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What is Socially Innovative Investing?

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Since 2007, Bank of America has been committed to sustainable and impact investing, or investing in portfolios with the dual goals of generating competitive risk-adjusted returns while simultaneously supporting societal or environmental progress. In 2011, we created Socially Innovative Investing (S2I), our first impact-focused strategy and have since expanded the S2I suite to include other impact-focused strategies such as Women & Girls Equality and Carbon Reserve Free. This expansion was based in large part on the growing awareness that corporate leadership across a broad range of environmental, social and governance (ESG) criteria and strong financial performance are not mutually exclusive; rather, they can be mutually beneficial qualities. Rather than engaging in “doing good” just for the reputational value, all S2I strategies seek to invest in leading performers in each economic sector based on ESG criteria because it can be good for business and potentially lead to better financial performance over the long term.  

BACKGROUND

When sustainable and impact investing was still considered a niche market segment, Bank of America was one of the first financial institutions to launch a sustainable investment strategy that sought to quantify how corporate actions affect people, communities and the environment as well as portfolios. Called Socially Innovative Investing (S2I), the strategy is predicated on the belief that companies demonstrating leadership in human capital management (i.e., social), environmental stewardship and corporate governance have an advantage over their peers in their ability to manage risk, increase productivity, nurture innovation, and develop long-term sustainable business models. In short, we believe better performance on ESG criteria will lead to better economic outcomes for the companies and potentially better risk-adjusted performance for investors.

Since its early days, sustainable and impact investing—and related ESG factors—has grown sufficiently enough to enter the investment mainstream. Assets under management (AUM) committed to funds incorporating ESG factors rose from $3.7 trillion (or 10% of all professionally managed investments) in 2012 to $12 trillion (25%) in 2018 and to a possible $34.5 trillion (50%) by 2025.1

Corporations are beginning to get the message. After years of following a philosophy that put shareholder returns above all other constituents, many corporate leaders are starting to re-think the purpose of a corporation. The Business Roundtable, an association of leading Chief Executive Officers (CEO) who collectively employ 15 million workers, recently redefined its purpose statement (see sidebar) to specifically acknowledge the value created by and responsibility to all constituents of their ecosystem.  

 

 

 

BUSINESS ROUNDTABLE STATEMENT ON THE PURPOSE OF A CORPORATION

We share a fundamental commitment to all of our stakeholders and commit to:

  • Delivering value to our customers.
  • Investing in our employees. 
  • Fostering diversity and inclusion, dignity and respect.
  • Dealing fairly and ethically with our suppliers.
  • Supporting the communities in which we work.
  • Embracing sustainable practices across our businesses.
  • Generating long-term value for shareholders. 

EVOLUTION OF SUSTAINABLE AND IMPACT INVESTING

With interest in sustainable and impact investing continuing to grow, a broader spectrum of strategies has evolved. These new approaches tend to be more active and rigorous, more focused on investment returns, risk control and measurable impact, and based on the notion that strong ESG factors and financial performance are positively correlated. Enabling this expansion is an increasingly robust set of data that companies publish in annual corporate sustainability reports. According to the Governance & Accountability Institute, over 86% of S&P 500 companies now publish such reports, up from just 20% in 2011.2 Government agencies are also pressing for more regular and detailed disclosure from the companies they regulate. And industry groups such as the Sustainability Accounting Standards Board are working to ensure that data is reported consistently from company to company and industry to industry. As a result, investors now have access to a rich data set on workforce diversity, carbon emissions, water/energy usage and waste, as well as community investment and programs that enable positive impact across their ecosystem.

Why is this new source of data so important? Part of the answer lies in the changing nature of the U.S. economy. During the 1970s, most of the value accruing to public U.S. companies was represented by tangible assets: machines, factories, inventory and so forth. But as we have shifted toward an information-driven economy and as much of the nation’s productive capacity has moved offshore, tangible assets have been largely superseded by intangible assets on the balance sheets of S&P 500 companies. Indeed, in 2018, 84%³ of the total assets of U.S. companies derived from intangibles such as brand, reputation, supply chain, employees, intellectual property and customer base. Investors can no longer rely exclusively on traditional financial analysis to evaluate the risks and opportunities facing today’s tangible asset-light companies. But by including ESG factors in their analysis, investors are better able to determine which companies are also effectively managing their (increasingly important) intangible asset base.

Exhibit 1: Growth of Assets for S&P 500 Companies

Growth of Assets for S&P 500 Companies

Source: Aon, “2019 Intangible Assets Financial Statement Impact Comparison Report."

THE CHIEF INVESTMENT OFFICE'S SOCIALLY INNOVATIVE INVESTING STRATEGY

Our Chief Investment Office's (CIO) Socially Innovative Investing suite of strategies incorporates an active, proprietary method for reviewing U.S. companies across a wide spectrum of criteria that weigh both S2I performance and financial fundamentals. We aggregate raw data from third-party providers and implement an objective S2I scoring methodology to identify leading performers in each economic sector. Our framework for assessing a company’s commitment to social innovation rests on three pillars:

  • Environmental stewardship. What policies does the company employ for interacting with the environment? How effective are companies at managing their environmental footprint and the associated risks? Considerations include climate change policy, greenhouse gas reduction, energy consumption, water management and waste mitigation.
  • Human capital engagement. How does the company treat all of its stakeholders (employees, shareholders, customers, suppliers and the community)? Considerations include hiring practices focused on diversity and inclusion (especially in leadership roles), fair and equal compensation practices, employee health and wellness benefits, human rights throughout the supply chain, and product safety and quality.
  • Corporate governance. What are the standards and procedures regarding its role as a corporate citizen? How does it treat shareholders? Considerations include shareholder voting policy, accounting practices, executive pay, management accountability and board independence.

Measuring a company’s actual commitment to these pillars involves a two-part review of stated policies and performance accountability. 

  • Policy review. We view progressive corporate policies, generous employee benefits and robust disclosure as indicators of good management and long-term value creation. Further, robust disclosure is the first step toward broad accountability.
  • Performance accountability review. Because good intentions don’t always result in positive outcomes, we utilize objective measures to assess actual performance against stated goals, societal norms and peer comparisons. We also consider whether companies’ products or services address specific societal needs (e.g., environmental solutions) and whether they have avoided costly fines, lawsuits and controversies.

The S2I scoring process leverages over 400 unique data points to measure how effectively companies are engaging human capital, mitigating environmental impact, and practicing good corporate governance. The table below highlights examples of select factors.   

KEY DRIVERS OF VALUE 

Environmental Stewardship

Human Capital Engagement

Corporate Governance

Enterprise Policy
Energy Intensity
Waste
Water
Environmental Impact

Labor
Diversity & Inclusion
Health, Safety & Privacy
Social Impact

Board 
Pay
Ownership & Control
Accounting

When weighting the relative importance of these factors, we consider “economic materiality” as it applies to different industries. Materiality refers to the assessment of which ESG factors are relevant to a company’s business activities and drivers of future financial success. For example, we place more weight on corporate governance factors for financial services companies, carbon emissions factors for energy companies, and water management factors for utilities. These assessments play an important role in our investment process, and they produce a potential universe of stocks we believe represent the best corporate performers across a broad range of ESG criteria. The final scores are normalized by sector as we intentionally include leading performers in all sectors of the economy, even those that have poor reputations for ESG performance (e.g., energy, materials or utilities).

Following the S2I scoring process is a fundamental review to ensure that we are purchasing good stocks on behalf of our clients, not just good companies. We seek companies with strong and stable returns on capital, conservative balance sheets, and healthy free cash flow generation. This review leads to a targeted list of 90 to 120 stocks that are attractive from both a fundamental and an ESG perspective. Finally, we conduct a portfolio construction exercise designed to minimize external risk factors and provide broad diversification. The goal of this step is to allow the S2I scoring process to drive the relative performance of the portfolio while neutralizing other potential market influences. The ideal result is a diversified portfolio of strong companies that we believe can deliver attractive risk-adjusted returns over a long-term investment horizon.

MONITORING AND MAINTAINING THE PORTFOLIO

Continual attention, monitoring and adjustment are required to keep the S2I portfolio properly balanced to achieve its goals and deliver the competitive long-term, risk-adjusted returns that we seek to capture. We review changes in fundamentals to make sure holdings remain appropriate for the portfolio. Similar assessments of ESG criteria help ensure that holdings remain consistent with environmental and social goals. Stocks are sold if they fall out of the investment universe, analyst ratings change dramatically and a review indicates selling is advised, or the social innovation score deteriorates. Position sizes are rebalanced to maintain appropriate limits, sector weights and market factor exposures. Since a company's ESG performance is generally consistent over time, we are able to keep turnover low (targeting 20%–30%) in order to minimize transaction costs. However, we continually seek potential new investments and opportunities to improve the ESG and fundamental profile of the portfolio. 

“A-B-C”: A NEW APPROACH TO SUSTAINABLE INVESTING

The evolving sustainable investing landscape has necessitated a new way to describe the intent of different sustainable approaches to match the motivations that individual or institutional investors might have when selecting these investments. One such framework adapted from The Impact Management Project4 is the “A-B-C” approach that helps classify the impact objective of a given sustainable investing strategy. Here’s a brief explanation of each of the three categories, along with an example:

  • “Avoid” seeks to reduce negative social or environmental effects and manage risk by limiting certain exposures. Examples include avoiding investments in “sin” stocks or those with particularly high carbon emissions or human rights violations relative to peers.
  • “Benefit” seeks to support positive social or environmental practices and enhance potential for long-term competitive financial returns. Examples include investments in companies that treat employees as a strategic asset (via comprehensive human resource policies and benefits) or minimize stranded asset risk.5
  • “Contribute” seeks to advance positive, measurable social or environmental outcomes and target opportunities where impact is intrinsic to financial performance. Examples include investments that aim to improve health outcomes or develop alternative energy solutions.

The S2I investment process includes elements from all three categories. Our approach is rooted in the concept that companies that are leading performers on ESG criteria benefit from developing more sustainable, and profitable, long-term business models. In addition to being better managers of their intangible asset base (as described on page 2), we believe such companies are better at developing talent, uncovering emerging opportunities, fostering innovation and managing risk.

Our proprietary scoring process penalizes companies whose products, services or practices harm workers, society or the environment. Thus companies with significant controversies, legal liabilities, product recalls or environmental fines are unlikely to score well relative to sector peers. Conversely, we give credit to companies that are trying to solve social or environmental challenges with innovative solutions (such as water treatment, waste management, child care, telemedicine, electric engines, wind power generation), boosting their scores. So we tend to avoid companies that are externalizing costs to the rest of society (pollution, unhealthy products) while striving to invest in companies that contribute market-based solutions to some of society’s largest and most difficult problems.

MEASURING IMPACT

One of the challenges of managing a U.S. equity portfolio is demonstrating its impact versus potential alternatives. We have developed a series of impact metrics to show the ESG performance of our portfolios compared to a broad-based market benchmark. For example, the S2I All Cap portfolio has better gender representation at the executive level than the S&P 1500, is 15% less carbon intensive, and 55% less water intensive (see charts below for details). Such portfolio impact measurement helps assure that our investment process is working as intended to identify leading performers across a wide range of ESG metrics. Many companies will not score well across all metrics, but the portfolio as a whole consistently demonstrates stronger ESG characteristics than the overall market.

Exhibit 2: S2I All Cap Holdings Demonstrate Better Social Characteristics than the S&P 1500…

S2I All Cap Holdings Demonstrate Better Social Characteristics than the S&P 1500…

Sources: Chief Investment Office and Bloomberg, as of March 2020. 

* Note: % of workforce in executive management roles in portfolio companies compared to companies in S&P 1500.

… And Environmental Characteristics Too

… And Environmental Characteristics Too

Sources: Chief Investment Office and MSCI, as of March 2020. 

* Note: Carbon intensity = Metric tons of scope 1 + scope 2 carbon emissions per $ million in revenue. Water intensity = Thousands of gallons of water consumed per $ million in revenue.

Debunking Sustainable and Impact Investing Myths

Myth There is limited demand for sustainable investments”
Reality – 72% of Americans are interested and one in five are extremely interested in sustainable investingi  

Debunking Sustainable and Impact Investing Myths

Myth – “Sustainable investments underperform traditional investing strategies”
Reality – 67% of all U.S. ESG funds performed in the top half of their peer groups on a 3 year basis through 12/31/19ii

Debunking Sustainable and Impact Investing Myths

Myth – “Sustainable investing is just a fad”
Reality - $20 trillion is expected to flow into sustainable investments in the next two decadesiii

Debunking Sustainable and Impact Investing Myths

Myth – “There are not enough competitive sustainable investment options”
Reality – 100+ sustainable strategiesiv  offered across all major asset classes and vehicle typesv

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