The Art and Science of ESG Investing
May 4, 2015Christopher C. McKnettManaging Director & Head of ESG
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This material is solely for the private use of NCPERS Conference and is not intended for public dissemination.All the information contained in this presentation is as of date Indicated unless otherwise noted
Evolution of ESG Investing
From values‐based to thematic and integrated approaches
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Source: SSGA.
Phase Goal MotivationPrimary Techniques
Management Style
1st Generation • Avoid investments in companies that are not compatible with mission and goals
• Align investments with values or mission
• Exclusionary screening • Active or Passive
2nd Generation • Incorporate ESG factors into investment decisions
• Recognize materiality of some ESG issues
• Balance ESG and market exposures
• Positive screening to preference desired ESG exposures
• Best in class selection to optimize ESG exposure within risk managed framework
• Active or Passive
3rd Generation • Harness ESG information to improve the investment outcome
• Generate alpha
• Risk management
• Integrate ESG signal into alpha model or portfolio construction
• Risk overlays
• Thematic investments
• Mainly Active
More Constrained
Less Constrained
Market Sizing
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As of February 24, 2015, updated annually. Sources: Global Sustainable Investment Alliance, SSGA. Underlying asset figures are as of various dates and in some cases assume currency adjustments to USD. Figures do not account for subsequent asset flows or market effects. Rest of World is calculated using a 1% multiple of the sum of other reported assets. Does not equate to the addressable market for SSGA.
$0.95tr
$6.6tr
~US$21.6 Trillion
$13.6tr$0.05tr
$0.2tr$0.26tr ROW
Performance Over the Long Run
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As of March 31, 2015. Source: MSCI. USD Gross Returns. Indexes rebased to 100 on September 30 , 2007This information should not be considered a recommendation to invest in any particular sector or to buy or sell any security shown. Index returns are unmanaged and do not reflect the deduction of any fees or expenses. Index returns reflect all items of income, gain and loss and the reinvestment of dividends and other income.Past performance is not a guarantee of future results.
MSCI World ESG Index and MSCI World Index
40
50
60
70
80
90
100
110
120
130
140
WORLD WORLD ESG
Performance Over the Longer Run
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As of March 31, 2015. Source: MSCI. USD Gross Returns. Indexes rebased to 100 on April 30 , 1990 This information should not be considered a recommendation to invest in any particular sector or to buy or sell any security shown. Index returns are unmanaged and do not reflect the deduction of any fees or expenses. Index returns reflect all items of income, gain and loss and the reinvestment of dividends and other income.Past performance is not a guarantee of future results.
MSCI KLD 400 Social Index and MSCI USA Index
0
100
200
300
400
500
600
700
800
900
1,000
1,100
1,200
1,300
MSCI KLD 400 Social MSCI USA
ESG Catalysts
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Sources: SSGA. The information contained above is for illustrative purposes only.
Confluence of Forces
Evolving Global Risk Landscape
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Source: Global Risks 2015 10th Edition . © World Economic Forum 2015 —All rights reserved.
2007 2008 2009 2010 2011 2012 2013 2014 20151st Breakdown of
critical information infrastructure
Asset price collapse
Asset price collapse
Asset price collapse
Storms and cyclones
Severe income disparity
Severe income disparity
Income disparity Interstate conflict w/regional consequences
2nd Chronic Disease (DM)
Middle East Instability
Slowing Chinese Economy (<6%)
Slowing Chinese Economy (<6%)
Flooding Chronic fiscal imbalances
Chronic fiscal imbalances
Extreme weather events
Extreme weather events
3rd Oil price shock Failed and failing states
Chronic Disease Chronic Disease Corruption Rising greenhouse gas emissions
Rising greenhouse gas emissions
Unemployment and underemployment
Failure of national governance
4th China economic hard landing
Oil and gas price spike
Global governance gaps
Fiscal crises Biodiversity loss
Cyber attacks Water supply crises
Climate change State collapse or crisis
5th Asset price collapse
Chronic Disease (DM)
Retrenchment from globalization (EM)
Global governance gaps
Climate change Water supply crises
Mismanagement of population ageing
Cyber attacks High structural Unemployment and underemployment
2007 2008 2009 2010 2011 2012 2013 2014 20151st Asset price
collapseAsset price collapse
Asset price collapse
Asset price collapse
Fiscal crises Major systemic financial failure
Major systemic financial failure
Fiscal crises Water crises
2nd Retrenchment from globalization
Retrenchment from globalization (DM)
Retrenchment from globalization (DM)
Retrenchment from globalization (EM)
Climate change Water supply crises
Water supply crises
Climate change Rapid and massive spread of infectious diseases
3rd Interstate and civil wars
Slowing Chinese Economy (<6%)
Oil and gas price spike
Oil price spike Geopolitical conflict
Food shortage crises
Chronic fiscal imbalances
Water crises Weapons of mass destruction
4th Pandemics Oil and gas price spike
Chronic Disease Chronic Disease Asset price collapse
Chronic fiscal imbalances
Weapons of mass destruction
Unemployment and underemployment
Interstate conflict w/regional consequences
5th Oil price shock Pandemics Fiscal crises Fiscal crises Extreme energy price volatility
Extreme energy / ag price volatility
Failure of climate change adaptation
Critical information infrastructure breakdown
Failure of climate change adaptation
Top 5 Global Risks in Terms of Likelihood
Top 5 Global Risks in Terms of Impact
Why ESG Matters
0%
20%
40%
60%
80%
100%
1975 1985 1995 2005 2010
Intangible Assets Tangible Assests
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* Source: Ocean Tomo, data updated every five years.The information contained above is for illustrative purposes only.Standard & Poor's S&P Indices are registered trademarks of Standard & Poor's Financial Services LLC.Tangible assets are assets that have a physical form including, but not limited to, property, plant and equipment and inventory.Intangible assets are nonphysical assets, including, but not limited to, patents, trademarks, copyrights and goodwill.
Components of S&P 500® market value* Value creation influenced by more than financial capital alone
Factor Indicators
Environment • Emissions (air, water)• Resource efficiency• Waste reduction• Water scarcity/stress• Natural capital
Social • Health & safety• Human capital• Human rights • Labor practices• Product safety & quality• License to Operate
Governance • Board – skill, succession, independence• Bribery & anti‐corruption• Reporting & disclosure• Executive remuneration• Shareholder rights• Internal controls
ESG and Materiality — An Example
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‐ ‐ Investor Focus
Sources: State Street Corporation 2013 Corporate Responsibility Report; SSGA. The information contained above is for illustrative purposes only.
Investors use ESG in a multitude of ways
• Macro‐economic analysis
• Industry level analysis
• Company analysis
• Valuation
• Screening
How Investors Use ESG
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Sources: Principles for Responsible Investment, SSGA. For illustrative purposes only and not intended as investment advice.
Investment Universe
Filters: Financial & Social
Portfolio Construction
Investment Portfolio
ESG As a Factor: What is known (or we believe is known)
• Positively correlated with cost of capital– Bauer and Hann (2010); Goss and Roberts (2011); El Ghoul, Guedhami, Kim, and Park (2014), etc.
• Positively correlated with quality (e.g., ROA, leverage)– Eccles, Ioannou, and Serafeim (2013); Guenster, Derwall, Bauer, and Koedijk (2011); SSGA (2008, 2014), etc.
• Negatively correlated with size– Russell Investments (2014), SSGA (2008, 2014), etc.
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Sources: SSGA, University of Oxford/Arabesque Partners “From Stockholder to the Stakeholder”, September 2014For illustrative purposes only and not intended as investment advice.
ESG Ratings and Financial Metrics
Sources: MSCI, FactSet, SSGA. As of March 31, 2015.MSCI is the rating agency. The information contained above is for illustrative purposes only and not intended as investment advice. Past performance is not a guarantee of future results. Index returns are unmanaged and do not reflect the deduction of any fees or expenses. Index returns reflect all items of income, gain and loss and the reinvestment of dividends and other income.
Debt/Equity (%) Return on equity
Return on assets (%)Weighted average market cap (US$ billion)
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0
20,000
40,000
60,000
80,000
100,000
AAA CCC World
0
2
4
6
8
10
12
AAA CCC World
0%
5%
10%
15%
20%
25%
30%
AAA CCC World
0
1
2
3
4
5
6
AAA CCC World
12
Integrating ESG — Quantitative Equity Investment Process
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Sources: SSGA, FactSet. As of December 31, 2014. Most recent data available. The information contained above is for illustrative purposes only and not intended as investment advice. Past performance is not a guarantee of future results. Index returns are unmanaged and do not reflect the deduction of any fees or expenses. Index returns reflect all items of income, gain and loss and the reinvestment of dividends and other income.
Three month quintile spread of ESG factor vs. three month market return
‐40%
‐30%
‐20%
‐10%
0%
10%
20%
30%
‐8%
‐6%
‐4%
‐2%
0%
2%
4%
6%
Jan‐06
Apr‐06
Jul‐0
6
Oct‐06
Jan‐07
Apr‐07
Jul‐0
7
Oct‐07
Jan‐08
Apr‐08
Jul‐0
8
Oct‐08
Jan‐09
Apr‐09
Jul‐0
9
Oct‐09
Jan‐10
Apr‐10
Jul‐1
0
Oct‐10
Jan‐11
Apr‐11
Jul‐1
1
Oct‐11
Jan‐12
Apr‐12
Jul‐1
2
Oct‐12
Jan‐13
Apr‐13
Jul‐1
3
Oct‐13
Jan‐14
Apr‐14
Jul‐1
4
3m QS MSCI World (RHS)
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Integrating ESG — Quantitative Equity Investment Process, continued
Source: SSGAThe information contained above is for illustrative purposes only and not intended as investment advice.
Value• Relative value analysis
Growth• Search for consistent earnings growth
Sentiment• Market Outlook
Quality• An indicator offuture profitability
Sources of Data
Financial StatementsCFO/PEquity Risk PremiumEBITDA/EV
Growth PotentialAsset Growth
Net Operating AssetsAccrualsSolvency & Oper. Efficiency
Analyst Forecasts Estimate Revisions
Operational Data
Market Data Short InterestReturn Consistency
Macro Variables
Risk
Example:Cash Flow to Price
Example:Growth Potential
Example:Short Interest
Example:Solvency & Operating Efficiency
RationaleCash flow to price is used as a reliable valuation estimate measure. Using cash based metrics limits a manager’s ability to manipulate figures through accounting, which at times can weaken earnings based valuation factors.
RationaleAnalyses financial strength of a firm, focusing on profitability, operating efficiency, leverage, and accounting quality. Firms that have strong fundamentals are more likely to outperform.
RationaleInvestors sell short because they have negative information on a firm and/or they seek to exploit overpricing. Additionally, security prices tend to be overpriced because pessimistic investors are restricted from short selling in the presence of short sale constraints.
RationaleCompanies that have strong balance sheets and higher operational efficiency should outperform over the long‐term and especially during periods of market stress. Some of the variables include Change in Debt/Assets, LT Solvency, Receivables Turnover, etc.,
Weighting Methodology Incorporates correlation of factors to produce model with strongest expectations of performance
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ESG• Evaluation of ESG risk and opportunity
Industry relative ESG rating
Example:Human Capital Development
RationaleA significant component of firm value is comprised of intangibles, of which human capital is a large share for many industries. Companies which successfully attract, retain and engage talent should increase productivity and reduce costs of attrition.
Integrating ESG — Quantitative Equity Investment Process, continued
Source: SSGA. As of January 31, 2015. Most recent data available. The information contained above is for illustrative purposes only and not intended as investment advice.
Optimal factor weighting for the MSCI World Index
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0%
10%
20%
30%
40%
50%
60%
2006 2007 2008 2009 2010 2011 2012 2013 2014 2015
value sentiment GQS util_rank ESGGrowth Quality
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Climate Change Observations
Global land and ocean temperature anomalies versus the 20th century average
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Source: National Climatic Data Center, National Oceanic and Atmospheric Association. Retrieved Feb 10, 2015. The information contained above is for illustrative purposes only.
‐0.60
‐0.40
‐0.20
0.00
0.20
0.40
0.60
0.80
1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000 2010
Tempe
rature Ano
malies, Degrees Celsius
Yearly Value 10 per. Mov. Avg. (Yearly Value)
33%
67%
Stranded Resources Resources Within Budget
Global Carbon Budget
Carbon budgets for different temperature thresholds Known resources in 2°C carbon budget scenario
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Source: © 2013 Carbon Tracker Initiative & Grantham Research Institute, LSE. Used with permission. Temperature thresholds refer to warming above pre‐industrial levels. The information contained above is for illustrative purposes only.
Coal
Oil
Gas
Source: Rystad Energy, as of July 3, 2013, International Energy Agency.The information contained above is for illustrative purposes only.
Coal –81%
Oil – 42%
Gas – 46%
0
500
1000
1500
2000
2500
3000
1.5°C 2°C 2.5°C 3°C TotalReserves
GtCO2
50% 80%
Carbon Exposure is Concentrated in a Few Sectors
Current and future carbon emissions
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Source: MSCI, data spans 2012‐13.The information contained above is for illustrative purposes only.
0
50
100
150
200
250
300
350
0
500
1,000
1,500
2,000
2,500
3,000
3,500
4,000
4,500
Energy Materials Industrials ConsumerDiscretionary
ConsumerStaples
Health Care Financials IT Telecom Utilities
Direct & Indirect Carbon Emissions in Mt Future Carbon Emissions from Reserves in Gt (RHS)
0
25
50
75
100
125
150
175
200
225
Guggenheim Solar First Trust ISE Global Wind Energy MSCI ACWI
MSCI ACWI Energy S&P 1200 Coal/Consumable Fuels S&P GSCI Energy
WTI
Waiting for a Carbon Price?
Global clean energy equities, global energy equities, global equities and energy commodities — three years through March 2015
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Source: Factset. Rebased to 100 at March 31, 2012. USD Gross Price Returns. Data through March 31, 2015 The information contained above is for illustrative purposes only. Past performance is no guarantee of future results.
‐54%
79%
Appendix A: Important Risk Disclosures
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Important Disclosures
Investing involves risk including the risk of loss of principal.
Risk associated with equity investing includes stock values which may fluctuate in response to the activities of individual companies and general market and economic conditions.
The whole or any part of this work may not be reproduced, copied or transmitted or any of its contents disclosed to third parties without SSGA’s express written consent.
The information provided does not constitute investment advice and it should not be relied on as such. It should not be considered a solicitation to buy or an offer to sell a security. It does not take into account any investor's particular investment objectives, strategies, tax status or investment horizon. You should consult your tax and financial advisor. All material has been obtained from sources believed to be reliable. There is no representation or warranty as to the accuracy of the information and State Street shall have no liability for decisions based on such information.
The views expressed in this material are the views of Christopher McKnett through the period ended April 30, 2015 and are subject to change based on market and other conditions. This document contains certain statements that may be deemed forward‐looking statements. Please note that any such statements are not guarantees of any future performance and actual results or developments may differ materially from those projected.
United States: State Street Global Advisors, One Lincoln Street, Boston, MA 02111‐2900
Web: www.ssga.com
© 2015 State Street Corporation —All Rights Reserved.
Tracking Number: CMINST‐11962
Expiration date : 05/31/2015
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Appendix B: Biography
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Biography
Christopher C. McKnett
Chris McKnett is a Managing Director of State Street Global Advisors. He is the head of the firms' global Environmental, Social and Governance (ESG) investments business. Chris works across asset classes, investment teams and key functional domains to champion sustainable and responsible investment on behalf of SSGA and its clients. Chris is co‐chair of SSGA’s ESG Working Group, a member of SSGA’s Proxy Review Committee, and a member of both State Street's Corporate Citizenship and Environmental Sustainability Working Groups. Before joining SSGA in 2007, he worked for KLD Research & Analytics, Inc. Chris began working in the investment industry in 1999.
Chris is a First Mover Fellow at the Aspen Institute Business & Society Program and a member of the Investment Commission of the United Nations Environment Programme Finance Initiative. Chris serves on the Advisory Council to The Sustainability Accounting Standards Board. He earned his MBA from the Daniels College of Business at the University of Denver and a Bachelors of Science in Business Administration from the University of Connecticut.
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