ValueWalk’s interview with Ducoulombier Frederic, the ESG Director for Scientific Beta. In this interview, Frederic discusses his and his company’s background, the differences between SDG, SRI and ESG, how the ESG and Low Carbon indexes work, if they have have any restrictions on their indexes, ethical investing, and why Developed Market companies are subjected to much more scrutiny than their Emerging Market counterparts.
Can you tell us about your background?
I am in charge of leading the design and management of Scientific Beta’s Climate Change and Responsible Investing offering and accompanying institutional investors in the porting of their ESG policies to passive investing. Prior to joining Scientific Beta, I headed the Asian operations of EDHEC Business School’s applied research centre in risk and investment management. Previously I held different programme and research management positions within the school that I initially joined as an instructor more than 15 years ago. Over the years, I have done research on various topics that roughly fall into three themes: the regulation of funds and indices, smart beta and factor investing, and the integration of environmental, social and governance criteria into investment.
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What about your firm?
Scientific Beta was established in 2012 by EDHEC Risk Institute, the risk and investment management research centre of France’s EDHEC Business School, to facilitate investor understanding of, and access to, smart beta equity investment strategies. It now has offices in Boston, London, Nice, Singapore and Tokyo and serves worldwide clients, which collectively had USD43bn of funds replicating its indices at the end of 2018. Over a third of these assets track indices that incorporate Climate Change and/or other ESG dimensions. Scientific Beta administers ESG and Low Carbon versions of its flagship multifactor indices, assists investors in the implementation of custom ESG policies and offers complimentary ESG Norms and Climate Change reporting on its Internet platform. The company is a signatory of the United Nations-supported Principles for Responsible Investment and the recipient of the Risk Award for Indexing Firm of the Year 2019 awarded by Risk Magazine.
Is SDG the same or different than SRI and ESG - can you tell us what these terms mean?
ESG stands for Environmental, Social and Governance and refers to a popular grouping of the dimensions by which to evaluate the non-financial performance of companies
The acronym SRI has traditionally referred to Socially Responsible Investing, an approach that is concerned with the promotion of a progressive ESG agenda in an investment context – its tools are engagement, divestment and investment in relation to the ESG performance of companies in the investment universe.
SDGs refers to the seventeen Sustainable Development Goals set by the United Nations General Assembly in 2015 for the year 2030. The SDGs guide the policy and funding of the UN Development Programme, but the support of governments, private sector entities and the civil society are sought in the achievement of these goals. The SDGs is one of multiple frameworks available to guide and benchmark the impact of investments.
Some historical background – this is from an interview I gave for our newsletter earlier this month:
“ESG incorporation into investment started with faith-based exclusions of sin stocks and diversified in the second half of the twentieth century with the advent of Socially Responsible Investing, an approach that relies on both financial and ESG characteristics to build portfolios with progressive ESG agendas. In an effort to develop demand for Socially Responsible Investing, some of its advocates introduced the promise of outperformance to try and address the concerns of fiduciaries that lacked a clear mandate to adopt ESG progressive strategies if this involved non-competitive risk-adjusted returns and lure business-as-usual investors. This had limited success, leading promoters of the mainstreaming of ESG incorporation to promote business-case or materiality ESG. Proponents of that approach correctly represent that ignoring ESG data with financial materiality is a breach of fiduciary duty. With this approach however, the investor loses agency on ESG matters and the ESG performance of an investment is an uncontrolled by-product of conventional risk and investment management decisions – there is no guarantee that the portfolio will meet ESG norms or produce ESG progress; we are back to business as usual, but with an extended dataset.
This is consistent with Milton Friedman’s view of business responsibility – the mission of the corporation is to maximise shareholder value within the confines of the law. In this model, it is incumbent on lawmakers to define standards and on the administration and courts to enforce them. This position has the great merit of clarity and underlines that ESG progress will be determined by stakeholders demanding it in their engagements with corporates or imposing it via political action.
Investment is one of multiple channels of engagement and while materiality ESG is presented as The End of History for ESG incorporation, there is clear evidence that a growing number of investors hold views that are consistent with the pursuit of truly progressive ESG agendas, in the spirit of Socially Responsible Investing. This is observed even in countries that lag in their adoption of ESG incorporation. By way of illustration, a 2017 survey of U.S. individual investors by the Morgan Stanley Institute for Sustainable Investing found 23% of the population and 38% of millennials to be very interested in sustainable investing (up 4 and 10 percentage points over 2015, respectively) and a majority of respondents and 63% of millennials to be expecting a financial trade-off from investing sustainably (Morgan Stanley, 2017). Analysis of fund flows suggests that investors act on sustainability preferences – Hartzmark and Sussman (2019) find that market-wide demand for U.S. mutual funds varies as a function of their sustainability ratings in manner that is “consistent with positive affect influencing expectations of sustainable fund performance and non-pecuniary motives influencing investment decisions.”
As business-case investors incorporating ESG dimensions with a view to strengthening risk management or enhancing returns join traditional values-based and socially responsible investors that wish to align their investments with personal values or social norms and to seek positive ESG impact, the motivations for incorporating ESG data into investment management have never been so diverse.
We thus think that the future of ESG incorporation is bright although we remain concerned by the risks of misleading denominations. It is telling that Responsible Investing – as defined by PRI, the largest ESG-focused organisation in the investment management industry – does not require a progressive ESG agenda or even a positive ESG impact. While PRI has demonstrated commitment to ESG progress, the amoral incorporation of ESG information into standard investment decision making is sufficient to claim the responsible investing badge. Potentially hosting ESG regressive investment strategies under the banner of responsible investing is fraught with reputational risk for the entire industry and in this regard, it is interesting to remark that “mistrust and concerns about greenwashing” is cited ahead of lack of advice, performance concerns or risk management issues as the main hindrance to the adoption of responsible investing (Eurosif, 2018). Assuming this could be corrected –– investors with progressive agendas would still need a label they could trust to identify products that go beyond compliance with laws and usage of ESG data for financial profile optimisation. The work of European lawmakers in respect of a taxonomy for environmentally sustainable economic activities is an interesting development.”
What does your index measure? Is it quant or hand picked - can you give us some color?
Our recently introduced ESG and Low Carbon Options enable investors to benefit from the performance of our flagship multi smart factor indices while upholding ESG norms and materially reducing exposure to companies with high exposure to ESG or Climate Change risks, respectively. Smart factor indices aim to reap the long-term rewards of risk factors beyond the broad equity market risk in an efficient manner, i.e. while mitigating non-rewarded risks, including by applying diversification weighting schemes on factor selections to reduce exposure to diversifiable risks. We are not claiming that the ESG and Low Carbon dimensions of these indices will lead to additional financial rewards – they are primarily intended to have a positive impact at the ESG level.
Do you have any restrictions on your new index? What would cause a company to be excluded?
Both options exclude companies that fall severely short of global standards of responsible business conduct, deprive shareholders of voting rights or are involved in activities that conflict with global ESG norms or their objectives (anti-personnel landmines and cluster munitions, tobacco manufacturing, coal).
The ESG option includes additional negative filters targeting companies facing critical controversies in the areas covered by the UN Global Compact, or involved in any category of inhumane weapons or deriving significant revenues from tobacco distribution.
The Low Carbon option includes an additional positive filter targeting companies with high Carbon Intensity, which leads to considerably reducing the indirect contribution to Climate Change of investment (the financed emissions) and which encourages transition to a low carbon economy; it also reduces exposure to the risks of this transition.
How does CEO and executive pay tie into your index?
This is not a dimension that we address in our ESG and Low Carbon option but we can do so in the context of investor mandates.
I always thought many ESG funds are just marketing gimmicks - a few weeks ago one big asset manager had their ESG head resign over a college admissions scam and it made me more cynical over the holdings of many funds - are many ESG funds out there missing the big picture?
One key issue with the current development of “responsible investing” is the divorce with the progressive ESG agenda that the general public rightly expects. See the last two paragraphs of my recent newsletter interview above.
How does your index help here?
The ESG incorporation philosophy of Scientific Beta centres on exclusions that are determined solely on ESG merits and demerits and applied as the first step of index construction. This approach respects the principles of ethical and socially responsible investors and, as a result, exclusions send clear signals to issuers and are straightforward to explain to stakeholders.
This is in stark contrast with “Responsible Investment” approaches that are devoid of a progressive agenda and with integrated ESG approaches that allow for compensation between ESG and financial characteristics at the security level and/or approach ESG performance as a portfolio average and allow a higher allocation to ESG leaders to make up for a higher allocation to ESG laggards – if unconstrained by minimum ESG standards, such approaches rightly deserve to be called out for ESG washing. Exclusions based on composites of ESG and financial performance convey mixed signals to issuers in respect of the importance of integrating ESG considerations and may be challenging to explain to stakeholders. For the average investor with progressive ESG motivations it is unlikely that the non-financial impact of holding a company facing a critical controversy could be neutralised by an investment of the same amount in a company that has earned a corporate sustainability award; and for investors following a deontological approach, the suggestion is obscene.
What companies or sectors should a fund dedicated to ethical investing avoid?
Ethical sensibilities are diverse, so there is no right or wrong answer here. For our off-the-shelf products, we target global norms and exclude companies that violate fundamental norms of responsible business conduct or engage in activities that are opposed to the objectives of global norms. That leads us to relying on the UN Global Compact (whose Ten Principles are derived from the Universal Declaration of Human Rights, the International Labour Organization’s Declaration on Fundamental Principles and Rights at Work, the Rio Declaration on Environment and Development, and the United Nations Convention Against Corruption) to assess conduct and to excluding companies involved in inhumane weapons, tobacco (the global norm here is the WHO Convention on Tobacco Control) or have significant involvement in the coal value chain (as coal is the fossil fuel that needs to be phased out as a priority to respect the objectives of the United Nations Framework Convention on Climate Change and the Paris Agreement).
How does an index differentiate from a fake and real ethical fund?
We invest in securities directly not in funds. Funds should not be assessed by the average of their constituents’ ESG rating but by exposure to companies that fail or oppose global norms. The use of average indicators may be sensible when they relate to physical realities such as greenhouse gas emissions for example.
Incidentally, that is how we approach the ESG performance of all our indices and we have introduced complimentary ESG and Climate change reporting on our index platform.
It seems like a lot of big firms keep getting implacted in ethical scandals like helping China build mass concentration camps - why do many mega-corps keep getting caught in sometimes horrific actions despite them paying lip service to human rights?
Related, companies get bigger and bigger it seems hard to find firms which do it all - treat workers well, do not pollute, care about more things than profits and other typical ethical issues - what do you think about the matter? How does it play in?
The largest multinationals remain predominantly Developed Market (listed) companies. With their global presence and extended supply chains, multinationals may have operations in or linked to multiple countries in which legal standards pertaining to ESG issues and/or their enforcement significantly lag global norms, which increases the risk that behaviour that is legal or passes as business as usual in a jurisdiction will contravene global norms – tellingly, the preamble to the Ten Principles of the Global Compact states that responsible businesses are expected to “enact the same values and principles wherever they have a presence”. In addition, for a variety of legal and cultural reasons, Developed Market companies are subjected to much more scrutiny on the part of stakeholders than their Emerging Market counterparts (including by regulatory agencies, non-governmental organisations, the media, consumers, employees, etc.) and alleged wrongdoing receives more media attention and generates more litigation.
On a positive note any big names you think are doing it right? Ones that would be near the topic of the index for example
Our focus is on excluding the companies that fall clearly short, so I am afraid I am not the person to recommend entries for the most ESG progressive company award.