There are two ways in which Dimensional incorporates ESG considerations and the reasons for each approach are described below.
1. Integration Alone
Dimensional incorporates ESG considerations into its investment analysis and decision-making processes and reflects those considerations in its policies and practices, as appropriate. In determining how to incorporate ESG considerations in the investment process, Dimensional performs a significant amount of research with the goals of improving our understanding of expected returns across securities, better managing risks in the portfolios, and reducing costs in the management of the portfolios.
Examining the research, we find that first, decades of research support the notion that market prices quickly incorporate relevant information about a company. This information includes current expectations about ESG-related risks or opportunities facing a company. Second, that expected returns across securities are driven by prices investors pay and the cash flows they expect to receive. Our ESG research tests for information in ESG data that may give us insight into a company’s expected future cash flows or differences in the discount rates investors apply to those expected future cash flows. While we have not currently found reliable evidence that ESG variables contain additional information about differences in expected returns across securities once we control for known drivers such as company size, relative price, and profitability, this represents a continuing area of research for Dimensional.
Thus, we integrate ESG considerations in our investment process where we expect those considerations allow us to better control risk and/or add value for our investors. Generally speaking, we incorporate ESG issues across three aspects of the investment process: 1) portfolio design, 2) buy/sell/hold decisions in the portfolios, and 3) maximizing the value of holdings in the portfolios through activities such as investment stewardship.
- Portfolio Design: Portfolio design refers to our process of selecting which securities are eligible in our portfolios and at what weight we may hold those securities in the portfolio. Dimensional incorporates ESG considerations in determining security eligibility within the portfolios. For example, we seek to exclude companies with heightened probabilities of fraud or expropriation of shareholder value through exchange eligibility decisions. We also exclude closely held companies in the portfolios, as these types of companies may have large strategic shareholders whose interests may not align with the broader shareholder base. While we believe information such as risk of fraud or strategic shareholder misalignment is reflected in market prices, it may present potential outcomes to which we do not want to expose our clients.
- Buy/Sell/Hold Decisions: With respect to buy/sell/hold decisions in the portfolios, we generally consider ESG data for risk management purposes. We may halt buying securities or refer those companies to our stewardship team for engagement based on certain ESG-related controversies or on a case-by-case analysis for specific situations. For example, if there is an environmental controversy that we expect to change the company financials significantly, we may halt purchases of that company until there is more clarity on the impact of the controversy. In the case of an acquisition or merger that we believe is not in the interest of target shareholders, portfolio managers coordinate with our stewardship team to vote against such deals. The stewardship team may also choose to engage with the target board or management.
- Corporate Governance/Investment Stewardship: Beyond our buying and selling decisions, Dimensional seeks to maximize the value of portfolio holdings by influencing positive governance practices across portfolio companies through our investment stewardship efforts. Dimensional believes that prices reflect relevant information about a company, including a company’s current governance and oversight of material ESG issues. We would expect successful efforts to improve governance practices to be reflected in higher prices through a combination of higher expected cash flows to shareholders and/or lower discount rates applied to those cashflows. Across all our equity portfolios, we therefore seek to encourage strong boards representing shareholder interests, including the mitigation of material environmental and social risks.
A main component of our stewardship activities is our engagement with portfolio companies. We use a systematic approach to identify E, S, or G issues that will inform our engagement efforts. We do not invest with the purpose or intended effect of changing or influencing control; however, our engagement practices are focused on letting boards know that we expect them to have processes to manage material ESG risks, to provide shareholders with information to assess the efficacy of those processes, and to act in the best interest of shareholders. More information about our approach to stewardship along with relevant policies and procedures may be found on the Corporate Governance section of our public website (www.dimensional.com).
2. Screening and Integration
Dimensional also has dedicated sustainability mandates, which apply an additional layer of ESG integration in the buy/hold/sell decision process. This process uses a data-driven approach to evaluate companies on a focused set of sustainability issues whose impact can be readily measured and reported. For these strategies, the primary ESG consideration is environmental impact from company emissions, including greenhouse gas emissions and potential emissions from fossil fuel reserves. The strategies also seek to reduce exposure to a select list of other key sustainability considerations, such as coal, factory farming, palm oil, land use and biodiversity, toxic spills and releases, operational waste, water management, and the manufacture of civilian firearms.
We also offer a variety of socially screened strategies that seek to exclude companies with meaningful involvement with client-specified business activities. These strategies can be readily customized to incorporate the ESG factors described above as well as additional considerations that clients may desire.