QUIET ABOUT BEING PASSIVE: How Index and ESG Are Changing the - PowerPoint PPT Presentation

THERE’S NOTHING QUIET ABOUT BEING PASSIVE: How Index and ESG Are Changing the Institutional Investment Landscape Jan January ry 2018 2018

The “Ripple Effects” of Index Ownership In Index In Investin ing = = Catalyst of of Chan anged Behavior Index ownership has created a dramatic shift in the behavioral paradigms that govern today’s capital markets Four Primary Impacts of Index Growth (“4 R’s”): • Redefining “Buy & Hold” • Revolutionizing SRI & ESG • Revising the Activist Mindset • Reforming Legislation (Both Explicit & Implicit): 3 There's Nothing Quiet About Being Passive - December 2017

Expanding the 4 R’s • Redefining “buy and hold.” Index investors, by definition, lack the ability to divest a stock if it meets the index’s criteria. This can lead to a considerably longer investment time horizon, where capital gains may not be realized for years or even decades. As a result, the index investor’s perspective focuses on those catalysts that will generate the best returns over the long term. While the lack of divestment discretion limits the index investor’s options to actively influence returns, their sizeable holdings can be wielded in creative ways to replace divestment with engagement. • Revolutionizing SRI and ESG. With empirical evidence indicating a strong correlation between weak corporate governance and poor profitability, a focus on SRI (Sustainable and Responsible Investment) and ESG (Environmental, Social and Corporate Governance) aligns with the index investor’s longer -term investment interests and tendency towards loss aversion. As a result, governance is increasingly being viewed as a proxy for long-term cost of capital. The importance of ESG is further underscored by the formation of the Investor Stewardship Group (ISG) in January. • Revising the activist mindset. Without divestment discretion, index funds are turning to ESG as a means to exert control. Increasingly, index investors are partnering with active managers to engage on governance matters and facilitate long-term changes at their portfolio companies. As a result, activist vulnerability is no longer isolated to the known activist names in a company’s ownership profile, as index holdings are now acting as a tailwind to activist demands. • Reforming legislation. Combining the impacts of MiFID II, the Brokaw Law, Corporate Governance Reform and Transparency Act and other reforms with the ever-shrinking set of buy-side and sell-side analysts, investors are increasingly adopting a generalist mindset. Unfortunately, this is happening just as information flow is constricting, thus raising the risk of undue reliance on misinformation or bias. Investors will increasingly rely on governance, which unites the generalist’s primary concerns: a healthy balance sheet, sound capital allocation, etc. 4 There's Nothing Quiet About Being Passive - December 2017

The Landscape C ontinues to Evolve… We have observed a distinct shift in the behavioral paradigm that governs institutional investing: • Traditional Models: How investors should make investment decisions • Will soon become somewhat obsolete – based in “old” interaction data • Never had to account for MiFID II, ESG or Index investing • Less peo Less people le coverin ing mor ore sto tock resulting in great weight place on individual perception and emotions • Behavioral Models: Explains and in interprets ob obse serv rved de decis ision mak aking and tendencies • How will the investment community adjust? • The Importance of Behavioral Finance • What is s mor ore important – fact acts or or bia biases? • Investors are l oss averse & display “Bounded Rationality” • Investors exhib ibit consis istent bia biases in expectations and methodologies 5 There's Nothing Quiet About Being Passive - December 2017

Redefining “Buy & Hold” Understanding the adjustment by active management is an exercise of behavioral finance Key Investor or Bi Biase ases: • Los Loss Aversio ion = the fear of loss is a far greater influence than joy of winning • Co Cons nserv rvatis ism = place more emphasis on info utilized for the ori origi ginal recommendation • Co Confir firmatio ion = seeking info and utilizing new info that justifies original opinion Ov Overcomin ing g Bi Bias as = Objectively listen to what the empirical data says! Contin Co inued Co Contractio ion of of the the Sel Sell / / Buy Buy Side Side – Enh Enhancin ing bi bias amo among g bo both th the the act activ ive AND AND pass passiv ive worl orld • Fewer people covering more stocks • “Illusion of Control” Bias (Active) – “I buy what I understand or what I can control” • Anchoring Bias (Passive) – Governance data is already available (ISS/ Glass Lewis Dilemma) Fee eedback Dyn Dynamic ic: • Active - Used to be a Recommendation…Now it is a more of a calculated demand • Passive – Engagement is the on only option 6 There's Nothing Quiet About Being Passive - December 2017

The Agent – Principal Dilemma Di Directional l trend of of investor te tendencie ies s – man anagement cla clamoring for or gr greater control • The continued contraction of both the sell- and buy-side has nar narrowed acti active man anagement to tole lerance ba bands. s. • The growth in index money has resulted in extremely concentrated positions and undesired exposures to “poor” equities The “Agent – Principal” Dilemma Applies to Passive Money Too • The perc perceived misa salignment between the incentives of management and the best interests of shareholders Ind Index mon oney doe does no not t pos posse sess th the luxury ry of of tim imed dis discretion an and has has VE VERY lon ong tim ime hor horizons • Index cannot practice divestment / Only active managers have luxury of discretion • Focus is less on “management” and mor ore on on control • Key question = What avenues of control are available for a passive or active manager? 7 There's Nothing Quiet About Being Passive - December 2017

How To Interpret ESG/SRI Although broad, the ESG Framework is a set of parameters that ultimately allows the relative comparison of respective discount/hurdle rates and risk premiums/discounts ESG/SRI primary focus = the relative strength of corporate governance • Do the values preached and strategies presented by management align with the bes best lon ong- term interests ts of the shareholders? Index money = 401(k) money, Pensions, Insurance and Endowments Empirical Evidence – ESG dir irectly ly affects Cos Cost of of Ca Capital • Empirically proven that stric icter governance results in:  Less latitude afforded to management (think “ free cash dilemma” )  Sma Small ller ri risk per per un unit of of cash fl flow • Strong correlation between weaker corporate governance and poor profitability 8 There's Nothing Quiet About Being Passive - December 2017

ESG – What To Really Focus On… ESG – “Little ‘E’, Little ‘S’, BIG ‘G’ – 100% of index funds are ESG focused (explicitly or implicitly) – Engagement is their only option to enact change ESG is is more of of a cos ost t of of capit ital is issue e th than it it is is id ideo eologic ical – Governance is a proxy for or risk risk that gauges the long term focus on management – Emotions and biases continually weig eighted hea eavi vier than facts! Mechanics of Index & Influence over sub-advisors forcing th the e Act ctiv ives to hop on the ESG bandwagon • Buy High / Sell Low – major issue during market cor orrecti tions • Vanguard Windsor Fund example How ISS and Glass-Lewis can potentially skew investor perspective 9 There's Nothing Quiet About Being Passive - December 2017

“The Vanguard P recedent” A variety of global institutions are now beginning to require greater ESG transparency: • State Street = Governance Focus • Vanguard = Climate Change • SEB Blacklist • Norges omission of Oil & Gas This move has less to do with the ideological and focuses almost entirely on the lon long g term erm cos ost of of capit ital Determining whether or not management has accounted and planned for any adverse catalyst that can potentially eat away at future returns 10 There's Nothing Quiet About Being Passive - December 2017

Understanding the ISG The In Inves estor Stewardship ip Group (ISG (ISG) ) is a group of leading institutional investors and mega-mutual fund advisors who have established the Framework for US Stewardship and Governance. The Framework provides a set of basic principles of investment stewardship for institutional investors and corporate governance for public companies based in the United States. 11 There's Nothing Quiet About Being Passive - December 2017

12 There's Nothing Quiet About Being Passive - December 2017