Lecture 4

Question 1

What is ESG integration?

Answer 1

Targets reducing portfolio risks or volatility, increasing returns, or adding value to the portfolio’s effect on society or the environment

Question 2

How is ESG integration implemented?

Answer 2

• ESG score based analysis
  + Picking individual firms (active)
  + Positive screening (passive)
• Thematic screening (pick a topic for selecting stocks)

Question 3

Evidence of ESG

Answer 3

1. ESG performance
2. Value drivers
3. Stock performance
4. Investor performance

Question 4

ESG integration into fundamental equities

steps Value driver adjustment (VDA) approach

Answer 4

1. Identify & focus on the most material issues
2. Analyse the impact of these material issues on the individual company
3. Quantify competitive (dis)advantages to adjust for value driver assumptions
4. Have an active dialogue

Question 5

Corporate social responsibility effect (not directly SI)

Answer 5

• Higher sales, lower financial volatility
• Better access to funding
• Higher trust and resilience

Question 6

Blitz & Swinkels

Does excluding stocks cost performance?

Conclusion

Answer 6

• Exclusions involve risk relative to the market and peers

- It is unlikely that excluding sin stock generate a higher cost of capital for them (no ESG results)

Question 7

Dimson

Goal

Answer 7

Does engagement work? Does it affect financial performance? Does it affect returns?

Question 8

Dimson

Conclusion

Success in engagements is more probable if:

Answer 8

• the engaged firm has reputational concerns
• has higher capacity to implement changes
• has been engaged successfully before
• there is collaboration

Question 9

Blitz & Swinkels

Does excluding sin stocks cost performance?

Solutions

Answer 9

• Tracking error may be minimized and expected portfolio return restored by filling the gap left by excluding sin stocks with non-sin stocks that offer similar hedging properties and factor exposures
• Mimic the Sharpe ratio of the market

Question 10

Dimson

Conclusion

Successful engagements, particularly on environmental/social issues, generate:

Answer 10

• improved accounting performance
• better governance
• increased institutional ownership
• better financial performance (not very strong results)

Question 11

Goals of ESG integration

Answer 11

• Optimizing the portfolio risk/return trade off by taking account of ESG factors (1.0 optimize F subject to E&S)
• Achieve a compromise of optimal portfolio outcomes and ESG outcomes at the same time (2.0 optimize E+S+F)

Question 12

Investing based on (..) is driving up prices of such stocks at the moment

Answer 12

Scores and themes

Question 13

CSR is also considered (..), as it has an indirect effect on ESG (..)

Therefore, ESG scores can help to (..)

Answer 13

SI, through better financial performance

Identify social responsible companies

Question 14

Conclusion CSR

Support SI 2.0: taking account of ESG factors primarily (..)

However the target is (..), not the ESG

Answer 14

In the fundamental analysis of firms

The financial returns

Question 15

Evidence of ESG

1. ESG performance

Answer 15

• Scores/ratings

- Material vs immaterial

Question 16

Evidence of ESG

2. Value drivers

Answer 16

• Sales growth
• Margins
• Cost of capital

Question 17

Evidence of ESG

3. Stock performance

Answer 17

Type of companies

Question 18

Evidence of ESG

4. Investor performance

Answer 18

Approach: ESG integrated vs ethical

Question 19

Blitz & Swinkels

Does excluding sin stocks cost performance?

Goal

Answer 19

The impact of excluding sin stocks on expected portfolio risk and return

Question 20

Blitz & Swinkels

Does excluding sin stocks cost performance?

Relationship

Answer 20

Investment choice directly on investment return

Question 21

Blitz & Swinkels

Does excluding sin stocks cost performance?

Financial arguments

Answer 21

Pro-exclusion: Sin sectors have no long term future, so they will underperform relative to other sectors

Against exclusion: Reduces diversification, which increases portfolio risk.

Question 22

Blitz & Swinkels

Does excluding sin stocks cost performance?

Background

Answer 22

• Tracking error: return deviation of an investment portfolio from the return of the market portfolio
• In CAPM, deviating from the market introduces risk and a rational investor seeks compensation
• The exclusion portfolio does not give the required return because it does not sit on the tangency line
• Sin sectors are expected to outperform the market according to Fama-French-5-Factor
• Sin premium – they are cheap enough for the cash flow they generate

Question 23

Dimson

Does engagement work? Does it affect financial performance? Does it affect returns?

Stewardship

Answer 23

Pay a company to engage on your behalf according to your principles

Question 24

Dimson

Does engagement work? Does it affect financial performance? Does it affect returns?

Data

Answer 24

Engagements performed by an institutional investment firm on U.S. companies, concerning ESG factors

Question 25

Dimson

Does engagement work? Does it affect financial performance? Does it affect returns?

Engagement success

Answer 25

• Apple Inc. announces eliminating toxics and more recycling
• Yahoo Inc. commits to human rights and freedom of expression online
• Illinois Tool Works Inc. publishes a Sustainability Report

Question 26

Dimson

Does engagement work? Does it affect financial performance? Does it affect returns?

Problems

Answer 26

Not explained deeply about engagement results

Only one investor data is used

Question 27

Dimson

Does engagement work? Does it affect financial performance? Does it affect returns?

Conclusion

Answer 27

A company is more likely to be engaged if it is:

• Large
• Old
• Performs poorly
• Sensitive to reputation
• Weak governance
• Investor shareholding is large

Successful (unsuccessful) engagements are followed by positive (zero) abnormal returns