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Sustainable Investing Opinion Briefs: November 30, 2018

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November 23, 2018 – A report from Cerulli Associates states that the “variety and scope of sustainable bond funds” are expected to “expand considerably” over the next 5 years. At present, most sustainable bond funds are focused on investment grade corporate debt. The report suggests that limited availability of sustainable sovereign and high yield bonds, “where only 21% and 24%, respectively, apply ESG criteria” is partially to blame. Adding to the problem may also be the difficulty in compiling ESG bond indices, when there are multiple issuers and issues per company. It is true that sustainable fixed income mutual funds and ETFs/ETNs, on a combined basis account for 19.4% of funds/share classes and only 8.7% of fund net assets. We feel that this is, in part, related to the fact that the idea of ESG integration was first applied to equities and attention has only recently begun to shift to fixed income and other asset classes. In addition, applying ESG to fixed income is much more complicated given issues such as the varying fixed income security types and consideration of time horizon. It may also be that the strong equity markets experienced over the last nine years may have something to do with it. It’s worth remembering the shift toward fixed income funds that took place in the early-to-mid 1980s, when bond markets outperformed and this segment of the mutual fund market took off.

November 19, 2018 – A study by InvestmentNews (sponsored by Calvert Research & Management) looks at the difference between male and female advisers’ “perception of ESG”. The report, “Female advisers more likely to consider ESG investing strategies,” finds that male advisers are “less likely to believe there is a positive association between ESG factors and corporate financial performance” – 49% of female advisors agree with this versus 30% of male advisers. Moreover, “zero female advisors strongly disagree with this statement”. We believe there is a cautionary concern to these findings, especially in light of research showing much interest by millennials in ESG investing. Male advisers could very well be left out of this important and upcoming market segment. As important, the reputational perception of male advisors could be damaged in areas beyond ESG considerations.

November 16, 2018 – In the Barron’s article entitled “A Better Approach to ESG”, Reshma Kapadia feels that ESG investing can better be served by something other than an exclusionary management approach. Her view is that an “inclusionary approach” which selects companies that are “less bad” with respect to sustainability practices may be the way to go. In no small part, an inclusionary approach may be more attractive to investors because it doesn’t need to sacrifice returns, which is a complaint from some concerning exclusionary investment processes. We agree. In fact, the argument made in favor of an inclusionary approach is that companies with overall good performance in their environmental, social and governance programs can increase their market valuation (see George Serafeim research below) and this could, in turn, have a positive impact on portfolio results, all else being equal. At the same time, an inclusionary approach that relies on ESG integration asks more of portfolio managers and analysts, and until clearer (and standardized) company reporting and sustainable records are available, particularly with regard to some of the uncertain and long-term and issues such as climate change, this presents challenges in the short-to-intermediate-term. Among these are analytical comparability among companies and ultimately portfolios.

October 29, 2018 – A working paper published by George Serafeim of Harvard Business School entitled “Public Sentiment and the Price of Corporate Sustainability” makes the case that combining corporate sustainability performance scores based on environmental, social, and governance (ESG) data with big data measuring public sentiment about a company’s sustainability performance, increases the valuation premium paid for companies with strong sustainability performance over time and that the premium is increasing as a function of positive public sentiment momentum. An ESG factor going long on firms with superior or increasing sustainability performance and negative sentiment momentum and short on firms with inferior or decreasing sustainability performance and positive sentiment momentum delivers significant positive alpha. This low sentiment ESG factor is uncorrelated with other factors, such as value, momentum, size, profitability, and investment. In contrast, the high sentiment ESG factor delivers insignificant alpha and is strongly negatively correlated with the value factor. The evidence suggests that public sentiment influences investor views about the value of corporate sustainability activities and thereby both the price paid for corporate sustainability and the investment returns of portfolios that consider ESG data. This research, in our view, boosts the case for ESG integration in portfolio investing. It should be kept in mind, however, that within the context of active portfolio management, as is the case with other factors, the impact that a positive ESG premium may otherwise deliver could be diluted or enhanced. These factors include portfolio industry/sector allocations and security weightings, geographic distribution, and company size factors, to mention just a few.

August 15, 2018 – United States Senator Elizabeth Warren (D-Mass) introduced the Accountable Capitalism Act which, according to the act’s text, is designed “to help eliminate skewed market incentives and return to the era when American corporations and American workers did well together. The legislation aims to reverse the harmful trends over the last thirty years that have led to record corporate profits and rising worker productivity but stagnant wages.” The act sets out the following requirements:• Requires very large American corporations to obtain a federal charter as a “United States corporation,” which obligates company directors to consider the interests of all corporate stakeholders: American corporations with more than $1 billion in annual revenue must obtain a federal charter from a newly formed Office of United States Corporations at the Department of Commerce. The new federal charter obligates company directors to consider the interests of all corporate stakeholders – including employees, customers, shareholders, and the communities in which the company operates. This approach is derived from the thriving benefit corporation model that 33 states and the District of Columbia have adopted and that companies like Patagonia, Danone North America, and Kickstarter have embraced with strong results. • Empowers workers at United States corporations to elect at least 40% of Board members: Borrowing from the successful approach in Germany and other developed economies, a United States corporation must ensure that no fewer than 40% of its directors are selected by the corporation’s employees.• Restricts the sales of company shares by the directors and officers of United States corporations: Top corporate executives are now compensated mostly in company equity, which gives them huge financial incentives to focus exclusively on shareholder returns. To ensure that they are focused on the long-term interests of all corporate stakeholders, the bill prohibits directors and officers of United States corporations from selling company shares within five years of receiving them or within three years of a company stock buyback.• Prohibits United States corporations from making any political expenditures without the approval of 75% of its directors and shareholders: Drawing on a proposal from John Bogle, the founder of the investment company Vanguard, United States corporations must receive the approval of at least 75% of their shareholders and 75% of their directors before engaging in political expenditures. This ensures any political expenditures benefit all corporate stakeholders. • Permits the federal government to revoke the charter of a United States corporation if the company has engaged in repeated and egregious illegal conduct: State Attorneys General are authorized to submit petitions to the Office of United States Corporations to revoke a United States corporation’s charter. If the Director of the Office finds that the corporation has a history of egregious and repeated illegal conduct and has failed to take meaningful steps to address its problems, she may grant the petition. The company’s charter would then be revoked a year later – giving the company time before its charter is revoked to make the case to Congress that it should retain its charter in the same or in a modified form.The fundamental premise behind the legislation is that harmful corporate ownership trends in the last thirty years have contributed to stagnant wages and these have to be reversed. Our opinion is that these observations should be debated and further scrutinized. At first blush, they don’t seem to be supported by factual data. Further, the idea behind obligating company directors to consider the interests of all corporate stakeholders is one that has been gaining attention and advocated, for example, by proponents of long-termism, including, BlackRock CEO Larry Fink who highlighted, in his 2018 letter to CEOs, the firm’s view that boards are central in the oversight of companies’ long-term strategic direction and what he believes is a connection between companies’ management of ESG risk factors and long-term value creation. We hold the view that the market is the best arbiter of whether companies are acting in the best interests of their shareholders, customers and their community.

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