June 2015 Schroders Responsible Investment Global and International Equities
At Schroders, Responsible principles drive our investment decisions and the way we manage funds. From choosing the right assets to engaging with our investments, positive principles guide our actions. Our responsible approach isn t merely a recent attempt to follow market trends, nor is it separate from our mainstream investment processes. While Schroders has always considered the impact of responsible investment issues, over the past 15 years we have formalised how we responsibly engage and manage our investments. Schroders has been a member of the Principles of Responsible Investment (PRI) since 2007. We see ourselves as long-term stewards of our clients capital and this means looking beyond the numbers. Our approach involves engaging with companies about their activities and helping them manage risks in an effort to drive better performance. Our investment experience and academic research show that companies with good environmental, social and governance (ESG) management often have performed better and delivered superior returns over time, both for investors and society. We firmly believe that companies with sustainable business models will be better investments over time. The following pages outline our approach to managing clients assets responsibly in Global and International Equities. Active management relies on a thorough assessment of opportunities and risks, as well as the responsibility to be an active owner in the companies we invest with. Alex Tedder, Head of Global Equities 2
ESG solutions 1) Schroders Global and International Equities Three layers of ESG integration 2) Segregated accounts with client specific ethical restrictions Ethical screening 3) Stewardship Screening, engagement and monitoring outcomes 4) Schroder Global Climate Change Thematic investment solution 3
1) Schroders Global and International Equities ESG Integration ESG considerations are embedded within every stage of our investment process Schroders Global and International Equity team views the integration of ESG considerations as an integral part of managing, protecting and enhancing our clients investments. Detailed and insightful research is the foundation for idea generation, stock selection and portfolio construction at Schroders. This is exemplified by the approach adopted by Schroders Global and International Equity team where fundamental, bottom up research drives the composition of portfolios and investment outcomes. The Team s philosophy is anchored around unanticipated growth and is based on the principle that companies delivering earnings above the level anticipated by consensus outperform the broader market. Through a process of fundamental stock research and analysis, combined with a detailed assessment of the fundamental risks of owning each stock, we seek to identify those companies which will deliver positive earnings surprise (we term this a positive growth gap ). We believe such stocks will outperform as their higher growth characteristics are recognised by the market. Our analysis is forward-looking, with a significant proportion of our appraisal based on a 3-5 year time-horizon. Risk to the sustainability of longer-term growth is therefore a key consideration when determining the trajectory of longer term growth, and it is in this context that the evaluation of non-financial risks, including ESG factors, are central to our expectations. We also believe that ESG has a fundamental bearing on the assessment of quality, another characteristic that is prominent within companies in which we look to invest in. Academic studies consistently support the premise that strong ESG policies result in a lower cost of capital, which not only reduces risk but also has the potential to contribute to enhanced returns. The chart below illustrates how ESG considerations are embedded in every step of our investment process. Investment Process Summary: Step 1: Filter universe Step 2: Research - local expertise/global perspective Step 3: Stock selection Step 4: Portfolio construction and risk control Quant screens confirm/challenge our views Local research coverage of 2,000 stocks Global sector overlay Local research grades 1 and 2 Best ideas Portfolio 2,400 stocks 1,600 Stocks 500 Stocks 130 150 Stocks Portfolio - Local analysts maintain company models using proprietary valuation framework. Assessment of ESG risks are integrated within this analysis and analyst rating. - Stocks are graded 1-4 based on local opportunity set - Global Sector Specialists (GSS) engage with local analysts to evaluate stock recommendations - Local analysis and ESG assessment is re-framed in the context of a wider opportunity set and global comparators - GSS stock recommendations based on: 1) Potential for earnings surprise i.e. positive Growth Gap, and 2) fundamental risk assessment (incorporating operational, financial, strategic, geo-political, management and ESG risks) - Team portfolio managers build high conviction portfolios, integrating client-specific guidelines, ethical screening and SRI exclusions, as applicable - Stocks are weighted based on upside potential, fundamental risk assessment and portfolio characteristics
Three primary layers of ESG integration ESG factors are integrated into our investment decisions in three distinct stages of our process: Research, Portfolio Construction and Engagement 1. Research Our Global sector specialists leverage the work of Schroders dedicated ESG team to assess issues and exposures when incorporating the ESG implications for stocks we are analysing. The ESG team consists of 8 specialists, who have on average 11 years investment experience. We use a proprietary ESG Guidance Document (drafted by ESG Team) which highlights key ESG risks for each GICS sub-sector. We also use a wealth of external sources; for example, we receive quarterly portfolio ESG ratings on invested stocks. We believe that ESG evaluation by investors is a critical component to assessing company quality. Within the Global Equity team, we adopt a flexible framework for our formal analysis of ESG items. These include (but are not limited to): Environmental: Climate change mitigation and adaptation Environmental risks and pollution Renewable energy Resource depletion Overall environmental leadership Social: Animal welfare Child and Slave labor Community relations Labour practices Predatory lending Governance: Dual-class share structure Executive compensation Majority voting Division of management roles Disclosure and transparency We believe integrating ESG analysis enhances our understanding of a company and its ability to deliver long-term value. While ESG factors are sometimes difficult to value, understanding them helps to make better-informed decisions. ESG considerations are used to identify risks and opportunities at the stock selection stage rather than to define an investable universe. At Schroders, ESG is not just a negative screen, our work on sustainability helps us identify companies potentially benefitting from: Sustainable competitive advantage Exposure to growth industries Above-trend earnings growth Attractive cash flow generation and attractive returns on capital Drawing from a wealth of resources, our analysts incorporate a well informed view on ESG considerations in all of their research notes, which may also impact the discount rate or risk premium applied when evaluating a company. 2. Portfolio Construction There are a wide range of fundamental risks which ultimately define the risk of owning a stock. These range from financial considerations such as the strength of a company s balance sheet to operational and ESG considerations such as a company s exposure to a particular regulatory risk. We have analysed the impact of these risks over time on stock prices to establish a well-designed and consistent framework toward evaluating fundamental risk. We utilize a formal scoring system with weighted risk scores in different categories, which results in a specific risk score for each stock that we own. These scores then become a key factor in determining the position size of stocks in the portfolio. A formal ESG score is assigned within the context of our fundamental risk scoring system, and this feeds directly into the decision making around whether to own a stock, and in what size. 5
3. Engagement - using Schroders position as an active investor to be good stewards by engaging with company management on ESG issues We believe that being a responsible owner will lead to better long-term results for clients, as well as helping society at large. When evaluating investments, we seek companies that are focused on delivering long term shareholder value. We have been investing for over 200 years and are known as a long-term investor. As a result, companies and their management are willing to engage with us on their strategy, risks, environmental and social performance, and their governance. We believe this should lead to stronger financial returns for both the company and its shareholders. The following chart is taken from an academic study analysing engagements with over 600 US public companies over a ten year period. This figure plots the cumulative monthly abnormal returns around the initial engagements from 1 month prior to the engagement month to 18 months afterwards. For each event month, the average abnormal returns are calculated using an equal-weighted portfolio of all target firms that initiated engagements in Month 0. The results clearly illustrate that companies that implemented change as a result of successful engagements on ESG issues generated significant outperformance over time. Cumulative abnormal return monthly return (%) Event window in months Source: Active Ownership, Dimson, Karakas and Li, December 2012. The key to success is the ability to measure outcomes and we have a long track record of promoting sustainable business practices. During 2014, global equity teams alone held 13,892 company meetings. ESG factors are regularly discussed at these meetings. The ESG team also hold dedicated meetings with company management. We expect engagements to become increasingly important as responsible business practices are recognised as important drivers to a company s competitive position, success and profitability. By engaging on our own and with other investors, we hope to speed up the process. Our track record for engaging with companies around ESG issues is shown in the chart below: Total number of ESG engagements since 2000 Source: Schroders, *YTD as at 31 March 2015. Engagement success is determined as achieved or almost achieved. Governance engagements are included from 2014 onwards. 6
2) Segregated accounts with client specific ethical restrictions Ethical screening - developing screens to meet our clients social, responsible and ethical investment objectives. Schroders long term view is also vital for the US$ 44 billion (as of December 31, 2014) of ethically screened investments we manage for clients who require investments to reflect their values and beliefs. These assets have helped us to develop a sophisticated and active screening process that excludes stocks from portfolios that fail to meet clients criteria. Using a range of research services we can, for example, determine a company s exposure to controversial activities such as tobacco, pornography, nuclear power to animal testing. Screens are tailored to specific client requirements. Schroders ethically screened assets have grown at a faster pace than group AUM. 87% of these assets outperformed their benchmarks over three year period to July 31, 2014 (gross of fees, based on US$ 42 billion of restricted accounts of which 3 years performance is available for US$ 35 billion). Schroders have a group wide policy on cluster munitions and run US$ 8.4 billion in line with terrorist state exclusions due to implementation of the USA Patriot Act (as at 31 December 2014). Our Global and International Equities team works with our clients to tailor mandates and investment guidelines to their specific objectives and needs. We currently manage a number of ethically screened mandates for our clients which include SRI and Sharia compliant mandates. 7
3) Stewardship Screening, engagement and monitoring outcomes In 2013 the life and pensions company that offers the oldest ethical assets in the UK market approached Schroders about how we might update the investment process around Stewardship for the 21st century. Schroders was selected to manage the mandate on the basis of our strong capabilities and innovative approach. Our process recognises the importance of engagement and outcomes, providing potentially more robust results than the traditional pure exclusions investment model. We utilize a three layer Responsible Investment process in which investors can evaluate a portfolio s environmental and social performance as well as financial performance; this provides explicit recognition of the impact engagement has upon improving the economic system. The investment process is also more accountable, with a shorter policy document and a clear process for excluding companies. The three layers of stewardship investment process At Layer 1, the focus is on a company s products and services. The ESG team screen the investable universe in-line with the policy of the fund. These exclusions are determined in consultation with the Committee of Reference (CoR). The CoR is an independent committee sitting between the client and Schroders. The screening process uses multiple sources of external data to establish a list of prohibited names. An additional sense check of the universe is provided by Schroders ESG analysts. The fund manager is then free to construct the portfolio from the screened universe. With Layer 2, the focus is around the ESG assessment of how a company does business. In our experience, companies are rarely black or white in terms of the development of their ESG processes and disclosure, which can be affected by the geographies and sectors in which they operate and by a company s leadership. The Stewardship criteria recognise these differences exist and so sets out, at first, the policies we would expect a company to have in place (depending on its sector) and then the performance indicators to demonstrate the implementation of its policies. The funds holdings are analysed against their disclosure of these policies or data sets, and a company specific ESG engagement plan will be created focusing on priority areas where ESG can be improved. We will engage with a company using cross-desk holdings at Schroders and we will collaborate with our peers. Engagements and requests for changes are monitored and tracked over time in our database and we will re-visit requests for change on a regular (i.e. within a year) basis. Should a company be deemed to have failed to make material improvements against our engagement objectives within a three year period then it will be added to the exclusion list. Layer 3 is focused on outcomes and impact. We believe that this is what makes this process unique, innovative and brought into the 21st century. Layer 3 sets medium to long-term portfolio level ESG targets which are aligned with the outcomes of the layer 2 engagement process. These targets are quantifiable portfolio level measures of the extent to which the fund is achieving the ESG results aligned with the Stewardship (client) philosophy. Data tools enable us to track this in a transparent manner. 8
We work with clients to set success targets on ESG issues such as: Equal opportunities policy Employee engagement Health & safety Board independence Climate change Waste For example, we aim for 100% of invested companies in the Stewardship products to have an equal opportunities policy by 2020 and data to support this by 2025. The product: Links Stewardship objectives to portfolio ESG performance Provides tangible assessment of portfolio ESG performance. E.g. carbon footprint or the percentage of holdings with health & safety data Aligns Stewardship philosophy and performance with planetary social and environmental challenges We believe that this is a unique proposition within the investment industry as it goes beyond simply integrating ESG engagement and analysis into the investment process and establishes measurable medium and long-term ESG portfolio outcomes. These ESG targets reflect the key concerns raised by the client and would likely evolve over time in response to technological innovations and changes in regulation and scientific analysis, among other factors. The goal is to deliver a portfolio in which our investments generate a positive impact. 9
4) Schroder Global Climate Change Thematic investment solution While the path to a low-carbon economy is predictable, we believe it is not well understood, or discounted, by the equity market. As a result, we think the fast-changing growth and relative valuation opportunity that climate change presents to investors represents a significant opportunity for alpha generation. We believe that companies that recognise the threats and embrace the challenges early, or that form part of the solution to the problems linked to climate change, will ultimately outperform the broader global equities market. In 2007, Schroders launched a thematic fund around climate change; Schroder ISF Global Climate Change 1. The timeline below highlights our long history of engagement in this area, across the business: 1 CC refers to Climate Change. 2 IIGCC refers to Institutional Investors Group on Climate Change. 3 CDP refers to Carbon Disclosure Project Investment philosophy Tackling climate change will have a powerful impact on the global economy. Long-term policy goals to cut greenhouse gas emissions require nothing less than an industrial revolution to engineer a low-carbon economy. Adapting to some climate change that is already inevitable and mitigating further climate change through the transition to a low-carbon economy will, therefore, affect all industries over time. What is distinctive about our philosophy is our appreciation that the effects of climate change will be far-reaching and affect a great many more companies than those purely involved in renewable energy, energy efficiency and environmental resources. As such, we believe that a dynamic and evolving universe across all sectors is the best way to capture the investment opportunity. The Schroders Global Climate Change Team conducts fundamental analysis of every major sector of the economy in constructing our investment universe. We have created a comprehensive investment universe comprising over 700 stocks from developed and developing markets from which to select our best ideas. This broad investment universe also gives us the opportunity to always focus on great investment ideas, not just the stocks of the moment. Only the very best stock ideas make it into the portfolio, and we are not afraid to exclude whole sectors if they become overvalued. The fund invests in companies that mitigate or adapt to climate change and will benefit from accelerating national / international policies on climate change. In 2015 the strategy evolved to a fossil fuel free approach. The fund invests around five themes: 1) Environmental resources 2) Low carbon 3) Clean energy 4) Sustainable transport 5) Energy efficiency Key points: Based on highest conviction Best Ideas Bottom up stock selection Benchmark unconstrained Contribution to Risk approach to construction efficiently combines large and small stocks Risk framework to monitor portfolio characteristics Two climate change specialists 1 Schroder ISF Global Climate Change is not available to US investors. 10
Important Information: The views and opinions contained herein are those of Global and International Equities Team and do not necessarily represent Schroder Investment Management North America s house view. This document is intended to be for information purposes only and it is not intended as promotional material in any respect. The material is not intended as an offer or solicitation for the purchase or sale of any financial instrument. The material is not intended to provide, and should not be relied on for accounting, legal or tax advice, or investment recommendations. Information herein has been obtained from sources we believe to be reliable but Schroder Investment Management North America Inc. (SIMNA) does not warrant its completeness or accuracy. No responsibility can be accepted for errors of facts obtained from third parties. Reliance should not be placed on the views and information in the document when taking individual investment and / or strategic decisions. The opinions stated in document include some forecasted views. We believe that we are basing our expectations and beliefs on reasonable assumptions within the bounds of what we currently know. However, there is no guarantee that any forecasts or opinions will be realized. Schroders has expressed its own views and opinions in this document and these may change. Past performance is not a guarantee of future results. The value of an investment can go down as well as up and is not guaranteed. Diversification and asset allocation cannot ensure a profit or fully protect against loss. All investments involve risk, including the risk of loss of principal. No investment strategy or risk management technique can guarantee returns or eliminate risk in any market environment. Further information about Schroders can be found at www.schroders.com/us. Schroder Investment Management North America Inc. 875 Third Ave 22nd Floor, New York, NY 10022 (212) 641-3800 11