We have long held the belief that prices quickly incorporate information and reflect the aggregate expectations of market participants, including information about a company’s current governance practices and oversight of ESG-related risks. There is significant evidence in the academic literature that ESG factors are reflected in market prices. We have also conducted our own research on this topic. For instance, we have performed research examining the relationship between company greenhouse gas emissions and future profitability as well as the relationship between greenhouse gas emissions and expected returns. In those and other studies we have performed on ESG variables, we have not found a reliable relation between ESG data and expected returns after controlling for current prices and profitability. With that said, we also incorporate ESG considerations in two aspects of portfolio management—our buy/hold/sell processes and seeking to enhance portfolio value by making portfolio securities “work” for the investors in our funds.
Many of our clients are familiar with our processes around how we decide what and when to buy, how long to hold, and when to sell a portfolio security. We use an integrated method that balances information about expected returns, risk, and costs from size, value, profitability, momentum, liquidity, etc. We also consider ESG data in buy/hold/sell decisions for risk management purposes. We look to avoid companies with heightened probabilities of fraud or expropriation of shareholder value. While we believe this information is reflected in market prices, it may present potential outcomes to which we do not want to expose our clients. Examples of this include our exclusion of closely held companies and companies listed on exchanges that do not meet our governance-related standards for eligibility. Additionally, we may halt buying securities or refer companies to our stewardship team for engagement based on certain ESG-related controversies or on a case-by-case basis for specific situations. For example, if there is an environmental controversy that we expect to change a company’s financials significantly, we may halt purchases of that company until there is more clarity on the impact of the controversy.
Similarly, many of our clients are familiar with examples of making securities “work” for investors in our funds. This includes how we elect on voluntary corporate actions and how our security lending and portfolio management process are integrated to maximize lending revenue while managing risk. Because we believe that a company’s ESG practices are reflected in the market prices of its publicly traded securities, improvements to a company’s governance practices may increase shareholder value through a combination of lower discount rates and higher cash flows to shareholders. These views lead us to the conclusion that an effective way to incorporate ESG considerations in all investment strategies that we manage is through the promotion of good corporate governance practices overseen by strong boards representing shareholder interests. Particular areas of interest include, but are not limited to, board independence and diversity, oversight of material risks, executive compensation, shareholder rights, and anti-takeover mechanisms.
Thus, another example of making securities “work” for the investors in our funds is our stewardship activities. We use a systematic approach to identify environmental (E), social (S), or governance (G) issues that will inform our engagement efforts. We do not invest with the purpose or intended effect of changing or influencing the control of a portfolio company; 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. We engaged with nearly 500 companies in proxy year 2019.
Finally, ESG data and research continue to develop. Dimensional spends significant time and resources to stay informed of those developments. For example, as part of its ongoing effort to better understand the science and drivers behind climate change, several members of senior management, including from portfolio management, have met with leading climate scientists on several occasions. Dimensional also monitors numerous vendors of ESG data to stay informed on data availability, generates its own data, monitors ESG-related studies in the academic literature, and performs internal ESG research. If there is compelling evidence that a firm’s ESG strength is additive to our understanding of expected returns or risk management processes after controlling for characteristics such as size, value, profitability, momentum, etc., Dimensional will consider using that evidence when managing portfolios.
For our dedicated sustainability mandates, Dimensional applies 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, and water management.
We also offer a variety of socially screened strategies that seek to exclude companies with meaningful involvement in 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.