As a leading global asset manager with more than €555bn in assets under management, DB Advisors is used to offering clients a broad range of services and products. With a truly global network spanning the Americas, Europe and Asia Pacific, combined with the financial strength and resources of the Deutsche Bank Group, DB Advisors makes a point of always trying to empower its clients with a choice of products specifically tailored to their requirements.

In recent years though, DB Advisors has discerned a trend amongst investors to seek out more than a straightforward return with their capital. Potential investors today are asking questions that go far beyond the financial detail. They want to know about the social, ethical, environmental and regulatory context before parting with their cash. So why is this happening?

Ethical investment
DB Advisors has identified three key drivers behind this trend towards responsible investment. The most important could be described as statutory and regulatory pressure. Increasingly, many pension funds in their statutes have clauses on ethical or social issues that have to be taken into account. So ethical issues now increasingly amount to a fiduciary issue for the trustees which was not the case before. As far as regulatory pressure is concerned, this might take the form of government mandates to reduce emissions, encouraging the uptake of cleaner energy and the avoidance of legacy-focussed fossil fuel companies.

Secondly, in this age of an omnipresent media, not just TV and radio, but especially the internet, there is more opportunity for extended and often negative media coverage for companies that make questionable judgements or just mistakes. This has led to the intense questioning of certain business practices, concerning pollution for example and so investors are asking fund managers, why do they own stock in certain companies that do not subscribe to the ethos of responsible investment?

Finally, there is more academic research on the effects of non-financial issues on a given stock – or bond’s – performance, the cost of capital and the financial returns of companies in general. Naturally, this is raising an awareness that was just not there before.

The evolution
In the beginning, social and ethical investment originated from an ideological niche, grounded in values that related primarily to the environment and they tended to have a more political, religious agenda, let’s call it a kind of negative exclusion approach. So this Weltanschauung (worldview) would say “These companies – oil, defence, gambling – are bad, end of story” What’s happened is that since then, ethical and social investment has evolved into a much more inclusive approach. At DB Advisors, it is believed that there are a range of factors, Environment, Society and Governance – call them ESG factors – that need to be taken into consideration. Using these ESG criteria, DB Advisors has been able to rank companies and focus on the best in their class rather than simply exclude the worst.

Improving performance
In recent years, the performance of SRI funds has increased markedly. This has happened for two reasons. First of all, many SRI funds have been invested in a high growth part of the market; namely alternative energy and emissions reduction technology. Secondly, unlike before, ESG funds have also increasingly focussed on performance as an outcome rather than a mere by-product.

Clearly, it is not easy to combine environmental, social and governance issues with investors’ financial objectives. At first glance, you would assume that these criteria would straight away reduce the size of the stock universe available to the fund manager. But that’s only if you apply the old understanding of ethical investing, i.e. you work to the negative exclusion approach. DB Advisors does not do that because its “best in class” approach does not start on the basis of exclusion. Rather DB Advisors takes an unconstrained global stock universe and then applies its proprietary ESG rating process. This filters the better half, whilst still looking at the fundamental upside. Typically, the system may find two stocks, with a similar valuation and risk consideration, so DB Advisors’s approach would be to then pick the one with the better ESG performance.

Understanding the ESG investment approach
One way you could look at the ESG criteria, is to examine the dynamic role of ESG factors over time. An unenlightened approach is to instantly decide that Company ABC is polluting the environment, therefore it is negative and has nothing to offer. But DB Advisors’s ESG system is more concerned with the positive momentum in ESG performance and the monitoring of how Company ABC is progressing in dealing with pollution. A good example of this is BP. BP is today working hard to make its pipelines less susceptible to leakages, following a major pipeline leak in Alaska in 2006. That is the sort of improvement that may provide upside for the future ESG rating. Equally, another example is Siemens and the emergence of a huge corruption and bribery scandal in 2006. They have taken great strides to prevent this happening again and that draws attention from a dynamic ESG perspective. Our ESG understanding also rewards exemplary behaviour, the pro-active introduction of policies in the company to avoid for example, corruption, child labour issues or health threats to consumers. That puts a premium on the company in terms of ESG ratings. And buying on the ESG improvement can go some way to reducing the long-term risk in the stock.

One must be careful though not to exclude smaller stocks that simply don’t have the resources, e.g. dedicated investor relations or sustainability departments, to fill in SRI questionnaires. The important point is that they are continuing on the right path and to recognize that clean energy business models are also evolving. The bottom line is that it’s all about the rewarding the positives rather than punishing the negative. This flexible dynamic manner approach means that you don’t really have to restrict the size of the portfolio

ESG investment themes
The areas that come under ESG are still evolving and DB Advisors fully anticipates them varying over time. Today the emphasis is on environmental issues, clean energy and renewables, energy efficiency, reducing, controlling or avoiding emissions and then anything to do with waste avoidance and waste recycling. Other areas to include are personal health and development and corporate governance. This last one is just as important. It covers the issues around proxy voting, fulfilling one’s fiduciary duties as a shareholder in certain companies. At DB Advisors we do believe in voting on Proxies, look at AGMs and voting with the shares we own. For all that, DB Advisors does not buy stock to exert pressure on a company, like an activist investor might do. But we do take our fiduciary responsibility very seriously.

The major advantages of ESG investment
For ESG factors, it does help to take a longer-term view. Business practices, models etc. are aspects that come to fruition over the longer term, not the next quarter. So on the plus side, if you are an investor with a long-term pension or savings plan, it is advantageous to think about areas such as Corporate Responsibility and the Environment which over time, will more likely be priced in as a positive than they are today.

Like any other investment theme though, how advantageous it is to you depends on the product. In broader terms, there’s some recent academic research that suggests that you can have the same returns with lower risk as corporate responsibility was found to influence the cost of capital. Accordingly, lower volatility can be achieved by investing in companies that have a higher ESG ranking. DB Advisors meanwhile, has a clear commitment to achieving non-financial objectives without compromising investment returns – this also includes taking a participatory role in business models of the future. DB Advisors eschews a mechanistic approach which tends to exclude smaller companies, which often don’t have the resources to provide answers to derive meaningful rating conclusions. It’s just wrong to penalise smaller companies.

From DB Advisors’s perspective, the ESG investment theme completes its product range nicely and broadens its market appeal. And if you look into the theoretical approach, it could actually become a mainstream aspect of financial analysis. So it’s well worth DB Advisors participating at the beginning. ESG factors certainly do appear to have an impact on the risk factors. Consequently, it may just become part of the mainstream investment selection process. Investors should understand that ESG is at least partly about evolving with the trends that are emerging and there’s no reason to miss out on them.

The major disadvantages
It depends on the offering and the product in question and the risk/return profile of the investor. One risk that exists for each investor is that if you focus too much on excluding stocks on various criteria without looking at the return opportunity. You could avoid any potential disadvantages that may arise from an offering by not compromising on the risk-adjusted return proposition. Similarly, all investment houses should be careful not to be put into an unintended ideological corner when implementing non-financial criteria in the investment process.

DB Advisors and ESG – the right side of the future
We firmly believe that DB Advisors is ahead of the curve in offering products based around ESG criteria. DB Advisors doesn’t take an ideological approach to investment. The focus is still on the return to the investor.

To that end, DB Advisors (and her sister company DWS) initiated the ESG Award for ESG Performance of German companies. There are two award categories, DAX 30 and TecDAX. The study was headed by Professor Alexander Bassen from the University of Hamburg and accompanied by the ESG Advisory Panel of DB Advisors. The quantitative analysis is based on DVFA/EFFAS Key Performance Indicators (KPIs) and on ESG data of SiRi Company. The KPIs for ESG performance was identified by Global Investment Professionals in collaboration with DVFA/EFFAS.

In the near future, we are looking to evolve and develop our ESG product range and investment process. Added to this DB Advisors shall include external research along with advice from the DB Advisors ESG advisory panel formed a year ago from academia, capital markets experts and investor groups that have a particular focus on subjects like pension funds, foundations and religious or charitable institutions. No investment house has a monopoly on information. That’s why DB Advisors shall listen to them, take their advice and when the time comes, take a decision on adjusting the ESG processes along those lines.

Be in no doubt, the Ethical, Social and Governmental dimensions of investment are fast-evolving and DB Advisors has every intention of being the thought-leaders in this process in the years to come.

DB Advisors is the brand name for the institutional asset management division of Deutsche Asset Management, the asset management arm of Deutsche Bank AG.