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For years, meetings between a corporation’s executive team and active investment managers have followed the same format. Investors sit down with the chief financial officer, or chief executive officer, and discuss the outlook for the company.
But the trend towards sustainable investing is finally driving a change to this formula. Now a CFO might bring seven or eight directors to talk about how their respective departments are addressing concerns from gender inequality to carbon emissions and supply chain risks.
Such a trend illustrates the seriousness with which corporate managers are taking environmental, social and governance (ESG) concerns, integrating it into decision-making at all levels of the business. We believe it also shows that the forum for driving real change is in the boardroom rather than from solely behind a computer screen.
Corporate engagement forms a central pillar of the active approach to sustainable investing, and a policy of regularly talking to and meeting corporate decision makers has some advantages over other approaches.
Firstly, and perhaps most importantly from the viewpoint of sustainable investing, a strategy of engagement provides a setting in which to raise concerns about how a company manages the impact it has on the society or environment in which it operates.
This can take several forms. Engagement often starts with questions submitted to a company’s investor relations team. These concerns can be escalated to discussions with management, and ultimately be expressed in voting patterns and shareholder resolutions.
For example, in discussions with executives at luxury goods firm LVMH, the company committed to targeted improvements in key areas such as recycling and monitoring potential weaknesses in its supply chain, such as slaughterhouses. As investors, we are now in a position to follow the company’s progress on these commitments.
Beyond the balance sheet
Secondly, an engaged asset manager is more likely to spot the sort of risks and opportunities that don’t show up on the balance sheet. These non-financial risks can have a real financial impact on a firm over time.
Interacting with corporate managers gives a good sense of the culture of a company. A poor culture giving rise to issues such as employment discrimination or product safety is a source of risk that is likely to materialise in the form of fines or recall costs later on.
There are important qualitative, as well as quantitative impacts. For example, companies that ignore the importance of a diverse board and workforce may find it harder to recruit and retain the most talented employees. Similarly, a leadership whose values are at odds with their employees’ risks harming morale and motivation among their staff, hampering the company’s ability to innovate and outperform its competitors.
Meanwhile, companies with poor governance face increased reputational risk, which, when realised, can severely depress stock prices in the short and medium term. Active asset managers have a role to play in holding corporate management to account and minimising these risks.
We firmly believe engagement ultimately delivers benchmark-beating returns. According to an academic study1, ESG engagements generate an excess return of 1.8 per cent over the year following the initial engagement. Engagement on corporate governance and climate change themes was found to be the most profitable, generating excess returns of 8.6 per cent and 10.3 per cent respectively.
The report found that interactions with investors on ESG issues focused the minds of corporate managers. “After successful engagements, companies experience improvements in operating performance, profitability, efficiency, and governance,” the study, published in the Review of Financial Studies in 2015, said.
Engagement is a two-way street, and it provides a forum for collaboration between asset managers and executives where they can discuss how best to realise their ESG objectives.
For example, now-nationalised Dutch bank ABN Amro capped the salary of its CEO at around €700,000, and with zero bonus, to limit expenses and curb risk-taking behaviour following the 2008 financial crisis. Engaged asset managers were able to help the company realise how important it was to promote the cap publicly as a best practice and make it more likely to be kept in place in the future. This was a long-term benefit to shareholders in that it by amending the remuneration scheme it reduced the executive’s incentive to pursue risky business strategies that have the potential to undermine the financial strength of the firm.
We note that around a quarter of companies we engage with ask us to give advice on how to improve their communication or disclosure on specific topics. Working together, we have a better chance of sustaining positive momentum.
There are several ways to approach sustainable investing, but the paths share the same aim: to combine the investor’s ESG priorities with maximised investment returns.
At Fidelity, we take an active ownership approach and strongly believe that fostering change through engagement is the most effective and lasting way to positively influence corporate behaviour.
This approach includes direct dialogue with management and directors; collaborating in coalition with stakeholders for greater impact; and the effective use of proxy voting. Through regular engagement we can create value, manage risk and help to improve outcomes for both the investor and society as a whole.
1: Dimson, E., Karakas, O., Li, X.: “Active Ownership”
The Review of Financial Studies, Volume 28, Issue 12, December 2015, Pages 3225–3268