1 Sustainable Investing: A Disciplined Approach Indrani De, CFA The presentation is based on the published empirical paper: Are All Components of ESG Scores Equally Important? Indrani De, CFA & Michelle Clayman, CFA Published in NYSSA ‘The Finance Professionals’ Post’, July 2010

2 Evolution of Sustainable Investing - From ‘Exclusionary’ viewpoint to a ‘Best in Class’ viewpoint. - From something dedicated to few investors to a mainstream product. Empirical research on responsible investing has concentrated on: (a)Does responsible investing improve or detract from investment performance? (b)A lot of the research has focused on one component of responsible investing - typically corporate governance issues, environmental-friendliness Our research builds upon existing literature by asking: Are all aspects of responsible investing equally important for stock analysis? Can you/ how to combine these different aspects of Sustainable Investing in a systematic quantitative way to make better equity investment decisions? Factors in Sustainable Investing Presence in ‘Sin’ areas – Gambling, alcohol, military…. E = Environment S= Social G = (Corporate) Governance

3 Methodology Database KLD Stats (KLD has since been taken over by MSCI) Annual database – data as of 12/31/YYYY, data released as of mid February year YYYY+1. Avoid look-ahead bias by measuring the dependent variables starting February YYYY+1 onwards. Sample years – 1995 through 2006 (first data as of 12/31/1995, till 12/31/2006) Sample size - initial 650 (S&P 500 or Domini 400), From 1100 (S&P 500 or Domini 400 or Russell 1000), From 3000 (S&P 500 or Domini 400 or Russell 1000 or most of Russell 2000) List out strengths & weaknesses in different areas. Broad areas–Environment, Social practices, Corporate Governance, Presence in ‘Sin’ Sub-areas within each Broad area: Social issues - diversity, giving to community, concern for employees. 1 or 0 in each sub-area strength or weakness. For Sin, lists out the different ‘sin’ areas it has presence in.

4 Component sub score = Quantify a company’s performance in each area (Environment sub score, Social sub score, Governance sub score) Social sub score = (# of Strengths in Social)–(# of Weaknesses in Social) Sin Sub Score = 0 – (# of Sin area presence) Each sub score is measured positively, meaning higher score is better. Overall ESG Score = ∑ (Component sub scores n ); where n = Environment, Social, Governance, Sin EW scoring – equal weight to every strength (weakness). Equal weight to each sub area of responsible investing. Equal weighting process precludes any subjective bias of assuming one area to be more or less important. Independent variables - the component sub-scores and the Overall score. Use the Scores in different ways: (a)as a continuous measure (b)as a discrete measure – (b i) binary classification of Good (G) or Bad (B), G = Score of [>=0], Else B (b ii) three-way classification of Good, Neutral or Bad. (Three definitions of G,N,B).

5 Since the results of the different discrete measures are broadly similar, I will report only the results of the binary classification (G) & (B). Dependent variables; - Stock Returns - Return on Equity - Stock returns & ROE measured over (i) One Year (ii) Three Years (iii) Five Years - 12 one-year periods, 11 three-year rolling periods, 8 five-year rolling periods Control variables; - Sector effect, using the GICs sector classification. - Size/ market Capitalization. - Analyze the consistency of results over time so that outlier time periods are not driving the results

6 Main Results Overall ESG scores have a predictive & positive effect on subsequent total stock returns and ROE. The predictive ability is much stronger for ROE. But the different sub-scores have very different information content. The most meaningful sub scores were (a) Corporate Governance (b) Social score The least meaningful sub score was presence in ‘sin’ areas. Corporate Governance scores are the best predictor of stock return, with a positive association. This effect is pronounced over the medium to long run (three to five year) Social scores have a greater positive effect on ROE. This effect holds true over the short, medium & long-term investment horizon. Our results are robust after controlling for the sector effect and size effect. ESG factors have stronger predictive power for midcap and small cap companies.

7 Overall Sample, [Binary Classification G, B] Impact of Overall ESG score on Stock Returns For G & B companies in each annual dataset, calculated their average Total Stock Return and ROE (for subsequent 1, 3, 5 years). T Test for the difference in mean. Impact of Overall ESG score on ROE ‘Good’ ESG companies tend to have higher stock returns over years. ‘Good’ ESG companies almost always have higher ROE, though the difference may not always be statistically significant. Time Period# of Rolling Time Periods# of Periods G had higher stock returns One Year125 = 42% of time (2=17% statistically significant) Three Year116 = 55% of time (2=18% statistically significant) Five Year 85 = 63% of time (2=25% statistically significant) Time Period# of Rolling Time Periods# of Periods G had higher ROE One Year1211 = 92% of time (4=33% statistically significant) Three Year1111 = 100% of time (3=27% statistically significant) Five Year8 8 = 100% of time (3=38% statistically significant)

8 Effect of Overall ESG, Controlling for Sector Effect Classified the G & B companies in each annual dataset by their GIC sector i. Calculated their dependent variables (e.g.1-yr return) for each rolling time period t (e.g.12 one-year period t). Mean(G i,t ), Mean(B i,t ). Get the average over all [t] for (G) & (B) in each sector i = Mean(G i ), Mean(B i, ) Calculate the % of sector i where (G) had higher one-year stock returns. Do the same for other dependent variables. % of Sectors G is higher/ better than B Average one - year stock returns50% Average three - year stock returns50% Average five- year stock returns70% Average one - year ROE80% Average three - year ROE90% Average five - year ROE90% Good companies have higher average long term returns, & ROE in majority of sectors

9 Effect of Overall ESG : Sector Effect & the Consistency Over Time Same data as last slide, summarize in what % of sample years [(G) > (B) in sector i ] The top-left cell reads that in 75% of years, (G) had higher 1-year stock return than (B) in the Discretionary. % of Years1Yr Return3Yr Return5Yr Return1Yr ROE3Yr ROE5Yr ROE Discretionary75%73%63%83%91%75% Staples58%55%75%67%73%50% Energy67%82%88%50%55%75% Financials33%45%0%83%100% Healthcare58%82%88%67%82%100% Industrials42%55%50%92%91%100% Technology67%82%75%92%55%63% Materials17%36%25%75%64%38% Telecom67%64%25%92%100% Utilities50%45%50%42%27%50% Results are consistent over time !!

10 Main Conclusions: Impact of the Overall ESG Score Good’ ESG companies tend to have higher stock returns over the three to five year investment horizon. ‘Good’ ESG companies almost always have higher ROE, though the difference may not always be statistically significant. Good companies have higher average long term returns, and ROE in majority of sectors (70% to 90% of GICs sectors) These results are consistent over time !!

11 Impact of the Component Sub-scores Multivariate Regression Model: Y = Intercept + α Environment + β Social + µ Governance + δ Sin + € Y = [1year return, 3year return, 5year return, 1year ROE, 3year ROE, 5year ROE] Run the regression model over rolling 1, 3 and 5 year horizons. Analyze the size, sign, statistical significance of the coefficients α, β, µ, δ Are the Coefficients (a) Positive and (b) Positive & Statistically Significant? Y# of Rolling time period α (Environment) β (Social) µ (Governance) δ (Sin) 1 year return129, 15, 25, 16, 1 3 year return116, 24, 17, 45, 0 5 year return86, 32, 16, 43, 0 1 year ROE123, 012, 102, 02, 1 3 year ROE114, 011, 82, 02, 2 5 year ROE83, 08, 63, 02, 0

12 Main Conclusions: Impact of the Component Sub-scores Corporate Governance scores usually have a positive, and often statistically significant impact on subsequent three & five year stock returns. Social scores have a very strongly positive and almost always statistically significant impact on ROE over short to fairly long term horizon. Environment scores tend to have a positive effect on returns & ROE Presence (absence) in ‘Sin’ areas have no measurable impact on returns or ROE. Corporate Governance and Social scores are the important component sub- scores in the ESG analysis.

13 Impact of the Overall ESG & Sub-Component Scores, Controlling for Size We analyzed whether the predictive power of the ESG factors holds after controlling for size effect. The three market capitalization (mc) buckets used: (a) Greater than $ 9 billion [Large cap] - L (b) Between $ 5 to 9 billion [Mid cap] - M (c) Between $ 250 million to $ 5 billion [Small cap] - S. We excluded the micro-cap companies since they tend to have outlier effects. Overall ESG & the sub-scores. Discrete classification - G & B. Classified the companies in each annual dataset into (a) G & B (b) Market capitalization mc. Calculated their dependent variables (e.g.1-yr return) for each rolling time period t (e.g.12 one-year period t). Mean(G mc,t ), Mean(B mc,t ). Get the average over all [t] for G & B in each Market capitalization mc Mean(G mc ), Mean(B mc, ) For Overall ESG & sub-scores, tabulate [2 x 2 table] of [MC, Dependent Variable] to see if G or B did better.

14 Overall ESG Scores1 Year Return3 Year Return5 Year Return Large CapGGB Mid CapGGG Small CapGGG Governance Sub-scores1 Year Return3 Year Return5 Year Return Large CapGBG Mid CapGGG Small CapBGG Environment Sub-scores1 Year Return3 Year Return5 Year Return Large CapBGB Mid CapGBB Small CapGGG Social Sub-Scores1 Year Return3 Year Return5 Year Return Large CapGGB Mid CapBGG Small CapGGG ESG factors have greater predictive ability on stock returns in mid and small.

15 Overall ESG Scores1 Year ROE3 Year ROE5 Year ROE Large CapGGG Mid CapGGG Small CapGGG Governance Sub-scores1 Year ROE3 Year ROE5 Year ROE Large CapGGG Mid CapBGG Small CapGGG Environment Sub-scores1 Year ROE3 Year ROE5 Year ROE Large CapGGB Mid CapGGG Small CapGGG Social Sub-Scores1 Year ROE3 Year ROE5 Year ROE Large CapGGG Mid CapBGG Small CapGGG The predictive ability of ESG factors on ROE remains after controlling for size.

16 Main Conclusions: Impact of the Overall ESG & Sub-Component Scores, Controlling for Size Effect The positive association between Good ESG scores and subsequently higher stock returns and ROE, holds after controlling for the size effect. For stock returns, the predictive ability of ESG factors is stronger in midcap and small caps. Summarize The ESG profile of a company is a predictor of its financial performance and long term stock returns. Good companies, defined as those having more strengths than weaknesses in various ESG fields perform better financially and give better returns. The corporate governance and social practices of a company are particularly important. These results hold after controlling for the sector and size effect. ESG practices of a company are important considerations from an investment perspective.