ESG Integration for Passive Managers:Opportunities and Challenges

Kensuke Niihara

Managing Director,

Chief Investment Officer - Japan

State Street Global Advisors (Japan) Co., Ltd.

4

ESG Integration for Passive

Managers:

Opportunities and Challenges

Kensuke Niihara

Managing Director, Chief Investment Officer - Japan

State Street Global Advisors (Japan) Co., Ltd.

5

Contents

Current Status of Passive Investment

- Background of Growth in Passive

- Criticism to Passive

Role of Passive Investment for ESG Expansion

Desirable Conditions for ESG Index

Examples of ESG Index Construction

6

Source: Morningstar Direct, as of December 31, 2017.

Mutual Fund data is exclusive of Money Markets and Fund of Funds.

13 16 2437

87 84 7663

0102030405060708090

100

2001 2005 2010 2017 YTD

Mar

ket

Shar

e(%

)

Passively Managed Actively Managed

Active and Passive Industry Market Share

US Mutual Fund Market

Growth of Passive Management

Maturing Market

7

Growth of Passive – Demand Side Factors

Cost

Lower expected return

Longer investment

horizon

Efficiency

Decreased alpha opportunity

Multiple active resulted in

expensive passive

Transparency

Requirement for

enhanced accountability

8

Growth of Passive – Supply Side Factors

Enhanced Portfolio Management Techniques

Cost Management

Flexible and practical

control of index deviations

Alpha

Pursue systematic

return opportunities

Index Construction

Customization

9

Criticism of Passive -1

Criticism

RealityIncreased demand for customized indices, not traditional ones

AnswersPassive is effectively the implementation of Asset Owner’s active decisionsT

Asset owners are solving issues themselves rather than relying on active investment

Passive investing is distorting the market

10

Criticism of Passive -2

Criticism

RealityPassive Managers are not allowed to select issuers and provide nearly permanent

capital

AnswersPassive Managers have obligations to foster long term market growth

Passive Managers are not active owners

11

Passive Investment – Future

The trend is supported by both demand and supply

factors and is unlikely to reverse

12

How to Expand ESG Investment

Need ESG integration in passive management

Need appropriate benchmark index to implement

ESG

13

What is Required for an ESG Index -1

Direct Requirements

Transparency

ESG Scoring System

to which Asset Owners,

Investment Managers and

Issuers have access

Fairness

Reliable

Multiple data sources

Effectiveness

Evaluate ESG factors

important for long term

performance

Sector/industry specific

= Financial Materiality

14

What is Required for an ESG Index -2

Indirect Requirements

Policy

BenchmarkLimited impact on strategic

asset allocation

Solution

Flexibility for

customization to reflect

Asset Owner’s interests

Stewardship

Integration with stewardship

activities

(voting and engagement)

15

ESG Scoring Model -1: Regarding E&S

Financially material E&S factors are industry specific

- Introduce “Materiality Map” to reflect financially material

factors for each industry

- Use multiple ESG data sources

16

Why Use Multiple Sources

Sustainalytics MSCI Robeco SAM Bloomberg

Sustainalytics 1.0 0.53 0.76 0.66

MSCI — 1.0 0.48 0.47

RobecoSAM — — 1.0 0.68

Bloomberg — — — 1.0

( As of June 2017)

Cross-Sectional Correlation for Constituents of the MSCI World Index

ESG Scores are Different Across Providers

(11 Sectors / 77 Industries)

(5 Sustainability Dimensions/

26 General Issue Items/

200+ Environmental and Social Specific Topics)

17

- Transparent framework widely

supported by Investors and

Issuers

Y

N

: Likely a material issue for

companies in the industry

: Not Likely a material issue for

companies in the industry

ESG Materiality Map - SASB**Sustainable Accounting Standards Board

Evaluate Financial Materiality for more than +200 ESG items by 77 industries

18

ESG Scoring Model -2: Regarding G

Governance practices are market specific as they are

based on legislation, regulation, ethics business norms,

etc.

- Reflect country-level corporate governance codes

developed by local regulators or Investors

19

ESG Scoring Model -3: ExampleIntegrated Model

Best-in-class

Multiple Data Source

Sustainalytics

Vigeo EIRIS

ISS ESG

E/S Scoring Model

= Materiality Map

ISS Governance

Governance Scoring Model

SASB (Sustainable Accounting Standards Board)

Integrated ESG

Score

Optimization(Control of Tracking Error)

Example of ESG Index Construction -1Construction Process (US Large Cap)

20

Base Index

-15Score

Missing

Number of

Constituents

ControversyMissing Data

Exclusions Screening

181

Eligible for

ESG Index

508 459-5Extreme Event

Controversies

-2Controversial

Weapons

-0Thermal Coal

-18UNGC

Violations

-6Tobacco

-0Civilian

Firearms

Final

ESG Index

Source: SSGA, Bloomberg as at June 30, 2019. For illustrative purposes only.

The characteristics shown are not intended to represent the characteristics of any particular security or other investment.

OptimizationConstraints :Control of TE, Sector/Issue weight

Objective : Maximization of ESG Score

- Flexible customization on Screening, Active Risk and ESG Outcomes

15.9%

34.1%32.1%

10.0%

3.1% 4.7%

Leaders Outperformer

Average Underperformer

Laggard n/a

39.8%

48.1%

9.4%2.8%

ESG Index

(BESGOX) 70.16

US Large Cap

Equity Index

（B500T） 62.89

21

Index Characteristics & ESG Score

ESG Index US Large Cap Index

Source: Bloomberg, Factset, State Street Global Advisors as of 06/30/2019.

Example of ESG Index Construction -2Better ESG Score (US Large Cap)

Example of ESG Index Construction -3Performance Back-test (US Large Cap)

Since

Inception

%

Volatility

%

Tracking

Error

%

Beta

ESG Index

(BESGOXT Index)

Back-tested

11.7 11.8 1.14 1.00

S&P500 Index 11.3 11.8 - -

22

Source: Bloomberg, Factset, State Street Global Advisors as of 06/30/2019, calculated using monthly

total returns in USD. The inception date of each of the ESG Index (Bloomberg SASB ESG Select ex

Controversies US Large Cap Index) is 3/25/2019. Pre-inception index performance shown above is

back tested (hypothetical) performance and is not a guarantee of past or future results. Actual

performance of any investment may have differed substantially from the back-tested performance

presented, as the performance was calculated with the benefit of hindsight and cannot account for all

financial risk that may affect the actual performance. Performance prior to the inception date of the

index referenced herein is derived from actual performance of underlying index constituents weighted

according to the index's predefined methodology, taking into account rebalancing schedules. Indices

are unmanaged, are not subject to fees and expenses, and are not available for direct investment. Past

performance is not a guarantee of future results.

Back-tested Performance (USD)From March 31 2014 to June 30 2019 (Annualized)

-2%

0%

2%

4%

6%

8%

10%

-20%

0%

20%

40%

60%

80%

100%

2014/3 2015/3 2016/3 2017/3 2018/3 2019/3

ESGインデックス（バックテスト）

S&P500

収益差（右軸）

ESG Index (Back-test)

S&P 500 Index

Return Difference (RHS)

Example of ESG Index Construction -4Performance Back-test (US Investment Grade Corporate Bond)

Since

Inception

%

Volatility

%

Tracking

Error

%

Beta

ESG Index

(I35146US Index)

Back-tested

4.54 3.90 0.30 0.99

Bloomberg US Corporate

Index4.40 3.94 - -

23

Source: Bloomberg, State Street Global Advisors as of 06/30/2019, calculated using monthly total

returns in USD. The inception date of each of the ESG Index (Bloomberg SASB ESG Select ex

Controversies US Corporate Index) is 2/28/2019. Pre-inception index performance shown above is

back tested (hypothetical) performance and is not a guarantee of past or future results. Actual

performance of any investment may have differed substantially from the back-tested performance

presented, as the performance was calculated with the benefit of hindsight and cannot account for all

financial risk that may affect the actual performance. Performance prior to the inception date of the index

referenced herein is derived from actual performance of underlying index constituents weighted

according to the index's predefined methodology, taking into account rebalancing schedules. Indices

are unmanaged, are not subject to fees and expenses, and are not available for direct investment. Past

performance is not a guarantee of future results.

Back-tested Performance (USD)From March 31 2014 to June 30 2019 (Annualized)

-1.0%

-0.5%

0.0%

0.5%

1.0%

1.5%

2.0%

2.5%

3.0%

-10%

-5%

0%

5%

10%

15%

20%

25%

30%

2014/3 2015/3 2016/3 2017/3 2018/3 2019/3

ESG社債インデックス（バックテスト）

バークレイズ米国社債インデックス

収益差（右軸）

ESG IG Corporate Index (Back-test)

Bloomberg Barclays US IG Corp

IndexReturn Difference (RHS)

24

Integration with Stewardship

Even in Passive Management,

we should look for synergy between an ESG index and

stewardship activities

- Refer to ESG score used in the index during engagement

- Foster improved ESG practices and disclosure through the

score

Increasing Role for Passive Management

Passively Managed ESG Investment is a key to Expand ESG Investment

Need for ESG Index

- ESG Scoring (Multiple Data Sources, Effective Materiality Map)

- Control of Tracking Error

Integration with Stewardship Activities

Customized Solution to meet each Asset Owner’s Interests

25

Summary

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