunities that can help investors pursue their long-term goals. Taking the Long-term View Investors are leveraging increasingly nuanced methods to evaluate and select impact investments. With additional tools at their disposal and growing availability of ESG data, investors can now measure both the risks associated with not taking into account environmental or social impacts as well as the potential positive impacts their investment selections may have. However, the ability to analyze and quantify the environmental and social impact at the individual portfolio level, let alone at a systemic level, requires analysis over a long timeframe. This need to take a long-term view is an important distinction for impact investing, as studies show that in the past decade the average investor has moved to shorter-term methods of evaluating potential investments and many corporates have followed suit. 2 KEY POINTS In this report we examine a number of factors including: The struggle in the markets between evaluating investments for short-term gain and long-term value creation The way larger, institutional investors are returning to evaluation of investments for their long-term return potential The role evaluating for impact investment factors, such as environmental, social and governance criteria can have in helping investors take the longterm view How ESG factors and a longterm approach may actually help investors and managers fulfill their fiduciary duties to their clients According to 2016 research cited by The Atlantic, the average holding time for stocks has fallen from eight years in 1960 to eight months in It also cites that almost 80 percent of chief financial officers representing 400 of America s largest public companies say they would sacrifice a firm s economic value to meet the quarter s Merrill Lynch Wealth Management makes available products and services offered by Merrill Lynch, Pierce, Fenner & Smith Incorporated (MLPF&S) and other subsidiaries of Bank of America Corporation (BofA Corp.). Investment products: Are Not FDIC Insured Are Not Bank Guaranteed May Lose Value MLPF&S is a registered broker-dealer and Member SIPC and a wholly owned subsidiary of BofA Corp.

2 earnings expectations. And companies are spending more and more on purchasing their own shares to drive stock prices up, rather than investing in equipment or employees. 3 This emerging focus on short-term evaluation and shorter holding periods may actually have the unintended consequence of both eroding long-term return potential to investors and increasing the environmental and social risk profile of investments. A focus on short-term results can have the perverse effect of encouraging companies and executives to make decisions that may generate profits today at the expense of potentially greater long-term value. The consulting firm, McKinsey, spoke with over 1,000 C-level executives and board members around the world and their responses substantiated this trend. The 2016 study found that short-term pressure on executives has increased since 2013 and the share of respondents who reported feeling the most pressure to demonstrate strong financial performance within two years or less rose from 79% to 87% while those who reported that they felt that pressure to deliver in 7 years or more fell to zero. 4 Exhibit 1: Surveys show that executives are feeling pressure from short-termism 87% 65% 55% of executives and directors feel most pressured to demonstrate strong financial performance within 2 years or less of executives and directors say short-term pressure has increased over the past 5 years of executives and directors at companies without a strong long-term culture say their company would delay a new project to hit quarterly targets even if it sacrificed some value Source: Rising to the challenge of short-termism. FCLT Global, September What is Impactonomics? Impactonomics is a thought leadership series published by the Impact Investing Council within the Global Wealth & Investment Management Chief Investment Office (GWIM CIO) that examines the relationship between economic growth, investing for impact and profit, and the measurable social and environmental change it can bring. This publication is the second of two follow-up papers to the original Performance Realities piece published in The first paper, Performance Realities II: Deconstructing Risks in Impact Portfolios can be found at ml.com/impactinvesting. The report also highlighted that the share of net income S&P 500 companies spend on buybacks is at all-time high of 58%, nearly 30 times its share in Instead of re-investing in research & development, human capital or initiating new projects, companies are buying back their stocks to stabilize prices and help meet analysts and shareholder s expectations. 5 This trend was substantiated in further 2017 studies by McKinsey that showed that 80% of CFOs would reduce discretionary spending on value-creating activities, such as marketing and research and development, in order to meet their short-term earnings targets. And nearly two-fifths of CFOs would give discounts to customers to make purchases this quarter rather than next. 6 A focus on quarterly earnings or other short-term performance variables may help firms boost performance today, but may require them to miss higher long-term benefits and may even introduce additional risks into their business model. For example, an agricultural firm that doesn t take into account the environmental impact of its operations is not considering the potential negative impact of climate change or the potential that consumer preferences may shift to sustainably produced goods may have on its future ability to grow and sell their crops. Unfortunately, there is not yet sufficient pressure on firms to take this long-term approach by investors. A 2017 study by State Street Global Advisors found that 47% of asset owners and 43% of asset managers believe it will take five years or more for ESG strategies to deliver outperformance. However only 10-20% of them use these time frames in evaluating investment performance, creating dissonance between their long-term investment goals and their investment evaluation process. 7 Impact Investing: The Long-Term View 2

3 Exhibit 2: Time Frames Used by Different Types of Managers to Measure Investment Performance Asset Owner / External Manager Asset Owner / Internal Portfolio Manager Asset Manager / Portfolio Manager Asset Manager / Sub-Manager 44% 41% 37% 1% 1% 1% 1% 1 to 6 months 12% 12% 20% 19% 6 months to 1 year 28% 1 to 3 years 39% 35% 29% 3 to 5 years 25% 5% 12% 4% 7% 3% 5% 5% 2% 2% 2% 3% 2% 5 to 7 years 7 to 10 years Source: The Investing Enlightenment, StateStreet Research. March, More than 10 years Short-termism also has other portfolio effects, including high turn-over that can lead to potentially adverse tax consequences and increased costs that can potentially erode returns and increase overall portfolio volatility. In aggregate, it also has a potential impact on the overall stability of a society, as shortterm decisions made on behalf of a small group of beneficiaries may impact the ability for a larger number of stakeholders to share in a stable environmental and financial system. The bottom line is that not all profit is created equal. Michael Porter, writing for Harvard Business Review, posits that this point has been lost in the narrow, short-term focus on financial markets and in much management thinking. Profits involving a social purpose represent a higher form of capitalism one that will enable society to advance more rapidly while allowing companies to grow even more. The result is a positive cycle of company and community prosperity, which leads to profits that can potentially endure. Creating shared value presumes compliance with the law and ethical standards, as well as mitigating harm caused by business, but goes far beyond that. The opportunity to create economic value through creating societal value will be one of the more powerful forces driving growth in the global economy. 8 Institutional Investors Are Leading the Way By the very nature of long-term factors, incorporating ESG factors into the business decision making processes may actually help firms increase long-term return and mitigate potential systemic risks. 9 While the retail investing public is starting to embrace impact investing tenets in their approach, it is pressure from large institutional investors that may re-orient companies to focus more on long-term financial success. In July 2016, a group of large institutional investors including Warren Buffett and representatives from BlackRock, Vanguard, and StateStreet Global Advisors released the Commonsense Corporate Governance Principles putting forth guidelines for companies to drive long-term prosperity for their shareholders as well as for American citizens. 10 When speaking about performance, the report stated that, companies should frame their required quarterly reporting in the broader context of their articulated strategy and provide an outlook, as appropriate, for trends and metrics that reflect progress (or not) on long-term goals. A company should not feel obligated to provide earnings guidance and should determine whether providing earnings guidance for the company s shareholders does more harm than good. If a company does provide earnings guidance, the company should be realistic and avoid inflated projections. Making short-term decisions to beat guidance (or any performance benchmark) is likely to be value destructive in the long run. A company should take a long-term strategic view, as though the company were private, and explain clearly to shareholders how material decisions and actions are consistent with that view. 11, 12 Furthermore, BlackRock has issued a number of letters on the negative effects of short-term investing, stating that one reason for investors focus on short-term horizon is that companies have not sufficiently educated them about the ecosystems they are operating in, what their competitive threats are and how technology and other innovations are impacting their businesses. Without clearly articulated plans, companies risk losing the faith of long-term investors. The reason these large institutional asset managers are focused on taking a long-term approach is that research has shown that focusing on long term can potentially lead to outperformance studies by the McKinsey Global Institute conclude that longterm focused firms in the McKinsey Corporate Horizon Index, an index constructed based on firms patterns of investment, growth, earnings quality and earnings management, generally exhibit stronger fundamentals in terms of investment attributes. 13 Impact Investing: The Long-Term View 3

4 Exhibit 3: Study shows that long-term firms may exhibit stronger fundamentals in terms of investment attributes $ Million per year $ Million per year $ Million per year $ Million per year Average Company Revenue Long-term (n=164) All others (n=451) Financial Crisis Average Company Earnings Average Company Economic Profit Average Market Capitalization Long-term (n=164) All others (n=451) % Long-term (n=164) All others (n=451) % Long-term (n=157) All others (n=418) % Source: McKinsey Global Institute. February Past performance is no guarantee of future results. Another example of long-term investing potentially generating strong return can historically be seen from the Long-Term Value Creation Index (LTVC). This index was developed to show the positive effects of long-term investing in sustainable companies with a quality bias. It combines analysis that seeks firms that: +$7B Generate higher revenue and cash while also enjoying more stable growth than the average company Adopt conservative, yet effective capital structures And companies that are run by managers who tend to exercise prudence in the administration of companies affairs On this last point, the index uses data from RobecoSAM s Corporate Sustainability Assessment (CSA), evaluating corporate governance performance of companies in the broader context of adding key measurements of management quality that are often overlooked by more traditional research frameworks. Specifically, the analysis includes a series of six to eight evaluations of the quality of a company s management systems, including board structure, board diversity, risk & crisis management, customer relationship management, supply chain management, innovation management and tax strategy. 14 Investing for Impact Offers an Opportunity to Refocus on the Long Term The long-term success of a company (and therefore its stock), in our opinion, relies on both management and its investors being willing to take a long-term approach, identify, and mitigate social and environmental risks, not only at the individual company or issuer level, but at a systemic level. When the two work together, true long-term value can be unlocked. The Investment Integration Project recently published an article detailing the consideration of non-financial impact considerations appropriate for investment processes. 15 The article pointed out that, as mounting evidence suggests, operations that have a negative environmental impact and operations that create or exacerbate social issues may have a negative impact on the performance of companies operations and in turn, their share price. The project advocates that risks like the deterioration of the environment should be quantified in analysts financial models when evaluating a firm for investments. For example, it is estimated that climate change risk affects 93% of the U.S. equity market. 16 By integrating ESG factors in the investment process, investors can potentially lower not only the risk they face from individual companies, but if applied broadly by the majority of investors, collectively the market could conceivably lower the systemic risks faced by all. Since the inception of KLD ratings (an annual snap-shot that analyzes ESG performance of companies rated by KLD Research & Analytics, Inc.) and other ESG ratings frameworks, ESG analyses have commonly taken place at the company level. ESG provided additional, forward looking data points, and a longerterm lens, but remain focused on a particular company. Changes to the availability of data and the ability to analyze this data means that investors can now take a more holistic approach. The escalating sources of ESG factors and the widespread availability of computing power to process large data sets allows investors to expand their analysis beyond the firm to explore systemic risk factors that may affect a firm and the economy or markets at-large. Impact Investing: The Long-Term View 4

5 Exhibit 4: Impact of data and data analysis on investor decision making Systemic Focus Firm Focus Short-Term View Multi-sourced ESG data drives systemic insights Company ESG data provides long-term insights Source: GWIM CIO Chief Investment Office Long-Term View As more research is completed and more data analyzing the connection between certain ESG factors and long-term performance comes to the forefront, institutional and individual investors are starting to realize the potential benefits that using an environmental, sustainability and governance lens can bring to their investment approach allowing them to look at the broad range of risk factors across time horizons and across an entire industry, not just the firm level. This evolution is helping investors of all stripes identify company and systemic risks as well as create long-term value. Impact Investing with a Fiduciary Lens Historically, many investment committees, gatekeepers and other types of fiduciaries have had a perception that integrating environmental or social factors into their decision making processes presented a risk to fiduciary responsibility - this was based in part on a belief that this type of investing would inhibit their ability to maximize return for their investors. Not all fiduciaries share this perception. In fact, some of the largest, including the California State Employee Pension Fund (CalPERS), New York State Common Retirement Fund (CRF) 17 and Japan s Government Pension Investment (GPIF) 18 have embraced ESG investment strategies as core to their approach. CalPERS, one of the largest pension funds in the world, is transparent about its commitment to sustainable investment and proud history of leadership and innovation in the field. The fund clarified that they act as fiduciaries first and foremost and believe that [a]s a significant institutional investor with a longterm investment time horizon, sustainable investment means taking account of environmental, social, and governance factors across all our day-to-day investment business. 19 Data has shown in many studies 20 that the benefits of considering a broader set of information which includes the impact of social and environmental and other systemic risks on the investment portfolio may actually help identify and potentially minimize risk. The real question is, Are impact investing risks similar to any other risks that fiduciaries take into account? While many fiduciaries historically cited the lack of available data to incorporate ESG considerations into investment decisions, that argument is becoming more difficult to make. There are a number of initiatives and frameworks for assessing risks that have been created to help investors identify both risk and investment opportunities. ESG ratings providers continue to conduct more proprietary research helping investors identify not only historical social, environmental and other corporate reporting and governance-based risks, but emerging risks in companies as well. Established in 2011, the Sustainability Accounting Standards Board (SASB) is an initiative developed to mirror the successful adoption of accounting standards that FASB brought to the investment and finance industry in the 1970s. SASB developed a framework for identification and assessment of material environmental, social and governance factors which will allow both companies and investors to identify risks to current and future valuations. This framework is based on the premise that material environmental and social risks affect the return on investments and that investors should be made aware of them. Other groups, including the Task Force on Climate-related Financial Disclosures are pushing companies to standardize and disclose environmental data and integrate financial and ESG reporting into formal financial reporting and regulatory filings. There is a shift underway in the fiduciary community as to how ESG focused factors are viewed both as an identification of risk and opportunity. The United Nations Environmental Program (UNEP) Finance Initiative, a partnership between the UNEP and the global financial sector has actually advocated that the analysis of ESG issues as an integral part of the investment process enables investors to make a full assessment of the risks and opportunities associated with particular investments. This fuller assessment: Allows better investment decisions by facilitating more accurate valuations of businesses by the investment markets Impact Investing: The Long-Term View 5

6 Drives a higher quality dialogue between companies and their investors on drivers of long-term value creation Provides incentives to companies to improve their governance and management of ESG issues Encourages investors to proactively seek out opportunities presented by these issues Over time, this analysis and dialogue could result in capital being allocated towards well-governed companies, contributing to the goals of a greener economy and a more sustainable society. 21 A 2016 United Nations study entitled Fiduciary Duty in the 21st Century went further to say, failing to consider long-term investment value drivers, which include environmental, social and governance issues, in investment practice is a failure of fiduciary duty. 22 Conclusion Stable long-term returns are largely built on the predictability and reliability of environmental, societal and financial systems. While these systems may be getting more complex to assess, the tools that are now at fiduciaries disposal to help identify numerous material environmental and social risks over both short and long-term investment horizons should be integrated into the investment assessment. At Bank of America, we believe that investors should take the time to understand how impact investments and may help them pursue their goals and take the time to identify ways that impact investments may help them create long-term value in their portfolios. With careful evaluation and investment selection, investors can support their investment objectives and offer a sustainable way to pursue both their financial and impact related goals. Bank of America s Commitment to Creating Positive Impact Committed $125 billion over ten years to finance lowcarbon businesses and solutions that address climate change 23 Lent $1 billion to community development financial institutions (CDFIs), making Bank of America the nation s largest lender to CDFIs 24 One of the U.S. institutions participating in the social impact bond (SIB) marketplace Issued $2.1 billion of corporate green bonds, including the first-ever green bond in Signatory to the Principles for Responsible Investment, listed on the Bloomberg Gender-Equality and Down Jones Sustainability indices, and named Best Global Bank for Corporate Social Responsibility in 2017 by Euromoney 26 Impact Investing: The Long-Term View 6

7 Endnotes 1. Deconstructing Risks in Impact Portfolios. Bank of America GWIM CIO. March Moving Beyond Quarterly Guidance: A relic of the Past. FCLT Global. October How to Stop Short-Term Thinking at America s Companies The Atlantic. December Rising to the challenge of short-termism. FCLT Global, September Rising to the challenge of short-termism. FCLT Global, September How to build an alliance against corporate short-termism, McKinsey & Company, January The Investing Enlightenment. Robert G Eccles and Mirtha D. Kastrapeli, State Street Research, Creating Shared Value by Michael E. Porter and Mark R. Kramer. Harvard Business Review, January-February Deconstructing Risks in Impact Portfolios. Bank of America GWIM CIO. March Open Letter: Commonsense Corporate Governance Principles. July Larry Fink s Annual Letter to CEOs A Sense of Purpose Larry Fink s Annual Letter to CEOs. 13. Measuring the Economic Impact of Short-Termism. McKinsey Global Institute, February Long-Termism: Index Impossible? S&P Dow Jones Indices. October Systems-level considerations and the Long-Term Investor: Definitions, Examples and Actions, The Investment Integration Project (TTIP), Climate Risk Technical Bulletin, Sustainability Account and Standards Board (SASB) NYS Common Further Integrates ESG within Manager Selection, Risk Frameworks. Chief Investment Officer. March Biggest Pension Fund Craves More After Foray Into ESG Assets. Bloomberg Markets. July Sustainable Investing. CalPERS. January Deconstructing Risks in Impact Portfolios. Bank of America GWIM CIO. March Fiduciary in the 21st Century, Sullivan, Rory; Martindale, Will; Feller, Elodie; Bordon, Anna, Fiduciary in the 21st Century, Sullivan, Rory; Martindale, Will; Feller, Elodie; Bordon, Anna, As of September 18, As of June 29, As of November 10, The ranking or ratings shown here may not be representative of all client experiences because they reflect an average or sampling of the client experiences. These rankings or ratings are not indicative of any future performance or investment outcome. Index Definitions Corporate Horizon Index: Created by McKinsey, this index is based on patterns of investment, growth, earnings quality and earnings management captured in five variables, with data drawn from McKinsey s Corporate Performance Analytics database. The five variables include: investment, earnings quality, margin growth, quarterly management and earningsper-share growth. Long-Term Value Creation Index: The LTCV index is constructed by combining the Economic Dimension Score (EDS) from RobecoSAM s Corporate Sustainability Assessment (CSA) with S&P s quality score for a company s earnings. Impact Investing: The Long-Term View 7

8 IMPORTANT INFORMATION The Global Wealth & Investment Management Chief Investment Office (GWIM CIO) provides investment solutions, portfolio construction advice and wealth management guidance. This material was prepared by the GWIM CIO and is not a publication of BofA Merrill Lynch Global Research. The views expressed are those of the GWIM CIO only and are subject to change. This information should not be construed as investment advice. It is presented for information purposes only and is not intended to be either a specific offer by any Merrill Lynch entity to sell or provide, or a specific invitation for a consumer to apply for, any particular retail financial product or service that may be available. Global Wealth & Investment Management is a division of Bank of America Corporation ( BofA Corp. ). Merrill Lynch Wealth Management, Merrill Edge, U.S. Trust, and Bank of America Merrill Lynch are affiliated sub-divisions within Global Wealth & Investment Management. This information and any discussion should not be construed as a personalized and individual client recommendation, which should be based on each client s investment objectives, risk tolerance, liquidity needs and financial situation. This information and any discussion also is not intended as a specific offer by Merrill Lynch, its affiliates, or any related entity to sell or provide, or a specific invitation for a consumer to apply for, any particular retail financial product or service. Investments and opinions are subject to change due to market conditions and the opinions and guidance may not be profitable or realized. Any information presented in connection with BofA Merrill Lynch Global Research is general in nature and is not intended to provide personal investment advice. The information does not take into account the specific investment objectives, financial situation and particular needs of any specific person who may receive it. Investors should understand that statements that regarding future prospects may not be realized. Commentary is general in nature and is not intended to provide personal investment advice. The information does not take into account the specific investment objectives, financial situation and particular needs of any specific person who may receive it. Investors should understand that statements regarding future prospects may not be realized. Past performance is no guarantee of future results. Any investment plan should be subject to periodic review for changes in your individual circumstances, including changes in market conditions and your financial ability to continue purchases. Impact investing and/or Environmental Social Governance (ESG) investing has certain risks based on the fact that ESG criteria excludes securities of certain issuers for nonfinancial reasons and therefore, investors may forgo some market opportunities and the universe of investments available may be smaller. The investments discussed have varying degrees of risk. Some of the risks involved with equities include the possibility that the value of the stocks may fluctuate in response to events specific to the companies or markets, as well as economic, political or social events in the U.S. or abroad. Bonds are subject to interest rate, inflation and credit risks. Investments in foreign securities involve special risks, including foreign currency risk and the possibility of substantial volatility due to adverse political, economic or other developments. These risks are magnified for investments made in emerging markets. Social impact bonds are a relatively new and evolving investment opportunity, which is highly speculative and involves a high degree of risk. An investor could lose all or a substantial amount of their investment. An investment in Green Bonds involves risks similar to an investment in debt securities of the issuer, including issuer credit risk and risks related to the issuer s business. You should review the relevant offering document carefully before investing. Neither Merrill Lynch nor any of its affiliates or financial advisors provide legal, tax or accounting advice. You should consult your legal and/or tax advisors before making any financial decisions Bank of America Corporation. All rights reserved. ARYWYN8Y/AR3H6LXP