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Customized Responsible Investing

By Jennifer Sireklove, Senior Investment Strategist

What is responsible investing?

A number of terms exist to describe responsible investing strategies including socially responsible, sustainable, mission, or values-based investing. For simplicity, we use the term responsible investing to refer to an investment process which prioritizes non-financial information about companies in order to build and manage portfolios. Generally, the goals of such a process are to ensure consistency with an investor's principles, improve returns, or influence company behavior.

Three primary tools available to achieve these goals are exclusionary screens, best-in-class selection, and shareholder engagement. Exclusionary screens are the most well-known of these methods and involve maintaining a list of securities to remove from the potential investment pool. Next, best-in-class selection is a more recent approach and involves maintaining a score for each security that reflects its performance on environmental, social, or governance (NASDAQ:ESG) issues and using this score to weight the security accordingly. Finally, shareholder engagement can be a powerful tool for expressing one's investment values, particularly for investors who are reluctant to divest, or move away from broadly diversified passive equity exposures.

Responsible investing mandates that require the total avoidance of certain business involvement or company behaviors will always require an exclusionary approach. But for those investors who want only to incorporate broad ESG issues in their portfolio, but still aim for minimal tracking error, a best-in-class ESG tilt may be a better solution. A more detailed discussion of exclusionary screens and best-in-class selection is in the Appendix.

Parametric Customized Responsible Investing

Responsible investing at Parametric is client driven. Our goal is to help to determine the most effective way to build a portfolio that aligns with the investor's own values, rather than dictate what those values should be. This approach lends itself to any variety of environmental, social or governance objectives and can be employed across a wide range of account sizes and types including taxable and tax-exempt, as well as portfolios that utilize active managers, or strive to track an index.

Although the number of options can seem vast, a customized responsible investing framework can generally be distilled down to the following key decisions:

  1. Specify the type of exposure
  2. Choose any exclusionary screens, if needed
  3. Select a shareholder engagement approach
  4. Determine whether tax-management is appropriate

Below we explain each of these decisions points in greater detail. Exposures and screens are flexible and can be added or changed at the client's discretion, subject to any tracking error or tax- management considerations.

1. SPECIFY THE TYPE OF EXPOSURE

The first step in our customized responsible investing process is to specify the desired exposure to which the various responsible investment techniques can be applied. Clients essentially choose from three options: (1) a standard index, (2) a responsible investing index, or (3) an actively managed strategy. In the case of a standard index or active strategy, the responsible investing functionality is typically fulfilled by overlaying a screen. But in the case of a responsible investing index, the exposure itself may fulfill the investor's responsible investing criteria with no further customization needed.

Those interested in an index-based portfolio can choose from either a standard index, adding exclusionary screens separately, or one already designed around various responsible investing criteria including best-in-class selection and screens. Which option is best for a given investor depends on a number of considerations but, in general, a responsible investing index is most attractive to those interested in finding a streamlined way to incorporate best-in-class methodology or emphasize certain business activities such as "clean tech". However, given the limited number of responsible investment indices available, a standard index may be necessary for investors looking for certain geographic exposures or styles. Furthermore, we have found that many investors are most comfortable using the exclusionary method, or selecting from among the more well-known indices.

Standard Index Exposure

Standard indices available at Parametric range from traditional market-weighted choices, such as the S&P® 500 or MSCI® EAFE, to alternative-weighted variants such as FTSE RAFI®. Clients can also choose to create a custom benchmark by combining indices. The flexibility of using a standard index plus exclusionary screens approach makes it quite popular, particularly for clients whose responsible investing criteria requires restrictions rather than tilts.

Responsible Investing Index Exposure

Parametric currently offers a number of responsible investing indices from MSCI, NASDAQ, Russell, and S&P, but may be able to access others, subject to licensing requirements and platform availability. Responsible investing indices range from broad diversified exposure, such as the MSCI KLD 400 Social Index, that can be used as a core allocation, to narrow ones such as the MSCI Global Climate Index, allowing investors to augment their portfolio by emphasizing certain themes. Catholic values and Shariah compliant indices are designed to adhere to typical faith-based investment criteria, making them a starting point for many religious investors. Although additional screens can be applied to any responsible investing index, many times they are unnecessary, making the implementation process less complicated.

The most expedient method to employing best-in-class selection at Parametric is to choose to track an existing responsible investing index incorporating these methods. However, for larger accounts, we can develop portfolio tilts to emphasize certain client specific ESG factors while seeking to minimize tracking error. This is essentially equal to creating a customized responsible investing index.

Actively Managed Strategy Exposure

Investors seeking actively managed strategies in accordance with particular values typically find themselves with a rather narrow pool of managers from which to choose. Parametric's customized responsible investment approach allows investors to combine the two goals by screening the holdings of outside managers in a unified managed account or a Parametric Systematic Alpha strategy,1 thus providing a greater range of potential investment opportunities. Parametric's mandate in this case would be to mimic the performance of the active strategy while reflecting the client's responsible investing criteria.

2. EXCLUSIONARY SCREENS

The second step in the customized responsible investing process is to choose a set of exclusionary screens. This is optional in the case of the responsible investing index exposure but integral for the other types of exposures. Choosing the optimal screen for any given portfolio depends on what the responsible investing strategy is trying to accomplish and what sort of portfolio impact is acceptable.

Accounts at Parametric can be screened based on a number of different sources. Clients may select from a standardized offering maintained by Parametric, choose screens that are designed by and unique to their financial advisor, develop their own screen or choose some combination of all three. Which approach is most suitable depends on many things, but screen complexity and sensitivity to tracking error are two especially important considerations. For example, for a client with a low level of desired involvement in screen design, and for whom tracking error is a secondary consideration, applying a single area business involvement screen, (such as alcohol production), using a standard Parametric screen offering may work best. However, a multi-faceted religious-based screen for a highly tracking-error sensitive client who enjoys being involved in portfolio decisions will likely be better accomplished with a more interactive, customized approach.

3. SHAREHOLDER ENGAGEMENT

At Parametric, shareholder engagement refers both to actively exercising voting rights as well as potentially choosing to file shareholder resolutions. Every client at Parametric today can take advantage of our responsible investing proxy voting policy or shareholder advocacy services regardless of their portfolio construction. Although the clients who are most interested in these services already tend to be applying screens or tracking a responsible investing index, it is an equally valuable tool for clients who care about ESG issues but do not choose to incorporate them into their portfolio. After all, only investors who remain invested in a security have the opportunity to vote proxies or file resolutions. Therefore, the investors who are best able to employ a responsible investing oriented shareholder engagement strategy, are those long-term investors who make the decision to remain fully invested in the broad universe.

Parametric's own responsible investment policy addresses shareholder resolutions on environmental, social, economic, and governance issues, with the majority of votes cast to support greater corporate disclosure as well as a minority advocating for corporate action. We utilize research by an outside organization dedicated to responsible investing issues, when we cast votes on behalf of clients who have chosen this policy. Clients may also choose to have their proxies voted in line with our standard policy.

In addition to proxy voting, we can also help clients who would like to utilize their ownership in a company to file shareholder resolutions on environmental and social issues. The resolution ling process is initiated and guided by As You Sow, an organization with a focus on energy, waste, environmental health, and human rights issues. Clients who meet certain holding requirements and agree to hold their shares during the process and for some time after can authorize As You Sow to file a resolution on their behalf. The entire process is initiated and managed by As You Sow. Clients will need to fill out the appropriate paperwork as required but do not need to personally appear at the annual meeting. Approval must be given for each resolution and is not open-ended.

4. TAX-MANAGEMENT

In addition to the flexibility of our responsible investment offerings, clients may also benefit from Parametric's extensive experience managing tax-efficient portfolios. For those who elect to do so, the tax-management process is essentially the same as it is for any tax-managed portfolio; managers seek to track the pre-tax returns of the selected exposure, including any screens, while seeking to maximize after tax returns. The primary methods for this are holding securities long enough to qualify for the lower long-term tax rate, selecting loss maximizing or gain minimizing tax lots for trades, and avoiding repurchases that would disallow the loss (i.e. wash sale rule).2 Additionally, the portfolio manager will strive to transition any accounts incepted in-kind in a tax- sensitive manner. Although certain indices or the extensive use of exclusionary screens may be less conducive to tax-management, in our decades of experience we have not found a meaningful difference in the tax alpha that can be generated between accounts incorporating responsible investment criteria and those that do not.

CONCLUSION

Parametric's customized responsible investing approach is designed to accommodate the diverse needs of a broad range of clients. Our flexible framework allows both taxable and tax-exempt clients to craft a combination of exposures, screens and ESG tilts to reflect their values, while incorporating our extensive tax management expertise. In addition, Parametric can assist in helping the investor engage actively as a shareholder in support of their values. Parametric is dedicated to remaining on the forefront of responsible investing and welcomes the opportunity to meet the evolving needs of investors who seek to incorporate ESG criteria in a transparent, cost-effective and tax aware manner.

1 Parametric's Systematic Alpha strategies are generally modified equal-weight portfolios designed to outperform capitalization-weighted benchmarks with less risk. Portfolios are re-weighted to manage concentration risk and dynamically rebalanced through time, with the goal of enhancing returns and minimizing implementation frictions. Strategies include Emerging Markets, International, Global, U.S., Commodities, and Dividend Income.

2 Please see Parametric's Approach to Tax Management, September 2014, for more information.