Principal Global Equities ESG Principles at Principal Global Equities Addressing your questions on Environmental, Social, and Governance (ESG) investing matters Institutional client interest and awareness in Environmental, Social and Governance (ESG) is on the rise. According to a recent CFA report: Both value-motivated and values-motivated investors consider ESG issues in investment decisions. * While the historical interest in ESG has been primarily on client-directed exclusions or values-motivated, that trend is changing. Today, there is growing consensus among the institutional investor community that a value-motivated perspective is also important. Integration of ESG into the investment process plays a role in the evaluation of companies and the long-term sustainability of their business models. In this paper, we explore customized strategies, how ESG fits into our overall investment process, and the role of engagement. Client design matters Customizing strategies for ESG client requests including mandates specific investment preferences Materiality matters Understanding how ESG fits into Principal Global Equities (PGE s) overall investment process with bottom-up stock selection and materiality identification Engagement matters Diving deeper into company engagement, ESG indices and ESG data benefits of direct communication with companies ESG data insights drive dialogue Principal Global Investors long-standing commitment to ESG 10+ years ESG experience You asked, we re answering United Nations sponsored Principles for Responsible Investing (PRI) Signatory since 2010 overall A rating Additional information available on page 14 In this paper, at the bottom of each section, we answer your frequently asked ESG questions. *Environmental, Social, and Governance Issues in Investing. A Guide for Investment Professionals. CFA Institute: October 2015. 1
ESG terminology matters Both client preferences and ESG adoption have evolved over the last 10 years. That said, ESG terminology and the way investors define it are also changing. The past decade has given rise to different terminology that describes ESG investing approaches including socially responsible investing (SRI), sustainability, impact investing, and mission-related investing (MRI), among others. In many cases, these terms have also become interchangeable, adding to the confusion of what exactly ESG is. ESG can mean different things to different types of investors and organizations. But, at the highest level, ESG can be broadly grouped as follows E Environmental S Social G Governance energy efficiency, renewability, and depletion of resources environmental impact including greenhouse gas emissions new or changing regulations water and waste management chemical pollution community relations corporate behavior labor standards and human rights issues for the company and its supply chain workplace health and safety accounting practices auditor structure and autonomy quality, structure and independence of the board compensation policies management protocols shareholder rights and anti-takeover measures transparency and accountability use of capital Of course, these are just examples and not meant to be an all-inclusive list. Now that we ve covered ESG terminology, let s dive into specifics. 2
Client design matters For institutional investors with an ESG mandate Historically, clients have shaped the evolution of institutional ESG mandates as a reflection of their principles. As ESG preferences have emerged, clients have found a reliable, proven, and experienced partner in Principal Global Equities (PGE). We successfully execute custom ESG or SRI mandates and investment objectives in accordance with client-defined policies. This can include: Over the last ten years institutional clients from around the world began judiciously seeking out PGE for their ESG related mandates, issues, and concerns. Negative screening Restricted securities list Selected industries Country or region Principal Global Equities Successful management of strategies for clients with varying needs including: global developed all country emerging markets small cap single country or region ESG index More on managing to an ESG benchmark PGE can also manage equity strategies against an ESG benchmark like the MSCI ESG indices or any other index requested by the client. MSCI Global MSCI Global ex MSCI ACWI MSCI Global Socially MSCI Global Sustainability Controversial Sustainable Responsible Investing Environmental Indices Weapons Indices Impact Index (SRI) Indices Indices Note: These are just examples. We can manage to virtually any suitable index requested by the client. 3
When a one-size-fits-all approach simply won t do Your ESG goals are unique and a one-size-fits-all approach simply won t do. That s where the customization capabilities of Principal Global Equities can help. You don t need just any investment manager. You need a strategic partner that s astute at customization with over a decade of experience executing the strategies in strict adherence to your policies. Your questions answered What is your ESG equity strategy customization experience? Is it more than 10 years? Yes No Can you manage to specific criteria like exclusions, inclusions and more? Yes No Are you able to manage to an ESG benchmark? Yes No Now that you know more about our capabilities on client- requested ESG customization, let s focus on how we integrate ESG into the investment process. 4
Materiality matters Investment process-oriented integration Many fundamental analysts confirm that E and S issues can be material in the analysis of company fundamentals. Governance (G) on the other hand, is inherently tied to company fundamentals and valuation. It impacts results for our clients. These examples demonstrate how E and S can be materiality drivers instances that showcase the inherent materiality of G Governance company fundamentals and valuation impacts client results E Environmental materiality driver: Water availability and supply affect a company that relies heavily on this resource as a key component in its manufacturing process. Supply shortages would have devastating impacts on shareholder value. S Social materiality driver: A history of labor disputes could impact a company that relies heavily on human capital for its product production. This can dramatically impact shareholder value. G Governance is material: Governance covers many aspects of a company, but two specific examples include: internal accounting or auditing controls are lacking the management team s compensation structure may lead to short-term decision making versus longer-term investment decisions. Governance is at the core of risk management and will be covered in more detail on page 7. PGE s commitment to ESG issues is centered on one key factor: our fiduciary responsibility to our clients to act in their long-term best interests first. Our bottom-up investment philosophy is at the core of every strategy We consider material ESG issues as a natural extension of our understanding the drivers of a stock s performance. ESG considerations are simply baked in as part of our bottom-up stock selection process. For clients interested in understanding how our investment process integrates with ESG issues, there are three parts to consider: Environmental (E) and Social (S) considerations as material qualitative risk factors Governance (G) standards and trends as inherent to our analysis of fundamental change. 5
1. Principal Global Equities investment philosophy bottom-up stock selection is the most reliable and repeatable source of consistent performance. our stock selection approach focuses on the early identification of fundamental change and differentiating companies on the basis of: Sustainable earnings trends Investor sentiment Relative valuation measures Generally, ESG comes into play in two ways within this philosophy as: a risk management tool a potential indicator of fundamental change Possible positive signal example Neutral signal example When studying a company s fundamentals, our analysts could uncover that the progressive management team is ahead of competitors on a material Environmental issue. It will allow the company to grow faster in the future. This, along with many other positive factors could signal the beginnings of a fundamental change to be exploited because it is not yet fully appreciated in the marketplace. Even when E and S considerations may be relevant, they may not be a differentiator among companies in the same sector. Implementing strong environmental practices in certain industries is the norm. This is not a fundamental driver because following the requirements is necessary to obtain permits for doing business. Our industry-specific analysts know the difference and dig deeper into what factors will drive future earnings. 6
2. Material E and S considerations are an element in our qualitative risk assessment in stock selection. Our analysts are specialized by region and sector. They have essential insights into industry trends and companyspecific considerations. Our bottom-up stock selection process hones in on material E and S issues that are relevant to the evaluation of sustainable earnings trends, sentiment and valuation. E and S issues are qualitative factors that contribute to an overall stock view. From fossil fuel to wind and beyond Practical application of E We currently own a Spanish based utility company with operations in over 40 countries. It is replacing its conventional fossil fuel capacity with renewables, especially wind and solar. In fact, the company is now the world s largest owner of wind farms representing almost one-third of their portfolio. The company s business and geographic mix should enable them to grow faster than peers, with less risk and further upside from efficiency gains. With a strong pipeline of projects, there is potential for positive surprise as the company benefits from new investment projects. Say no to child labor in the supply chain Practical application of S If the company finds underage workers in their suppliers factories, they make the suppliers return the children to their homes, pay for their education at a school of their family s choice and to provide income for basic needs until they reach legal working age. A third party organization is enlisted to monitor the children s progress and report back to the company. After they complete their education, suppliers must offer them re-employment. 3. Governance (G) standards and trends are inherent to our fundamental analysis. Governance is material because it is inherently tied to company fundamentals and valuation. Companies with strong governance are generally correlated with improved valuations while companies with deteriorating governance historically underperform and are a source of risk. Governance is multi-faceted and includes internal auditing controls, management compensation, shareholder rights protections, board independence, transparency and proxy voting. Aggressive accounting triggered sell of long-time holding Practical application of G We sold a long-time holding in a multi-national pharmaceutical company with manufacturing sites in Canada, Brazil, Poland, and Mexico when their fourth quarter earnings unveiled questionable business practices and aggressive accounting, this suggested a lack of essential business controls within the company. Executive pay given to the third degree Practical application of G We engaged with a prospective company about why their executive compensation policies were very different from the industry norms. During those discussions, we learned more from the senior management team. Executive compensation was above the industry norm if the company performed, but well below average if the company missed key targets. We determined that this was a positive fundamental driver and in alignment with long-term shareholder value. 7
In summary, our commitment to ESG issues is centered around our fiduciary responsibility to our clients to act in their long-term interests first. With this in mind, we take a three-step approach. Our investment philosophy Based on bottom-up stock selection and the early identification of fundamental change E S E Environmental S Social G Governance Considerations Standards and trends If material to long-term shareholder value, they are included in the qualitative risk analysis. Are inherent to our analysis of fundamental change. Your questions answered What is your thinking on ESG as it relates to stock selection? E and S are qualitative risk factors to the extent they are material G is inherent to our analysis of stock selection and fundamental change Now that we ve covered ESG client design matters and ESG issues as bottom-up matters, let s turn our attention to engagement matters. 8
Engagement matters Company conversations, data, insight-driven dialogue, and proxy voting 1. Company conversations Direct communication between investors and companies on ESG matters (engagement) is an important element of the portfolio management services provided to our clients. Engagement is one of the many elements that influence our holistic view of shareholder value and long-term risk-adjusted return potential. Engagement includes: Collaboration with the companies on responsible ESG practices Greater transparency in their ESG practices and how those practices may fit into the company s overall business activities Management of governance risks and reacting swiftly to achieve a competitive advantage relative to peers 2. Data insights that can drive additional dialogue In recent years, many third party research and data providers have undertaken efforts to formalize ESG considerations in the contexts of scoring systems, quantitative factors, qualitative assessments, reporting, and advice. We find the company ratings and ESG insights from external sources may be relevant to understanding the fundamental outlook for future earnings of companies. This information may impact our outlook on the company s ability to be competitive in the short-term and long-term among their peers. Information from these third-party sources can inspire more ESG engagement when our fundamental analysts are meeting with companies. A key distinction of our research process is the depth of coverage, encompassing companies large and small, in developed and emerging markets worldwide. We have also found there are practical limitations to currently available ESG data worth noting. ESG information can be limited, tilted toward larger companies, and have systematic biases that could be detrimental to the economic interest of clients as Exhibit 1 illustrates on the next page. 3. Proxy voting We have retained the services of Institutional Shareholder Services (ISS). ISS is a top-tier provider of proxy voting solutions to institutional clients globally. The service provides in-depth research, voting recommendations, vote execution, recordkeeping, and reporting. Proxy voting guidelines can be customized to client preferences. 9
Exhibit 1: European indices in major developed markets disproportionally lead the ESG Ratings ESG ratings for indices are from AA (higher) B (lower) European indices in major developed markets disproportionally lead the ESG ratings. The (unintended) result is a bias toward investment in Europe, away from emerging markets, and explicitly favoring large-cap over small-cap companies. AA A BBB BB B European indices Emerging markets indices All other indices Source: MSCI, BlackRock calculations Data shown is as of 31 December 2016. Please refer to the disclosure section for a complete list of indices shown in this exhibit. For illustrative purposes ratings AA to B are shown above. MSCI ESG ratings range from AAA to C. While ESG indices have come a long way and continue to evolve, there are gray areas, gaps in research coverage, and tilting in indices. These gray areas highlight why company engagement on ESG issues and our bottom-up stock selection process is so critical to strong long-term return potential for our clients. Your questions answered What is your engagement with companies on ESG issues? One of the many elements that influence our holistic view of shareholder value and long-term risk-adjusted return potential. Especially important given the global reach of our investment strategies. Do you offer proxy voting customization? Yes No We take seriously our commitment to society on a global basis. We believe that we must take responsibility for educating others and ourselves by addressing a range of ESG issues that are critical to the well-being of the many communities in which our company operates and our investments impact and may maximize shareholder value. 10
Summary Client design matters Consider us for your next ESG equity mandate. We are an experienced and capable asset manager with a wide range of customized strategies for your investment objectives. Materiality matters Material Environmental (E) and Social (S) considerations are elements in our qualitative risk assessment in stock selection. Governance (G) standards and trends are inherent in our analysis. Engagement matters Direct communication between investors and companies on ESG matters (engagement) is important. It is one of the many elements that influence our holistic view of shareholder value and long-term riskadjusted return potential. 11
Our commitment to a continual learning culture Training and third party research insights are two important components contributing to our learningfocused culture on ESG. Training Implemented training programs with research analysts and other key investment personnel to enhance their awareness of the Principles of Responsible Investment and general ESG considerations and will continue to expand upon those in the future. Third party research insights Bloomberg ESG Data- Since 2013 More than 120 indicators for approximately 5,000 publicly-listed companies globally. Also provides sustainability news, research, indices, funds, energy and emissions data, legal and regulatory as well as robust screening, scoring and other portfolio optimization tools. MSCI ESG Data- Starting in 2016 Began subscribing to MSCI ESG analytics and suite of ESG indices. MSCI offers coverage on the broadest universe among its peers. MSCI ESG ratings are designed to identify ESG risks or opportunities that may not be captured through conventional analysis. They offer analysis that evaluates companies among their peers, aligned with PGE s research process. Our analysts will have access to company tear sheets to summarize the key drivers of the ratings. This can further inform their conversations with company management. Several of our fundamental and quantitative analysts are currently beta testing company research within the framework of our investment process. 12
Long-standing tradition of corporate stewardship United Nations sponsored Principles for Responsible Investing (PRI) Became a signatory in December 20101 PRI signatory status: overall A rating The Principles for Responsible Investing are based on the premise that ESG issues can impact the performance of investment portfolios and investors should give them appropriate consideration to fulfill their fiduciary duty. In signing the principles, Principal Global Investors publicly commits, where consistent with our fiduciary responsibilities to the following: 1 2 3 4 5 6 to incorporate ESG issues into our investment analysis and decision-making processes to be active owners and incorporate ESG issues into our ownership policies and practices to seek appropriate disclosure on ESG issues from the entities we invest in to promote acceptance and implementation of the principles within the investment industry to work with other signatories to enhance effectiveness in implementing the principles to report on our activities and progress towards implementing the principles Our most current Responsible Investing Transparency report can be found on the UNPRI website or using the link provided at the end of this paper. Timeline 2010 Principal became signatory to the PRI 2016 PGE began using MSCI ESG analytics. 2001 PGE began managing equity ESG-related mandates 2013 PGE began using Bloomberg ESG Data 1 Many institutions committed to ESG principals have become signatories of the Principles for Responsible Investments (PRI). As of April 2016, some 1,500 financial institutions with total assets in excess of $60 trillion were PRI signatories. Further information can be found on www.unpri.org 13
For additional information, please visit us at www.principalglobal.com. Unless otherwise noted, the information in this document has been derived from sources believed to be accurate as of April 2017. Information derived from sources other than Principal Global Investors or its affiliates is believed to be reliable; however, we do not independently verify or guarantee its accuracy or validity. Past performance is not necessarily indicative or a guarantee of future performance and should not be relied upon to make an investment decision. The information in this document contains general information only on investment matters. It does not take account of any investor s investment objectives, particular needs or financial situation and should not be construed as specific investment advice, an opinion or recommendation or be relied on in any way as a guarantee, promise, forecast or prediction of future events regarding a particular investment or the markets in general. 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Principal Global Investors disclaims any and all express or implied warranties of reliability or accuracy arising out of any for error or omission attributable to any third party representation, example, or data provided herein. All figures shown in this document are in U.S. dollars unless otherwise noted. This document is issued in: The United States by Principal Global Investors, LLC, which is regulated by the U.S. Securities and Exchange Commission. Europe by Principal Global Investors (Europe) Limited, Level 1, 1 Wood Street, London EC2V 7JB, registered in England, No. 03819986, which has approved its contents, and which is authorised and regulated by the Financial Conduct Authority. Singapore by Principal Global Investors (Singapore) Limited (ACRA Reg. No. 199603735H), which is regulated by the Monetary Authority of Singapore and is directed exclusively at institutional investors as defined by the Securities and Futures Act (Chapter 289). 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Exhibit 1 indices information AA A EURO STOXX 50 ex Financials EURO STOXX Total Market (TMI) Large Cap Growth EURO STOXX Total Market (TMI) Large Cap Value FTSE Eurofirst 80 MSCI Developed France MSCI Europe Sector Neutral Quality MSCI Europe Socially Responsible Index (SRI) MSCI European and Monetary Union (EMU) MSCI EMU Large Cap MSCI Japan SRI NASDAQ OMX Stockholm 30 STOXX Eurozone 50 STOXX Eurozone Select Dividend 30 EURO STOXX Small FTSE 100 FTSE 250 FTSE European Public Real Estate Association/ National Association of Real Estate Investment Trusts (EPRA/NAREIT) UK FTSE EPRA/NAREIT Developed Europe ex UK Dividend FTSE Eurofirst 100 FTSE Milano Italia Borsa (MIB) FTSE UK Dividend+ MSCI Developed Australia MSCI Developed United Kingdom MSCI EMU Mid Cap BBB MSCI Europe MSCI Europe Diversified Multiple-Factor MSCI Europe Enhanced Value MSCI Europe ex EMU MSCI Europe ex UK MSCI Europe Mid Cap Equal Weighted MSCI Europe Minimum Volatility MSCI Europe Momentum MSCI UK Investable Market Index (IMI) Core Real Estate Volatility Tilt MSCI UK Large Cap MSCI UK Small Cap STOXX Europe 50 STOXX Eurozone Mid MSCI Emerging Markets SRI Dow Jones Asia/Pacific Select Dividend 30 Dow Jones Sustainability World Enlarged ex Alcohol, Tobacco, Gambling FTSE Macquarie 100 MSCI Developed Canada MSCI Developed Pacific ex Japan MSCI Developed World Islamic MSCI USA SRI MSCI World Sector Neutral Quality S&P Global Clean Energy S&P 500 Information Technology BB B MSCI EMU Small Cap Dow Jones Emerging Markets (EM) Select Dividend MSCI All Country World Index (ACWI) EM Consumer Growth MSCI EM Latin America MSCI EM Minimum Volatility MSCI EMU Small Cap MSCI Emerging Brazil MSCI Emerging Chile MSCI Emerging Poland MSCI Emerging South Africa MSCI Emerging South Korea MSCI Taiwan Dow Jones Industrial Average FTSE Brazil, Russia, India and China (BRIC) 50 MSCI China A International MSCI EM MSCI EM Asia MSCI EM Eastern Europe 10-40 MSCI EM IMI MSCI EM Islamic MSCI Mexico Capped FTSE EPRA/NAREIT Developed Asia Dividend+ FTSE EPRA/NAREIT Developed Dividend+ MSCI All Country (AC) World MSCI Developed Japan MSCI Developed US MSCI Japan Small Cap MSCI North America MSCI US Islamic MSCI USA Diversified Multiple-Factor MSCI USA Enhanced Value MSCI USA Mid-Cap Equal weighted MSCI USA Momentum MSCI USA Sector Neutral Quality MSCI World MSCI Russia MSCI Turkey S&P EM Infrastructure FTSE EPRA/NAREIT US Dividend+ MSCI AC Far East ex Japan Small Cap MSCI AC World Far East ex Japan MSCI USA Small Cap S&P 500 Commodity Producers Oil and Gas Exploration and Production MSCI World Diversified Multiple-Factor MSCI World Enhanced Value MSCI World Mid Cap Equal Weighted MSCI World Minimum Volatility MSCI World Momentum NASDAQ 100 Nikkei 225 S&P 500 S&P Commodity Producers Agribusiness S&P Global Water S&P 500 Minimum Volatility S&P Global Timber and Forestry S&P 500 Consumer Discretionary S&P 500 Healthcare Sector S&P 500 NET Total Return (TR) Energy Sector S&P 500 NET TR Financials Sector S&P 600 Small Cap S&P Commodity Producers Gold FTSE China 50 15