Emerging Markets Enhanced SRI

We recently sat down with Andy Wright from the Active Quantitative Equity (“AQE”) team to talk about the Emerging Markets Enhanced SRI (or “EM Enhanced SRI”) strategy and how it can serve investors. The following is a transcript of that interview, which has been edited and condensed for clarity.

The editors: Tell us about the EM Enhanced SRI strategy. How does it extend the core EM Enhanced strategy we discussed last quarter?

Andy Wright: As an Enhanced strategy, we look to add a small, incremental amount of value over and above the benchmark return on a consistent basis, with tight active-risk control. We do that by taking small, relative index bets on stocks that we like, using the same proprietary stock-selection model that we use across all of our Active Quantitative Equity strategies.

Like the Emerging Markets Enhanced (or “EM Enhanced”) strategy, our reference benchmark is MSCI Emerging Markets Standard. The difference between the standard EM Enhanced strategy and its SRI — or “socially responsible investing” — counterpart is that we actually use a screening process for those stocks that might be more sensitive to negative ESG (“environmental, social and governance”) issues.

How does your screening process work?

We use a normative- or negative-screen approach to exclude securities that would normally be contained within our investment universe, based on three criteria.

First, we exclude companies that are complicit in breaches or violations of international norms and conventions in areas such as labor rights, human rights, environmental degradation, bribery and corruption. Second, we screen out companies that manufacture controversial weapons, such as cluster munitions, antipersonnel weapons, land mines, and nuclear, chemical and biological weapons. And finally, we exclude companies that manufacture tobacco products.

Where do you source the information that you use to apply this screen?

We use data from Sustainalytics, a firm with a very long track record in this space, to aid us in this screening process, which is updated on a quarterly basis. We also cross-reference that Sustainalytics data against the exclusion list of the Norwegian Ministry of Finance, as an additional check. Normally the difference between the two lists is very minor, but we’ve got that second check just in case.

What kinds of investors typically seek the EM Enhanced SRI strategy? Who might benefit from it?

Typically, investors seeking to apply negative screens are restricted by law from investing in companies that fail these criteria. These kinds of legal restrictions are common in Scandinavian countries, for example. Others have their own investment policies or mandates that they must adhere to.

We recently integrated an ESG alpha signal in our stock-selection model, which doesn’t prevent us from holding a badly scoring ESG company, although it can reduce our exposure. But this doesn’t go far enough for some of our clients who, through their own principles or through country regulations, either can’t or don’t want to hold companies that don’t have good ESG practices.

Over the last 10 or so years, companies have increasingly approached us with their own set of SRI restrictions. These are typically very similar, if not identical, to the sorts of restrictions that we have within this strategy. So we have built these products to be in compliance with existing restrictions that companies have in place.

In terms of opportunity or benefit: overall, we believe these less-developed markets, whether it’s emerging or small cap, could provide great opportunity for adding value for a range of investors. We would certainly encourage investors to consider emerging markets over the long run. If you’re a value investor, we believe there could be opportunity for you.

How is corporate social responsibility and good ESG practice taking shape in emerging markets?

Emerging-market companies want to be attractive to investors. They want to be seen to be doing the right things. Adhering to higher standards does tend to increase their valuation and their appeal to international investors, as firms in developed markets are becoming increasingly aware of the effect their supply chains could have on their business and reputation.

When our team undertook the integrated ESG research project last year, we actually weren’t sure how well it would work within the emerging-market investment universe. We assumed that the available data wouldn’t be good enough. But when we actually ran our simulations, we were surprised to find that the signal actually did appear to work in emerging markets.

Have you observed any interesting trends in socially responsible investing over the past 10 years or so?

When I first joined the AQE team back in 2006, clients would typically opt for standard products. There would be the occasional client, typically based in a Scandinavian country, who might request some restrictions. But what we’ve seen now is that people are a lot more aware of their social responsibility, and that awareness has built up over the past 12 years. Companies today are more prepared to take action — to actually back their views and their principles and tilt their investments towards those that are having less of an impact socially, environmentally and from a governance perspective.

This trend has been developing more quickly in certain areas. Continental Europe has had these kinds of restrictions for years, but the rest of the world is starting to catch up.

What impact has this additional screening had on the returns that EM Enhanced SRI is able to deliver?

When looking at a three-year annualized return for the EM Enhanced SRI strategy as of June 30, 2018,  the active return over and above the benchmark on an annualized basis has actually been slightly higher than that of the standard EM Enhanced strategy — 1.17 percent for the SRI strategy, versus 1.06 percent for the standard EM Enhanced strategy. Depending on the timeframe, of course, it could go either way.  On a two-year basis, annualized active return over the benchmark for the SRI strategy is 1.5 percent, compared with 1.6 percent for the standard strategy. Over the longer term — and we typically look at two-, three- and five-year timeframes, as do our clients — there is very little difference in the realized returns that we’ve seen since running these two strategies side by side.1 The same is true on a risk basis. When we look at the information ratio, which is active return per unit of active risk, again there’s very little difference between the two strategies. We’ve observed no meaningful loss of performance by applying the SRI screen.

On a personal level, what does it mean to you to be involved in an investment strategy that included socially responsible investing?

Environmental, social and governance investing is something that I am very keen on from a personal and professional perspective. I was one of the team members on the working group when we developed the ESG alpha signal that we recently integrated into our stock-selection model. I was very pleased to be involved in that project and to be able to contribute. Certainly, my personal belief is that we should be taking a stance on those companies that have poor records, whether it’s a poor record for human rights, for environmental pollution or for other ESG-related shortcomings. It’s great to be able to continue to provide socially responsible investment vehicles that add value, that aren’t detrimental from a return perspective, and in some cases can be seen to be adding value, as well. I think it’s a great approach to be able to offer to clients.

Footnotes

1 Past performance is not a guarantee of future results. All returns reflect capital gains and losses, income, and the reinvestment of dividends (net of withholding taxes), and are calculated in US dollars. Performance returns for periods of less than one year are not annualized. The performance shown is of a composite consisting of all discretionary accounts using this investment strategy.  Net returns are provided net of actual trading, audit, custody, administrative and legal fees and expenses, and since 9/30/2014, reflect the highest investment management fee on the actual fee schedule.

Glossary

Alpha: Alpha is used in finance as a measure of performance. Alpha, often considered the active return on an investment, gauges the performance of an investment against a market index or benchmark which is considered to represent the market’s movement as a whole. The excess return of an investment relative to the return of a benchmark index is the investment’s alpha.

Emerging Markets: 23 emerging economies: Brazil, Chile, China, Colombia, Czech Republic, Egypt, Greece, Hungary, India, Indonesia, Korea, Malaysia, Mexico, Peru, Philippines, Poland, Qatar, Russia, South Africa, Taiwan, Thailand, Turkey and the United Arab Emirates.

Environmental, Social and Governance (ESG) Investing:
Incorporates an analysis of ESG credentials into the decision to invest — in addition to traditional financial metrics. It can also encompass efforts by investors to influence the activities of the companies within investment portfolios through voting and engagement, either directly or by an investment manager on the investor's behalf.

Negative-Screen Approach:
Avoiding securities on the basis of an organization or individual’s values, standards and norms, or other ESG considerations.

Signal:
A term used interchangeably with Alpha, is a measure of performance, the excess return of an investment relative to the return of a benchmark index.

Quality: Quality
has long been established as an investment approach, dating back to Benjamin Graham, but it is less well accepted as a factor, especially when compared with value, size, yield, momentum and low volatility.

Disclosure

Important Risk Information

The views expressed in this material are the views of Andrew Wright through the period ended August 31, 2018 and are subject to change based on market and other conditions.

This document contains certain statements that may be deemed forward-looking statements. Please note that any such statements are not guarantees of any future performance and actual results or developments may differ materially from those projected.

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Equity securities may fluctuate in value in response to the activities of individual companies and general market and economic conditions.

Foreign investments involve greater risks than U.S. investments, including political and economic risks and the risk of currency fluctuations, all of which may be magnified in emerging markets.

Quantitative investing assumes that future performance of a security relative to other securities may be predicted based on historical economic and financial factors, however, any errors in a model used might not be detected until the fund has sustained a loss or reduced performance related to such errors.

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