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Sustainable Investing Takes Off A new generation of investors wants strategies that deliver performance and peace of mind - The magazine of ...
The magazine of independent research for the world’s financial professionals   December/January 2016

Sustainable Investing Takes Off
A new generation of investors wants strategies that deliver performance and peace of mind.
Sustainable Investing Takes Off A new generation of investors wants strategies that deliver performance and peace of mind - The magazine of ...
Rights and Responsi-                                      products, for these vehicles. In embracing
                                                          the corporate structure, the act defines investors
                                                                                                                even a single business is engaged. The research
                                                                                                                for a diversified portfolio of investments can
bilities We should                                        as owners and gives them advocates in the
                                                          form of a predominantly independent board of
                                                                                                                be daunting. Fortunately, the market increasingly
                                                                                                                offers assistance, as firms are stepping up
be encouraging ESG,                                       directors to represent their interests to the
                                                          management company that is employed to run
                                                                                                                to provide insights into the practices of different
                                                                                                                businesses. Morningstar will soon aggregate
not mocking it.                                           the fund. That view is utterly different from         the insights of one such firm, Sustainalytics, to
                                                          the product view of funds where manufacturers         offer fund investors insights into the ESG footprint
                                                          make product, which is sold through distribution      of the funds they consider for their portfolios.
                                                          channels to consumers. Owners have rights;            To me, this transparency is wholly in keeping with
 PHILLIPS CURVE                                           consumers are prey, hence the phrase “buyer           the rights due to those individuals responsible
Don Phillips                                              beware.” Those that treat investors as owners         enough to live within their means and save and
                                                          bestow upon them the respect due to those             invest for the future.
                                                          who accept the responsibility of planning for
Environmental, social, and governance, or                 tomorrow rather than just living for today.           ESG is a great and powerful movement,
ESG, concerns are often presented as liberal forces                                                             not because it rights some wrong inherent
combating the evils of Big Business to somehow            Chief among these rights that those responsible       in business, but because it removes obstacles that
make the ugly activity of investing more palatable        individuals who become investors are due              keep people from investing. It’s far too easy
to good-hearted individuals. This view has                is transparency and choice about how their money      an excuse to not save for tomorrow because you
been strengthened by right-wing opponents of              is invested. They have a right to know who            think investing supports causes you dislike.
ESG, such as a noted U.S. business periodical that        is running the businesses they invest in, what        ESG research empowers investors to make more
has long derided ESG investing approaches,                practices they deploy in managing those               informed choices, to better align their money
claiming that investors should invest for maximum
gain and if they feel guilty about how those gains
were won to simply make a charitable donation
out of some of their winnings to ease their               ESG is a great and powerful movement, not
conscience. To me, this explanation of ESG gets
it dead wrong, being founded on false premises,           because it rights some wrong inherent
most notably that investing is a somehow
tainted activity that needs to be cleaned up.             in business, but because it removes obstacles
I believe that investing itself is a socially conscious
                                                          that keep people from investing.
act. It means deferring gratification today for
greater security and opportunity for yourself and
your loved ones tomorrow. It is, quite simply,
what a responsible adult does. Those who can
invest and don’t do so, such as Vice President Joe
Biden, who boasts (falsely) of owning no stock
or bonds, are in my eyes irresponsible and                businesses, and what consequences those               with their values, which is their right to do. It
poor role models. Conversely, those who step up           activities have on the world in which they operate.   gives investors a louder voice to corporate leaders.
and embrace the responsibility of becoming                Investors have the absolute right to choose           Over time, the practice, which today is in its
investors deserve our respect and should                  which activities they are comfortable embracing       infancy, will evolve and become more sophisti-
be entitled to fundamental rights as responsible          and which they desire to avoid. They do not           cated. In the process, it will lead to better behavior
citizens. Our society benefits from having more           have to buy every stock in the market just because    and increased accountability. But already it is
investors, not fewer.                                     some academic believes buying the whole market        a powerful force that appropriately reflects investor
                                                          is the sainted way to invest. They can—and            rights. And that is a very responsible thing. K
The Investment Company Act of 1940, the                   should—direct their hard-earned money in the
legislation on which the U.S. fund business is            ways that they choose.                                Don Phillips is a managing director with Morningstar. He is
                                                                                                                a member of the editorial board of Morningstar magazine.
based, embraces this notion of investors’
rights, choosing a corporate organization of              Of course, that’s not always an easy task. It takes
investment companies, rather than investment              great effort to uncover all the activities in which

                                                                                                                global.morningstar.com/Morningstarmagazine                1
Sustainable Investing Takes Off A new generation of investors wants strategies that deliver performance and peace of mind - The magazine of ...
Spotlight

 ESG                                                 ESG Thrives in Europe
                                                     Sustaining Success
                                                                                                             42
                                                                                                             44

The Appeal of
Sustainable Investing
Amid a demographic
shift, more investors want
to have an impact.
 SUSTAINABLE INVESTING                               Grantham’s obsessions reflect widespread
Jon Hale                                             concerns of investors over sustainability issues,
                                                     as well as the growing recognition of the
                                                     need to move toward a more sustainable global
Sustainability is on a lot of people’s minds these   economy. In areas such as consumer choice
days. Jeremy Grantham opened his keynote             and workplace satisfaction, surveys report
address at last summer’s Morningstar Investment      widespread support for sustainability concepts.
Conference by outlining several issues that he       According to the 2014 Nielsen Global Survey
said were “obsessing” him, among them long-term      of Corporate Social Responsibility, more
resource limitations, climate problems,              than half of consumers surveyed globally said
food problems, income inequality, and the loss       they would be willing to pay more for products
of corporate stakeholders.                           and services from companies committed

                                                     global.morningstar.com/Morningstarmagazine          3
Spotlight: ESG

    EXHIBIT 1

    The ESG Landscape Assets in sustainable investments are growing in the                                                                 to positive social and environmental impact.1 Two
    United States.                                                                                                                         thirds said they would prefer to work for a socially
                                                                                                                                           responsible company.
                                                                                                                          (USD Billions)
                                                                                                                                           Similarly, interest in sustainable investing
                                                                                                                                  7,000
                                                                                                                                           appears to be growing in the investment world,
                                                                                                                                  6,000    particularly among women and younger
                                                                                                                                           people, two groups who are rapidly becoming
                                                                                                                                  5,000
                                                                                                                                           more influential investment decision-makers.
                                                                                                                                  4,000    Recent studies by U.S. Trust 2 and Morgan Stanley 3
                                                                                                                                  3,000    found a large majority of female investors,
                                                                                                                                           more than 70% in each study, agreed that
                                                                                                                                  2,000    environmental, social, and governance, or ESG,
                                                                                                                                  1,000    factors are important considerations when
                                                                                                                                           making an investment, while men were more
    1995         1997          1999          2001         2003         2005      2007          2010      2012     2014                0
                                                                                                                                           evenly divided. A 2011 Pew Research survey found
    Source: US SIF, The Forum for Sustainable and Responsible Investing.                                                                   Gen-Xers and, especially, millennials to be
                                                                                                                                           more concerned about environmental issues and
                                                                                                                                           global warming than baby boomers.4 The Morgan
    EXHIBIT 2                                                                                                                              Stanley survey found that 84% of millennial
    Jumping on the Bandwagon Nearly 1,400 asset-management firms, representing                                                             investors were interested in sustainable investing
    $60 trillion in assets under management, have signed the U.N. Principles                                                               and were twice as likely as investors overall to
                                                                                                                                           make sustainable investment decisions.
    for Responsible Investment.
                                                                                                                                           Women and millennials are becoming more
    Assets under management (USD trillion)                                                                        Number of Signatories
                                                                                                                                           influential investment decision-makers.
    70                                                                                                                            1,400     1400
                                                                                                                                           In the United States alone, women now have
                                                                                                                                           decision-making control over an estimated 40%
    60                                                                                                                            1,200     1200
                                                                                                                                           of the nation’s investable assets.5 By some
                                                                                                                                           estimates, $30 trillion is going to pass from baby
    50                                                                                                                            1,000     1000
                                                                                                                                           boomers to younger generations over the next
                                                                                                                                           half century.6 That money will move into the hands
    40                                                                                                                              800        800
                                                                                                                                           of investors who appear to be significantly
                                                                                                                                           more interested in sustainable investing than
    30                                                                                                                              600        600
                                                                                                                                           their elders.

    20                                                                                                                              400        400
                                                                                                                                           A Growth Industry
                                                                                                                                           With these favorable demographic trends just

    10                                                                                                                              200        200
                                                                                                                                           starting to provide a tailwind, sustainable investing
                                                                                                                                           has already seen a significant increase in

    0                04/         04/         04/          04/       04/       04/       04/       04/      04/     04/                0             0
                                                                                                                                           assets under management ( EXHIBIT 1 ). In its 2014
                                                                                                                                           biennial report on assets under management,
                     2006        2007        2008         2009      2010      2011      2012      2013     2014    2015
                                                                                                                                           US SIF, The Forum for Sustainable and Responsible
    Source: U.N. Principles for Responsible Investment.                                                                                    Investment, identified $6.6 trillion invested in the

1   “Doing Well by Doing Good: Increasingly, Consumers Care About Social Responsibility, but Does Concern Convert to Consumption?” June 2014. The Nielsen Co.
2   “2015 U.S. Trust Insights on Wealth and Worth.” 2015. U.S. Trust.
3   “Sustainable Signals: The Individual Investor Perspective.” February 2015. Morgan Stanley Institute for Sustainable Investing.
4   “The Generation Gap and the 2012 Election.” Nov. 3, 2011. Section 8: Domestic and Foreign Policy Views. Pew Research Center.
5   “Power of Purse Highlights Women’s Wealth Leadership.” Jan. 23, 2015. Morgan Stanley.
6   “The ‘Greater’ Wealth Transfer: Capitalizing on the Intergenerational Shift in Wealth.” 2015. Accenture.

    4      Morningstar December/January 2016
field in the United States, a 76% increase from                    to incorporate ESG factors into their investment                Definitional
 its 2012 study. That’s a big number, and it includes               analysis and decision-making process, to be active              What exactly is meant by sustainable investing?
 a wide range of approaches, some more                              owners engaging with companies about ESG                        There are not only varying definitions and
 comprehensive in their approach to sustainability                  issues, and to report publicly on their activities and          approaches, but investors have often been able to
 than others, among mostly institutional investors.                 progress. Nearly a decade later, the number                     define it for themselves and then have asset
 The same study showed a much smaller,                              of signatories is nearing 1,400, and assets under               managers customize portfolios to suit. This can
 yet growing, retail segment with just less than                    management are nearly $60 trillion ( EXHIB IT 2 ).              work in the institutional and high-net-worth space,
 $2 trillion invested in various open-end,                          Signatories include many large institutional                    but raises the challenge of scalability in retail
 variable-annuity, exchange-traded, and closed-end                  investors, investment managers, and investment                  investing, where asset managers have to offer
 funds. The size of that segment, however, more                     service providers. Among the more than                          standardized, rather than customized, portfolios.
 than tripled between 2012 and 2014.7                               900 investment managers are 11 of the 15 largest                That means the conventional asset managers
                                                                    in the world, including BlackRock, Vanguard,                    wanting to get into the game will have to decide
  Asset-management firms are showing more                           JPMorgan, Goldman Sachs, PIMCO, and                             how to define sustainability.
  interest in sustainable investing. In April 2006,                 Franklin Templeton.
  the United Nations-supported Principles                                                                                           Overcoming the definitional challenge requires
  for Responsible Investment, or PRI, was launched                  Challenges Remain                                               sustainable investing to be defined in a reasonable,
  with 100 signatories, representing $6.5 trillion                  As it moves toward the investing mainstream,                    easily understood way that reduces the
  in assets under management, committing                            sustainable investing faces several challenges.                 confusion that can derail a conversation from

7 “Report on US Sustainable, Responsible and Impact Investing Trends.” 2014. The Forum for Sustainable and Responsible Investing.

  What’s in a Name?
  While we refer to sustainable investing as an approach            nuclear-power producers. The first retail SRI mutual            part of the broader anti-apartheid movement, but
  that incorporates environmental, social, and gover-               funds used a similar approach.                                  progress is more typically made in a lower-profile way
  nance, or ESG, factors in an investment process, there                                                                            through discussions with company management.
  are a number of other terms commonly used to                      Still in widespread use today, exclusionary screening
  describe the field: socially conscious (a term still used         is more investor-centric than outcome-oriented.                 As more investors focused on engagement issues, these
  in Morningstar’s database), socially responsible,                 It is also relatively easy for asset managers to use            concerns increasingly found their way into evaluations
  ethical, green, and impact. The US SIF industry group             to address the needs of institutional and high-net-worth        of companies that, in turn, began to be used as part
  calls itself “The Forum for Sustainable and Responsible           investors who want customized portfolios that align             of the security-selection process. Rather than excluding
  Investment.” An annual industry meeting is                        with their values. An asset manager can adapt many              companies based on objectionable product involvement
  called “The Conference on Sustainable, Responsible,               of its existing strategies by simply excluding companies        in a traditional SRI portfolio, investors expanded
  Impact Investing.”                                                based on a client’s list of concerns and re-optimizing          their focus on how well companies were addressing the
                                                                    the portfolio. While this approach raised concerns that         range of environmental, social, and governance
 Investors have engaged these kinds of issues since the             exclusionary screening would lead to inferior                   issues that had often been the subject of corporate
 1970s, when many faith-based institutions, colleges                investment results, those concerns have proved                  engagements, and these factors were increasingly seen
 and universities, and foundations began to better align            to be largely unfounded.                                        as material to a firm’s financial success.
 their investments with their missions. Commonly
 known as socially responsible investing, or SRI, this              Many 20th century SRI investors did not simply have             What we are calling sustainable investing encompasses
 approach was largely concerned with screening                      screened portfolios. As active owners, they also                these broader ESG concerns in portfolios and while
 out certain types of products or services that were                engaged companies on broader issues of corporate                many traditional SRI-screened portfolios still exist,
 inconsistent with the values of the investor. Tobacco,             social and environmental responsibility through proxy           the field overall has become increasingly focused on
 alcohol, and gambling were common exclusions                       voting, filing shareholder resolutions, and importantly,        the more comprehensive ESG approach.
 from the portfolios of certain religious organizations,            direct engagement with management. Perhaps
 for example. Investors also frequently excluded firearms           the most notable instance of active engagement                  Jon Hale
 and military weapons manufacturers, and reflecting                 occurred in the 1980s when investors pressured
 one of the key environmental concerns of the day,                  companies to stop doing business in South Africa as

                                                                                                                                                                                             5
Spotlight: ESG

                                                       EXHIBIT 3

the onset and helps advisors and consultants move      Different Interests A high percentage of millennials and women say they are
their conversations with clients forward.              interested in ESG investing. Financial advisors? Not so much.
I propose the following basic definition:              p Investors                                                                    p Advisors                                      Interest (%)
                         100                                                                                                                                                                  100
Sustainable investing is an approach that takes
                            90
into account environmental, social, and
governance factors and their80impact throughout                                                                                                                                                   80
the investment process. 70
                            60                                                                                                                                                                    60
Beyond that, the specifics will vary, just as they
                            50
do for any investment approach. Value strategies,
for example, share the basic40
                             goal of investing in                                                                                                                                                 40
undervalued companies, but30  employ many
different approaches to do that. Some sustainable
                            20
investment strategies may focus on a best-in-                                                                                                                                                     20
class approach by industry. 10
                            Others may emphasize
                              0 or focus on
metrics such as carbon footprint                       Millennials        Female              Overall             Male                Little or   Somewhat            Highly                      0
positive product impacts. Some asset managers                                                                                         No Interest Interested          Interested
may be active owners who publish proxy voting
                                                       Sources: Morgan Stanley Institute for Sustainable Investing, Cerulli Associates.
guidelines, pursue shareholder resolutions,
and engage directly with companies on ESG issues.

Regardless of the specifics, when the would-           analysis. If anything, the weight of existing                                      At the portfolio level, there is even less information
be sustainable investor walks through an               research suggests that there is not a performance                                  on how the holdings in a fund stack up on various
advisor’s door, most often with only an inchoate       penalty for sustainable investing and that there                                   sustainability criteria. This is the main reason
notion of what sustainable investing actually          may be a performance advantage.                                                    why Morningstar is working on portfolio sustain-
means in practice, the above definition provides                                                                                          ability scores using data from Sustainalytics.
a common basis to move forward.                        In the final analysis, there are so many possible                                  (See our interview with Sustainalytics’ CEO
                                                       ways to address sustainability in the investment                                   Michael Jantzi on Page 44.) These scores, due
Performance                                            context that performance ultimately comes                                          out in 2016, will give advisors and investors
Performance is a perennial challenge. What             down to execution. Some managers will be better                                    the ability to compare funds based on how well
should be the performance expectations                 at it than others, pure and simple.                                                their holdings are handling ESG risks and
of sustainable investors? There are theoretical                                                                                           opportunities. They will allow investors to compare
reasons why sustainable investing might be             Information                                                                        conventional funds with self-identified sustainable
expected to underperform conventional investing.       Before sustainable investing can enter the                                         funds, as well as to choose funds based on
Limiting one’s investable universe for nonfinancial    mainstream, information and analysis of sustain-                                   whatever level of sustainability score they desire.
reasons can result in outperforming stocks             able investments have to become more readily                                       The portfolio sustainability scores will help
being left out of a portfolio and, in any event,       accessible to advisors and investors. We’ve seen                                   advisors and plan consultants evaluate funds
tracking error relative to benchmarks. There           large firms such as Merrill Lynch, Morgan                                          as well as client portfolios and plan lineups.
is also the argument that stocks that are shunned      Stanley, and UBS starting to rectify this problem
by investors for whatever reason exact a premium       by creating sustainable-investing platforms                                        Supply and Demand
and, therefore, are expected to outperform.            for their advisors.                                                                Despite the widespread and growing interest
                                                                                                                                          in sustainable investing, the supply of viable
In practice, however, there is little evidence         While firms like Sustainalytics are in the business                                strategies in the retail space is relatively limited.
indicating a performance penalty for sustainable       of providing company-level ESG ratings and                                         Even among the institutional and high-net-
investing, particularly among mutual funds.            analysis, their information flows primarily to asset                               worth investors who dominate the space today,
It is also possible that sustainable investing can     managers to assist them with incorporating ESG                                     options are lacking for truly integrated ESG
lead to outperformance because the consideration       factors in their strategies. Very little of this                                   strategies and for targeted high-impact
of ESG issues can point analysts to material           company-level ESG information reaches advisors                                     investments in areas such as private equity and
issues that may not surface in traditional financial   or everyday investors.                                                             infrastructure. The number of retail mutual

6    Morningstar December/January 2016
funds tagged in Morningstar databases as
socially responsive stands at 175 in the United
States and 1,797 globally. Many of these                       ESG Strategies Perform Well
funds are older, more-traditional SRI funds that
use exclusionary screening. Not surprisingly,
                                                               More and more academic and industry studies                  A Morgan Stanley study of U.S.-based mutual
there have been a number of new fund launches                  are demonstrating that sustainable investing                 funds and separately managed accounts,
in the space in 2015.                                          does not underperform conventional investing, and            using Morningstar data, concluded that sustain-
                                                               there is mounting evidence that incorporating                able investments usually met and often
Despite these recent gains, however, it remains                environmental, social, and governance factors can            exceeded the performance of comparable
difficult for practitioners to put together                    have a positive impact on performance.                       traditional investments on both an absolute and
client portfolios that include sustainable options                                                                          risk-adjusted basis.2
in all parts of the asset allocation. It is also               In 2014, researchers at Oxford analyzed nearly
                                                               200 studies, reports, and articles on sustainability         As of September, there were 1,797 funds
hard for fiduciaries to recommend sustainable
                                                               and found that at the firm level:1                           in Morningstar’s database tagged as “socially
investment options that don’t have sufficient—
                                                                                                                            conscious.” Using the Morningstar Rating
and successful—track records. Perhaps these                  g90% of the studies on the cost of capital show                for funds as a measure of risk-adjusted return
challenges help explain the lack of interest in ESG           that sound sustainability standards lower the cost            relative to investment category, we see in
of financial advisors ( E X HI BI T 3 ).                      of capital of companies.                                      the chart below that socially conscious funds have
                                                             g88% of the research shows that solid ESG practices            a positive tilt relative to the overall universe
As a result of these difficulties, client demand may          result in better operational performance of firms.            of funds.
not be met with a portfolio entirely consisting              g80% of the studies show that stock price
of sustainable investment options. In those cases,            performance of companies is positively influenced            Jon Hale
                                                              by good sustainability practices.
the Morningstar sustainability scores will help
meet the demand by allowing investors to evaluate
conventional funds’ portfolios on the basis
of sustainability criteria and plugging them in               p All Morningstar Rated Funds p Socially Conscious Funds                                                           (%)
alongside more-intentional sustainable strategies
                                                                                                                                                                                 50
to form a sustainable portfolio for the client.

Jury Is Still Out
These challenges, in the end, are not insurmount-                                                                                                                                40
able, but they show that while sustainable
investing may be poised to enter the mainstream,
its success is not guaranteed. At the same
                                                                                                                                                                                 30
time, given the demographic trends favoring
sustainable investing, investment professionals
today have strong incentive to meet that
demand as they transition their book to be younger                                                                                                                               20
and more female-oriented. Sustainable investing
offers advisors a way to add value not just in terms
of performance but in terms of aligning client                                                                                                                                   10
portfolios with a desire to support the transition
to a sustainable global economy. This, in turn,
ties investors more closely to their investments,
making it more likely that they will stay the course           Q                        QQ                   QQQ             QQQQ                 QQQQQ                           0
for the long run. K                                            Source: Morningstar. Data as of 09/30/2015.

Jon Hale, CFA, Ph.D., is Morningstar’s director of manager
research, North America. He is a member of the editorial
board of Morningstar magazine.
                                                             1 Clark, Gordon, Andreas Feiner, and Michael Viehs. 2014.“How Sustainability Can Drive Financial Outperformance.”
                                                             2 “Sustainable Reality: Understand Performance of Sustainable Investment Strategies.” March 2015. Morgan Stanley
                                                               Institute for Sustainable Investing.

                                                                                                                                                                                   7
                                                                                                                           Electricity Consumption Forecast in 2020 (TWh)
Spotlight: ESG

ESG Thrives in Europe                                                                                                            sible Investment, have included the UN Global
                                                                                                                                 Compact principles in their investment

Continent’s institutional investors lead
                                                                                                                                 processes, and have developed a policy regarding
                                                                                                                                 controversial weapons.

way in making offerings sustainable.                                                                                              Of course, Europe is not a homogeneous market.
                                                                                                                                  Some notable differences and variations
                                                                                                                                  in ESG practices can be spotted between different
                                                                                                                                  European countries. According to Eurosif, the
                                                                                                                                  pan-European sustainable and responsible
                                                                                                                                  investment membership organization, the French
    ESG                                                           pension funds in the world. Already perceived                   ESG market is traditionally defined by combining
San Lie                                                           in the market as one of the front-runners in                   “best-in-class” and “sustainability-themed”
                                                                  sustainable investing, ABP announced in October                 strategies. In the United Kingdom, the most
                                                                  a radical change to its investment policy.                      practiced strategy is “engagement and voting.”
Europe has a large head start over the United                     In response to members, ABP said it will target                 In the Netherlands, “exclusions” is the most
States in ESG investing ( E X H I BI T 1 ). According             sustainable and socially responsible investments.               popular strategy, followed by “norms-based
to the 2014 Global Sustainable Investment                         It also now has a number of concrete objectives,                screening” and engagement and voting. The latest
Review, 58.8% of European invested assets already                 including cutting 25% of carbon-dioxide-                        trend in most European markets is growth
are invested in a sustainable way, compared                       related investments from its equity portfolio by                of “impact investing” vehicles.
to 31.3% in Canada and 17.9% in the United States                 2020. Also, investments that contribute to a better
( E X H I B I T 2 ).                                              and cleaner future are to be doubled from EUR                  European governments play a large role, too.
                                                                  29 billion to EUR 58 billion by 2020.                          In France, public authorities are creating
One of the reasons Europe is leading the way                                                                                     an SRI label for funds applying ESG criteria. In the
is the fact that European institutional investors see             Private banks and wealth managers are also                     Netherlands, the government published the
sustainable investing as part of their fiduciary                  in the process of making their offerings more                  Pension Governance Code in September 2013.
responsibility. A recent example is the Dutch civil               sustainable. Rabobank, for example, decided years              It gives guidance to pension funds on ESG themes
service pension fund, ABP, which has about                        ago to limit its offerings to funds that have                  such as transparency, accountability and
EUR 350 billion in assets and is one of the largest               signed the United Nations Principles for Respon-               communication, financial control, diversity, and
                                                                                                                                 good governance. The code also requires pension
                                                                                                                                 funds to define a “responsible investment”
EXHIBIT 1                                                         EXHIBIT 2
                                                                                                                                 strategy and make it available for stakeholders.

ESG Assets by Region Europe has                                   Growth in All Regions The proportion
                                                                                                                                 What the United States and European countries
twice as many assets in sustainable                               of professionally managed assets                               have in common, however, is weakness in the
investments as does the United States.                            devoted to sustainable investments has                         retail ESG market. This may be due to the
The world total in 2014 was $21.4                                 increased to 30.2% globally.                                   lack of clear definitions, or the view that ESG
trillion, up from $13.3 trillion in 2012.                                                                                        comes with a performance penalty. This perception
                                                                  Proportion of Sustainable Investments Relative                 should change over time. Academic and industry
Region                                              ($ Billion)   to Total Managed Assets                                        studies are demonstrating that sustainable
                                                                                                                                 investing does not underperform conventional
Europe                                                13,608      Region                               2012 (%)       2014 (%)
                                                                                                                                 investing, and there is mounting evidence
United States                                          6,572      Europe                                   49.0          58.8    that incorporating ESG factors in an investment
Canada                                                    945     Canada                                   20.2          31.3    process has a positive impact on performance. K

Australia/New Zealand                                     180     United States                             11.2         17.9    San Lie is director of manager research, Benelux
Asia                                                       53     Australia                                 12.5         16.6    with Morningstar’s EMEA fund research team.

Total                                                 21,358      Asia                                       0.6          0.8
Source: 2014 Global Sustainable Investment Review                 Global                                    21.5         30.2
                                                                  Source: 2014 Global Sustainable Investment Review

8         Morningstar December/January 2016
Sustaining Success                                                                                                business. It made a lot of sense to me that if we
                                                                                                                  are going to influence corporate behavior, we

ESG is a win-win for companies and
                                                                                                                  could do it through capital markets and directing
                                                                                                                  capital in particular ways. And then it didn’t
                                                                                                                  take me long even 25 or 30 years ago to uncover
shareholders, Michael Jantzi says.                                                                                research that was hinting at the fact that by
                                                                                                                  investing money in that way, you could generate
                                                                                                                  positive shareholder returns over the long term.

                                                                                                                  For me, it was a no-brainer. You could have your
                                                                                                                  cake and eat it, too. Why wouldn’t we look
                                                                                                                  at social and environmental issues if it could have
 SUSTAINALYTICS                                       There may be those who are considering ESG                  a positive impact more broadly and also
Jon Hale                                              factors because they feel it’s a part of their              for shareholders? So, that’s what drove me in
                                                      fiduciary duty in today’s complex investing world.          this direction.
                                                      They’re looking at environmental and social issues
Sustainalytics has provided the global                to evaluate risks and opportunities that might              When you think back on the 1990s, some investors
investment community with research and analysis       otherwise be missed. In other words, they’re doing          were starting to think about sustainability issues,
on companies’ sustainability performance              it to have a more informed investment decision              but not that many companies were. Today, we
for more than 20 years. Now commonly called ESG,      with the expectation that it leads to a positive            see many more companies addressing sustainability.
for environmental, social, and governance, a          contribution to longer-term shareholder value.              Why is that? How did that all happen?
confluence of factors in the market and corporate                                                                 Jantzi: You’re absolutely right that when I started
world is making this investing theme a main-          There are other investors who approach sustain-             in this in 1990, there were very few companies
stream approach. Beginning in 2016, Morningstar       able investing through a values lens—while                  talking about sustainability or thinking about
will rate the portfolios of mutual funds and          not necessarily committing to an investment                 it, and certainly not many at all that would actually
exchange-traded funds on environmental, social,       mandate, these investors are considering                    publish reports or disclose what they were
and governance factors. Morningstar will              companies that are doing a better job with regard           doing in the area. I think it’s safe to say that it was
base the scores on ESG company ratings from           to their environmental and social footprints and            the capital markets—investors both retail
Sustainalytics. The founder and CEO of                integrating these considerations into the                   and institutional that brought these issues to the
Sustainalytics, Michael Jantzi, has seen firsthand    investment process. There are other investors that          corporate agenda.
the development of ESG investing over the             hold a combination of those objectives. But
past two decades. He has a deep understanding         to me, sustainable investing is about the discipline        They were brought to that agenda in two ways.
of its history and the roles companies and            itself and the integration of those things into an          In some instances, it was values-based—
investors are playing in this burgeoning              investment process or philosophy.                           you shouldn’t be doing business in South Africa
area of the investment universe. I sat down                                                                       because of the apartheid regime. But increasingly
with Jantzi in October to discuss the                 You’ve been at this a long time. How did this idea          it became business-oriented—you need to
state of sustainable investing and what the           of sustainability first occur to you as something you’d     pay attention to how you are managing the risks
future holds.                                         end up spending your career doing?                          that seem to be central to your business.
                                                      Jantzi: It occurred to me very early in my career.
You hear a lot of terms batted around these days      In fact, in Canada, I was in the process of                 For a long time, it seemed that investors and other
describing sustainable investing. How does Michael    writing my exams, heading down to be licensed               stakeholders were dragging companies into the
Jantzi define it?                                     by the Interior Securities Commission, and                  discussion. That’s changed wholeheartedly
Michael Jantzi: Sustainable investing is about        where that would have led me, I don’t know.                 now. Boards of directors and senior management
the discipline of integrating environmental,                                                                      teams are looking at sustainability in a much
social, and governance themes or indicators into      But I heard a radio interview that focused on               more sophisticated way now and in fact, in
an investment decision-making process.                some U.S. pioneers in this space that were starting         some parts of the world, are bringing investors
                                                      to look at environmental and social issues                  into the discussion.
There are a variety of reasons that practitioners     as part of the investment process. That was like a
are going to undertake that sustainable               light bulb going on for me. It brought together             For example, in Asia, where we see capital markets
investment process or that integration, and they’re   my personal interest in environmental and social            lagging behind on sustainability issues, we see
not mutually exclusive of one another.                issues with my passion for capital markets and              some very strong corporate sustainability

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Spotlight: ESG

 reporting, especially out of Japan, that is helping         shifts driving this. Especially in the retail          social, and governance policies and less to
 put these issues on both the government and                 high-net-worth market, there’s no question that        do with actual performance metrics. Is that a fair
 corporate agenda.                                           with younger demographics, with women                  criticism? Does having these policies and procedures
                                                             becoming more focused on their financial futures,      in place indicate something more than just a
 We’re also seeing today corporate and capital               and so on, we’ve seen a shift here. We’ve seen         check the box to get a better sustainability score
 markets working together to address some                    that plan participants and pension funds, as           mentality on the part of the company?
 common challenges, like excessive short-term                well as individuals, are beginning to understand       Jantzi: I think it’s a fair critique in some ways.
 thinking in markets. For companies or investors,            that the decisions they make on the investing          But I think that looking at policies, programs,
 the longer time frame you have, the more                    side are important not just from a financial           and how certain environmental, social, governance
 likely it is that you’ll be identifying ESG risks or        standpoint, but they can have a positive impact        risks are being managed is underappreciated.
 opportunities that you need to take account of.             on the broader world as well.                          These disclosures are indicative of actual practices
                                                                                                                    and resulting outcomes. Maybe the starting
                                                                                                                    point is that oftentimes a critique like that is
                                                                                                                    underpinned by a mistaken belief that traditional
       It was a no-brainer. You could have your                                                                     financial analysis is all science and no art. That
                                                                                                                    simply is not true either.
 cake and eat it, too. Why wouldn’t we look
                                                                                                                    Generally our approach to ESG analysis and
 at social and environmental issues if it could have                                                                providing insights starts with the idea
                                                                                                                    that any company faces a variety of ESG risks and
 a positive impact more broadly and also                                                                            opportunities. We understand these are going
                                                                                                                    to differ by industry and by sector. But what
 for shareholders?                                                                                                  are those key ESG issues that companies face?
                                                                                                                    Do the companies understand those issues?
                                                                                                                    If so, to what extent? And if there are ESG risks
 Michael Jantzi                                                                                                     there that we believe can be material to
                                                                                                                    their business, of course we need to understand
                                                                                                                    how those risks are being managed.

                                                                                                                    For us, looking at environmental management
 So, it’s quite exciting how corporations have come          I think another driver, though, is the understanding   systems, looking at supply chain issues, looking
 up the learning curve, but it’s even more                   that environmental issues and social issues are        at what level within the company those issues
 exciting to me to see how capital markets and               not just values issues, that these are and can         are managed, these are important indicators for
 companies are working together.                             be material risks and opportunities for a business.    us to understand not just whether the company
                                                             So, quite apart from what the market demand            understands these risks, but how seriously they’re
 There appear to be a number of factors in place today       might be telling them, again it’s this idea that—      taking them, and then it gives us an indication
 that are increasing demands on asset managers               wow, we’re living in a much more complex world,        of how they will manage these risks if they hit the
 to pay more attention to integrating ESG factors,           and I am charged, as a portfolio manager,              radar in a real way. If we see a gap between
 namely shifting demographics to a younger generation        to come to a judgment and make a decision in           the exposure to these issues and what we think
 of investment decision-makers who have a greater            an increasingly uncertain world and that by            is their ability to manage them, then yes, we think
 affinity for sustainable investing. The same goes           looking at ESG datasets and insights, I can make       that’s something investors need to know about.
 for women. Public policy in some places is also a driver.   more informed decisions. There are some
 What are your thoughts on this idea that sustainability     very powerful forces, both from the market but         Measuring performance is also a critical part
 is becoming a more mainstream investment theme?             also within the organizations themselves, that         of the equation. There are an increasing number
 Jantzi: There’s no question that the main-                  are heading towards that same end point, which         of themes and indicators that we can quantify.
 streaming of responsible investment is real, and            is a mainstreaming of sustainability investing.        They can be on the environmental side, so it can be
 it’s probably something that you can date                                                                          looking at carbon output, or intensity. It can be
 back to the mid-2000s with the formation of the             I’ve heard the criticism that a lot of the ESG         on the human capital side of the equation, looking
 U.N.-backed Principles for Responsible Investment.          indicators that Sustainalytics uses in its company     at key indicators like turnover, absenteeism­—
 I think you’ve highlighted one of the key drivers           ESG ratings have more to do with companies             those types of things. That quantitative side is
 of the mainstreaming. We’ve seen demographic                documenting and disclosing various environmental,      getting more sophisticated every year. But then

10   Morningstar December/January 2016
there also is the qualitative side of looking at         Jantzi: There’s no one set course on how to             in sustainability. You can then ask, well,
performance and controversies. We not only look          become a leader, even within the same sector.           why have regulations been advanced in Europe?
at the number of controversies occurring but also        I’m an old-fashioned guy. I like holding a              Probably because people living in a more
where they are happening within the organization,        roadmap in my hand. GPS is nice, but it gives           dense environment have demanded it. But the
and how often they are happening, and how                you the illusion that there’s only one way              reality is, from a product innovation stand-
companies are managing those controversies.              to your destination. You do this, that and this, and    point, from a lifecycle standpoint, from a supply
                                                         it’s very easy to follow. But when you look at          chain standpoint, European companies are
So, really it’s about taking that 360-degree view        a map, you understand that there are a variety of       ahead of the curve. But I think that the gap
of a company and coming, at the end of the               ways that you can get to your destination,              between Europe and North American companies
day, to our final call on whether it’s well positioned
to manage ESG-related risks. It’s not just about
checking a box.

Sustainalytics designates the top 5% in each industry
                                                               If you’re in an industry that relies on the best
as industry leaders. What is it that companies are       and the brightest, you want to make sure
doing today to make themselves sustainability leaders?
Jantzi: The first thing to understand is there’s         that you’re attracting the best and the brightest
no single definition. As I’ve alluded to, companies
in different sectors and in different industries         from the widest possible talent pool … and
face different challenges and have different
opportunities, so leadership varies differs by sector.   providing them career development opportunities.
But generally speaking, a leader is going beyond
putting that environmental management                    That’s what leaders are doing. They’re integrating
system or auditing procedure in place. It’s going
beyond just being transparent and disclosing             the ESG indicators we look at into their
what it’s doing on the sustainability front.
It’s taking ESG to the strategic level and saying
                                                         strategic and operational decision-making.
this is helping us uncover risks that have
the ability to blindside the business; it’s helping us
stay ahead of the curve.                                 Michael Jantzi

But more important is the opportunity side of the
equation. Is sustainability being used to drive
business innovation or product development? Is it        and there may be trade-offs along the way, and          is narrowing. The fact is that American companies
being used to drive competitive differentiation,         I think that’s what sustainability is about. You need   are global in nature. They understand that as
whether that’s on the branding side or the human         to find a way, from a corporate perspective,            consumers become more attuned to these issues,
capital side. If you’re in an industry that relies       that fits your culture, that fits your competitive      they understand that as their supply chains or they
on the best and the brightest, you want to make          positioning, that fits your broader industry            themselves directly are operating in more
sure that you’re attracting the best and the             plans. It’s really about integrating ESG consider-      challenging parts of the world, whether that’s
brightest from the widest possible talent pool.          ations into your business decision-making that          from a community relations standpoint, a human
You want to know that vis-à-vis your competitors,        provides you the advantages that you need               rights standpoint, or an environmental standpoint,
you’re bringing people in and providing them             and hopefully then helps you identify and avoid         that these are issues that they have to understand
career development opportunities. That’s what            potential risks down the road.                          and manage. So, I think American companies,
leaders are doing. They’re integrating the ESG                                                                   because they are global citizens, are impacted not
indicators we look at into their strategic and           What about the global picture? Are there significant    just by what American government or American
operational decision-making. That’s really what          regional differences over how companies address         consumers are saying, but what their consumers
separates the leaders from those that are                ESG issues?                                             are saying in other parts of the world.
considering ESG factors at a more basic level.           Jantzi: Broadly speaking, European companies
                                                         are ahead of North American and Asian                   And then when you go to Asia, there’s a misunder-
I’ve heard you use the roadmap versus GPS analogy        companies. The regulatory environment in                standing that sustainability issues are not on
that I thought was insightful.                           Europe has done a lot to spur the interest              the agenda at all. That’s simply not true. In some

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Spotlight: ESG

sectors, real estate for example, there’s global         think about putting management structures                   long-term horizons that fit well with sustainability
leadership in Asia. You have some very progressive       in place, even though at this point your exposure           issues. On the retail side, we’ve talked about
Asian real estate companies. You have strong             may be several levels below what you’re seeing              demographic changes and transfers of
sustainability reporters out of Japan.                   for your larger-cap competitors.                            wealth. Individuals are looking for ways now
                                                                                                                     to align their personal financial decisions
Asia is not homogeneous. It’s a collection               Let’s talk more specifically about the big question of      with their values, and that’s going to continue
of different cultures and we can’t expect them           whether sustainability creates shareholder value.           to drive retail demand.
to adopt a European or North American model              What’s the evidence for that from your perspective?
of sustainability. Asia will find its own way forward    Jantzi: First of all, that’s a question that will           What are the challenges going to be? We are living
on what sustainability means. I think what               never be settled. I think, though, that there’s been        in a world that is more and more data-rich.
they’ll do is take the best practices in Europe and      a very important shift. When I started in this              We have overwhelming amounts of data coming
North America and Australia and other parts              business, the idea was, if you want to look at ESG          at us from every direction every single second.
of the world, adapt it for their own situations, and     issues as part of your investment decision,                 So, the challenge for the field of ESG research will
move forward accordingly.                                God bless. Good for you. Just as long as you                be to cut through that noise—that vast amount
                                                         understand that achieving a competitive financial           of information and data—to provide real insights
What about smaller companies that don’t have             return is on absolutely the other end of the                to our clients. That’s a challenge we’ve had
sustainability policies and practices in place because   spectrum. Today, there is a much better under-              for 25 years, and that’s just going to be ratcheted
they don’t have the resources or scale to do so?         standing that they’re not on opposite ends                  up more as we move from being large-cap-
How should investors evaluate that?                      of the spectrum. Actually, these two themes are             focused to include smaller companies, as we
Jantzi: It’s a great point and an important theme        sitting side by side. In fact, increasingly, the            include additional asset classes and other parts
for responsible investment going forward.                mainstream understands that they’re dependent               of the world.
I think the fact that we have focused on large           upon one another.
caps is appropriate. They’re the companies                                                                           One final question: 20 years ago, I recall a fairly
that are going to have the largest environmental         Two and a half decades ago, people would say                dubious attitude toward corporate ESG practices on the
and social footprint.                                    it’s against your fiduciary duty as a portfolio             part of sustainable investors. Is that mood more
                                                         manager or an investment professional to look at            optimistic today?
But small caps are obviously important for the           anything but the bottom line. Today, that’s                 Jantzi: Yes, it is more optimistic, because
investment community. Responsible investors              flipped on its head. If you’re not looking at ESG           more companies are paying more serious attention
and those of us who are charged with providing           issues as part of the investment process, you may           to ESG issues. Fewer companies are treating
insights into company performance need to                be transgressing your fiduciary duty.                       sustainability as marketing or window-dressing
continue to find effective ways to measure how                                                                       and more are integrating these issues into their
smaller companies are doing.                             So, the debate is still out there. But there’s an           strategic decision making.
                                                         overwhelming amount of evidence that’s
It’s not fair to compare a small-cap company             showing a positive correlation between sustain-             But let’s step back for a moment and understand
to a large cap. From a Sustainalytics perspective,       ability and shareholder value. The burden                   that we still have issues, like Volkswagen
we understand that and have developed                    of proof is now on those who think these issues             recently, that highlight the fact that no matter
an analytical framework that reflects that. By the       are not important to prove to us why they’re                how good a job we’re doing, there are still
same token, whether you’re small or large,               not. That’s a huge shift.                                   going to be instances out there where companies
if you’re operating in a high-exposure industry, you                                                                 are not meeting the sustainability standards
want to know that management understands the             Looking ahead, what are some of the challenges              we expect from them. We’re a long way from
risks that may be coming down the pike.                  surrounding sustainability and what issues will             where we need to be, but certainly we’re heading
Those risks may not be there at this particular          characterize the field, do you think, in the next decade?   in the right direction and have been for the past
moment, but you want to understand whether that          Jantzi: We’re going to continue to see growth               two decades. K
management team is looking ahead. For us, it’s           globally. We’re going to start to see sustainable
finding that balance between having lower                investing extending beyond traditional equity               Jon Hale, CFA, Ph.D., is Morningstar’s director of manager
                                                                                                                     research, North America. He is a member of the editorial
expectations than you would for their larger-cap         and fixed-income asset classes. We’re already
                                                                                                                     board of Morningstar magazine.
brethren, but still understanding that the same          seeing ESG being embraced in areas like private
issues can be out there lurking.                         equity, real estate, and infrastructure.

And then it’s part educational process on our            We’ll see continued growth on the institutional
part to say to smaller companies—you need to             side. Sovereign wealth pension funds have

12   Morningstar December/January 2016
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