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The Michael Shearin Group Morgan Stanley: Investing With Impact - Social, Environmental and Financial Values

Matthew Rizzo

Head of Investment Strategy and Content

Consulting Group Investment Advisor Research

Morgan Stanley Wealth Management


Vipul Gautam

Consulting Group Investment Advisor Research

Morgan Stanley Wealth Management


Lori Villatoro

Consulting Group Investment Advisor Research

Morgan Stanley Wealth Management


Many investors may be familiar with the term “socially responsible investing” (SRI), an approach to investing that encourages responsible environmental, social, consumer, human rights and diversity policies. SRI strategies typically involve negative screening to weed out companies in select industries, such as alcohol and tobacco. Within Morgan Stanley & Co.’s Investing With Impact framework, SRI falls under the Values Alignment category. The other categories are Environmental, Social and Governance (ESG) Integration; Sector Exposure; and Impact Investing.


So, what is different here? Historically, SRI investing has been a way for investors to avoid certain industries or companies that were not aligned with their values. The ESG Integration framework, for instance, takes things a step further by potentially allowing investment managers to more effectively identify important drivers of longer-term risks and returns. As a result, some investment managers have begun looking toward ESG Integration as a way to more fully evaluate companies and potentially find attractive investment opportunities. The sector-exposure category is more focused, targeting specific themes or niches, such as solar energy or clean-water technologies. Impact investing is the most direct way of trying to effect positive social or environmental change, but that channel is typically addressed through private equity or hedge funds.


The Investing With Impact framework is part of the investment industry’s embrace of socially responsible investing. The industry’s increasing commitment to such goals is evidenced by the growing number of signatories to the United Nations Principles for Responsible Investment. Globally, approximately $34 trillion is managed or advised by these signatories. According to a 2012 report from the United States Forum for Sustainable and Responsible Investment, about $3 trillion of professionally managed assets in the US investment marketplace are managed “responsibly.”


Each individual investment process is different, and performance results will vary by strategy. However, we find that indexes with ESG guidelines have generally performed well versus broad market indexes like the S&P 500 (see table). ESG is not as developed on the fixed income side; in looking at recently created indexes that incorporate ESG guidelines, there is some evidence suggesting ESG Integration can help mitigate losses in challenging market environments, while overall returns were fairly similar to non-ESG index returns.



ESG Integration


ESG Integration has particular significance to the investment industry. A number of managers are employing the technique as both a means of aligning values and a way to potentially identify more attractive investment opportunities, and the proper management of ESG issues can significantly affect company profitability and thus share price. Although it is still an evolving area of investment management, a study by the Global Sustainable Alliance estimates there are nearly $14 trillion in assets managed using ESG globally, or around 20% of the assets managed in the regions covered by the study.


Investors utilizing ESG Integration methodologies have traditionally focused on public equities, but utilizing ESG factors can help identify risks that could have a material impact on bond issuers. Examples of these risks include those that are credit related, liquidity related, regulatory, legal and even reputational. ESG principles can also potentially help investment managers construct lower-risk bond portfolios and preserve client capital. While traditional stock and bond research and analysis is generally effective in identifying shorter-term risks, longer-term risks associated with high-impact and low-frequency events are much more difficult to model and forecast.


Increasing numbers of investment managers are creating specific ESG-branded investment products, and some traditional money managers have begun incorporating ESG principles into their investment processes as well. For example, PIMCO became a signatory to the UN PRI, which was formulated by the investment community and takes the view that ESG issues can affect financial returns and therefore should be considered when making investment decisions. According to the PRI Association, there are currently more than 1,200 signatories to the principles.





Public companies can benefit from operating in an environmentally friendly manner or, in the case of carbon-related industries, from making a concerted effort to reduce the environmental impact of their products and mitigating operational risk. Companies in the oil and gas sector, especially those in higher-risk operations such as offshore drilling, benefit from embracing stringent safety standards that may exceed federal regulations, since the damage caused by oil spills and related accidents expose these companies to substantial financial costs and lower equity valuations.


In response to demand from consumers seeking to reduce their environmental footprint and in pursuit of profit growth, auto companies continue to develop a wide range of alternative-fuel vehicles. Makers of consumer products, concerned about limited water resources, work to educate their customers and also change their manufacturing processes to better manage water use.


The environmental management of bond issuers is relevant to bond investors because it has direct value implications. A study by the European Centre for Corporate Engagement found that regulatory, legal and reputational risks associated with environmental incidents lead to increased financing costs and lower credit ratings. Conversely, companies with a history of practicing proactive environmental policies were associated with a lower cost of debt.


The costly fines, awards and cleanup that go along with environmental violations can threaten the financial viability of issuers. In addition, in the event of default, bondholders may find their claims subordinated by an issuer’s environmental liabilities due to US legal and regulatory law.





Aspects of social-management policies that can increase risk include workplace issues related to diversity, health, safety and labor relations. Class-action lawsuits stemming from these issues not only result in costly litigation and potential awards but can also damage brand reputation.


Community impact is another area of which investors need to be conscious. Negative impact can damage brand loyalty and possibly affect the ability of an issuer to operate in the manner it is accustomed to should new rules and regulations be imposed.





Strong corporate governance has now become a common risk factor that many investment managers use in stock selection. Company management teams are usually the first to be credited when the company does well—and vice versa. Having senior leadership that is transparent, shareholder friendly and risk focused has been shown to be positive for share prices. Some investment managers will invest in a company due to their familiarity and confidence in the corporate governance.


Bond issuers that practice strong corporate governance implement appropriate rules around corporate actions such as mergers and acquisitions, and they generally emphasize a culture of strong risk management, shareholders’ rights, transparency, and responsibility to employees and stakeholders.


Some believe that stronger corporate governance could have helped mitigate the severity of the financial crisis in 2008. Although corporate governance did not directly cause the crisis, lax control mechanisms may have contributed to excessive risk taking. Companies with strong corporate governance are typically managed in a more sustainable manner. Thus, individual-company bankruptcy risks (default risk) may be reduced, as well as overall systemic risks.The Investor Responsibility Research Center highlights 24 provisions of corporate governance with relative importance for the benefit of management, which may be valuable to shareholders. A study by Bebchuk, Cohen and Ferrell published in Harvard Law School’s Review of Financial Studies identifies six of those provisions as having the most meaningful impact and correlation with lower firm valuations and returns. Those provisions are:


- Staggered boards

- Limits to shareholder amendments of the bylaws

- Supermajority requirements for mergers

- Charter amendments

- Poison pills

- Golden-parachute arrangements


When screening for only these six provisions, companies that ranked highly for corporate governance outperformed those ranked worst by more than 12%.

Source: http://investorinsights.morganstanley.com/content.do?action=displayContent&cid=1755942&oid=1473333&xsl=88/monthly/enewsletter.xsl

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