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The international business of Federated Hermes (formerly Hermes Investment Management)

PRI reporting framework 2020

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Outputs and outcomes

LEI 12. How ESG incorporation has influenced portfolio composition

12.1. Indicate how your ESG incorporation strategies have influenced the composition of your portfolio(s) or investment universe.

Describe any reduction in your starting investment universe or other effects.

Relevant ESG issues are considered on a company-by-company basis with implications for both inclusion and weighting in an investment portfolio. Further sector and country exposures will be considered in the context of exposure to ESG risks (for example exposure to carbon). Further, across the firm we exclude companies that produce cluster munitions and anti-personnel land mines. It is difficult to determine the percentage impact on the portfolio due to the incorporation of ESG.

Specific strategies such as our Global Equity Screened ESG strategy screen out companies that, for example, generate 10% or more of their revenues from armaments, gambling, or old growth logging. The ESG risks of these portfolios can be attributed to two sources, benchmark relative risks incurred as a result of not investing in companies included on the exclusion list and absolute/relative ESG risks taken as a result of the team's stock selection.

Hermes Global Equities maintains an estimate of the impact of the exclusion list via a custom index, the MSCI World Excluded Rebalanced (ex Australia) Index.

Specify the percentage reduction (+/- 5%)

0.6 %

Describe any alteration to your investment universe or other effects.

The investment universes of our thematic funds are linked to the UN SDGs.

Our investments in our Impact Opportunities fund are aligned with nine impact themes that are aligned with the 169 targets underlying the 17 SDGs. We have therefore developed our own impact themes to address these unmet needs; Water, Food Security, Health & Wellbeing, Education, Financial Inclusion, Future Mobility, Impact Enablers, Energy Transition and Circular Economy. 

SDG

The Hermes SDG Engagement Equity Strategy aims to generate attractive investment returns and positive societal and environmental impacts through engagements with companies focused on the United Nations’ Sustainable Development Goals (SDGs). To achieve this, Federated Hermes combines the proven stock-selection and engagement skills within its equity and stewardship teams. The investment opportunity that the strategy addresses is that engagement will enable positive change, and will encourage investee stocks to create more resilient businesses, as well as tackling pressing social or environmental needs. These companies should then begin to increase market share in their industries, improve business ecosystems, and strengthen market practices.

Select which of these effects followed your ESG integration.

12.2. Additional information.[Optional]

Taking an active management approach is a central part of our investment proposition, and, as a result, our funds are able to take a selective approach to stocks by only investing in companies with the necessary characteristics, in the team's opinion, to be sustainably successful over the long term.

Generally, funds cannot adopt an overly prescriptive approach, as they are charged by clients with beating, in a prudent and risk-adjusted manner, a benchmark index that encompasses a broad range of companies, with widely differing standards on these issues. What they can do is analyse companies with these issues in mind and recognise that management's attitude toward these challenges will be part of identifying "best in industry" practices, a key factor in delivering sustainable and superior returns to shareholders. ESG issues will rarely be the sole driver behind any investment decision. Instead, ESG considerations provide further insights into the risks and opportunities inherent within a company or sector and gives greater colour to our teams' fundamental analysis and thus plays a part in informing their judgement to buy, sell or hold. Material ESG factors are therefore integrated into investment decision making. These considerations may be stock-specific issues or equally they may be macro risks. What is clear, however, is that companies actively pursuing 'good' ESG performance will often have the ability to become market leaders, with true franchise value, either through the perception of the sustainability of the brand or through product innovation, driven by finding solutions to some of the key issues in their industry.

The Hermes Global Equities team would generally not expect their strategies to include stocks with a low ESG score unless there is evidently improving performance; however, the universe would not necessarily be explicitly reduced through the team's analysis. If a company recommended by their Model had significant company-level ESG risk, the team would look to invest in a similar company without those risks if an alternative was available. If not, they might look to underweight that position. The emphasis on sustainability and responsibility is further enhanced by the integration of ESG considerations in the investment process, particularly governance, which is one of the characteristics embedded in their Model. A company may rank highly in every regard, but if it displays poor corporate governance or is over-leveraged, then its overall score will be significantly reduced. The portfolio is also rebalanced monthly and will incorporate any new information that becomes available, including ESG information that may cause a company to fail. In addition to the monthly rebalancing, the team may sell a stock if there is a large change in the model's ranking of the stock or if there is significant news flow that would cause the stock to fail the team's sense check.

The Hermes European Equities team incorporates ESG aspects as a complement to their analysis and decision making. ESG considerations, therefore, are an important element in the assessment of a stock for inclusion in portfolios but are not a dominant factor. As with our Small and Mid-Cap teams, a positive ESG stance is considered favourable to an investment case, but it is just one of several factors considered when deciding whether or not to make an investment.

For our Global Emerging Markets strategy, the portfolio manager looks to identify a catalyst before investing rather than buying and hoping a catalyst appears. Some of the catalysts the team looks for include improvements in corporate governance / ESG, and improved capital allocation. The team makes use of both a top-down and bottom-up approach, and their top-down analysis led to removing direct exposure to the oil & gas industry, partly informed by their view that long-term climate risks were too high and made the industry generally unattractive. Additionally, because emerging markets are not as transparent as developed markets, the risks are higher and the team recognises that investors need to be more prudent, with a margin of safety. An approach integrated with the analysis of ESG factors gives this margin of safety in the strategy.

Similarly, for our Asia ex Japan fund, assessments of corporate governance factors are particularly important when considering potential investments in certain countries, such as China. The team has a varied and lengthy list of warning signs that they keep in mind, and the team seeks to visit and/or speak directly to management prior to accepting a stock into the portfolio.


LEI 13. Examples of ESG issues that affected your investment view / performance

13.1. Provide examples of ESG factors that affected your investment view and/or performance during the reporting year.

ESG factor and explanation

Environmental, Governance, and Social

We became aware of a Chinese supplier of digital surveillance products, that we held in our portfolio being involved in helping the government implement a nationwide surveillance network named Skynet. In recent years, the effort has aggressively focused on the Xinjiang region, where the Communist Party is implementing a crackdown on ethnic Uighurs, a Muslim minority, under the pretext of countering terrorism. The company has in the past tried to downplay its connection to the Chinese regime, portraying itself as an independent corporation. We discovered that the company is actively engaged in operating the Uighur Monitoring Program, not merely selling cameras to the government.

ESG incorporation strategy applied Screening|Integration

Impact on investment decision or performance

In 2019 we exited our position in the company due to the ESG concerns even though the stock had been a strong contributor to performance.

ESG factor and explanation

A french company that provides liquefied natural gas (LNG) containment systems. Liquefied natural gas is a key fuel that will help the planet transition to cleaner energy sources. It is estimated that this transition will see demand for LNG grow by 65% to 2040, partly driven by the substitution of coal as a source of energy. Regulation will be one of the main drivers behind this growth and more challenging shipping regulations brought in by the International Maritime Organisation, which aims to reduce Sulphur and Nitrous Dioxide emissions is one such example. LNG is the only viable alternative that will ensure ships adhere to these regulations. Furthermore, as LNG becomes more widely used, demand for more storage and refuelling infrastructure will increase.

ESG incorporation strategy applied Screening|Integration

Impact on investment decision or performance

To enable this low carbon economy transition and meet the new regulations, ships will need to be fitted with a membrane, known as LNG bunkering, which forms an impermeable lining that prevents contact with a ship’s hull and enables the use of LNG to fuel the ship. Its technology is also used in the storage and transportation of LNG and enables a more efficient use of space than other solutions, which is particularly important for cargo ships. A position in the company was opened on the basis that this structural growth opportunity had been underestimated by the market.

ESG factor and explanation

A Dutch-listed supermarket operator, which has been identified as being well-run on the basis of a strong corporate governance score and above peer margins, which is driven by its operational efficiency. The company is highly cash generative and looks attractive across numerous valuation metrics. As a retailer the company has significant exposure to human capital issues through its large workforce. Despite historically having challenges in this area the fact the company has added ESG performance metrics to its executive remuneration programme highlights that this is an area the company is focussed on improving contributing to our view that the company is attractively valued as this improvement is under appreciated by the market. 

ESG incorporation strategy applied Thematic|Integration

Impact on investment decision or performance

The company is part of the EOS engagement program and has proven itself open to engagement. During 2019 the company established a plan to review its climate change ambitions and disclosures. To that end, it has signed up to the Science Based Targets Initiative and is aiming to align itself with climate-related risk disclosures under the TCFD framework, while new emissions targets will be published in 2020. Additionally, the company announced the CFO retirement and a woman has been named as his successor. On human rights the company is finalising the review of its due diligence process for a report to be released in early 2020. The engagement has positive outcomes contributing to achieving SDGs 3, 4, 5, 7, 8, 12, 13 and 15. A position in the company was opened on the above basis

ESG factor and explanation

In the search for potential new positions in the materials sector, the team has been considering several stocks for its inventory of ideas. In doing so, the team has put environmental considerations first in the research phase. The team excludes coal fired utilities as well as coal miners because of the exposure to thermal coal.

The team recently considered an integrated aluminium producer and copper manufacturer. Its stock offers high beta and it could be considered in a risk-own market. However, the company is a large CO2 emitter (37 mln tons CO2), the 20th worst in the Metals and Mining sector (ranking based on 175 companies disclosing environmental data). According to a “what if” simulation by our’ Responsibility Office dated January 2020, addition of the company to the Fund would have a strong detrimental impact on the carbon footprint of our portfolio.

ESG incorporation strategy applied Screening|Integration

Impact on investment decision or performance

This simulation has helped us better understand the risks of stock both in isolation and in a portfolio context and it has contributed to our decision to exclude the company from our pipeline for the time being.

13.2. Additional information.[Optional]


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