What is Socially Innovative Investing?

Since 2007, Bank of America has been committed to sustainable and impact investing, or investing in portfolios with the dual goals of generating competitive risk-adjusted returns while simultaneously supporting societal and environmental progress. In 2011, the Chief Investment Office (CIO) created Socially Innovative Investing (S2I), our first sustainable strategy and have since expanded the S2I suite to include impact-focused strategies in thematic areas such as the environment and social equality. This expansion was based in large part on the growing awareness that corporate leadership across a broad range of environmental, social and governance (ESG) criteria and strong financial performance are not mutually exclusive; rather, they can be mutually beneficial qualities. Rather than engaging in “doing good” just for the reputational value, all S2I strategies seek to invest in leading companies in each economic sector based on ESG criteria because it can be good for business and potentially lead to better financial performance over the long term.

Background

When sustainable and impact investing was still considered a niche market segment, Bank of America was one of the first financial institutions to launch a sustainable investment strategy that sought to quantify how corporate actions affect people, communities and the environment as well as portfolios. Called Socially Innovative Investing (S2I), the strategy is predicated on the belief that companies demonstrating leadership in human capital management (i.e., social), environmental stewardship and corporate governance have an advantage over their peers in their ability to help manage risk, increase productivity, attract and retain key talent, nurture innovation, manage supply chains, and develop long-term sustainable business models. In short, we believe better performance on ESG criteria will lead to better economic outcomes for the companies and potentially better risk-adjusted performance for investors.

Since its early days, sustainable and impact investing—and related ESG factors— has grown sufficiently enough to enter the investment mainstream. Assets under management (AUM) committed to funds incorporating ESG factors were on track to surpass $41 trillion by year-end 2022, up 80% from $22.8 trillion in 2016. The most recent figure accounts for 33% of the total global assets under management.¹

Evolution of sustainable and impact investing

With interest in sustainable and impact investing continuing to grow, a broader spectrum of strategies has evolved. These new approaches tend to be more active and rigorous, more focused on investment returns, risk control and measurable impact, and based on the notion that strong ESG factors and financial performance are positively correlated. Enabling this expansion is an increasingly robust set of data that companies publish in annual corporate sustainability reports. In 2021, 96% of S&P 500 and 81% of Russell 1000 companies published sustainability reports.² Government agencies are also pressing for more regular and detailed disclosure from the companies they regulate. And industry groups such as the International Sustainability Standards Board and Financial Stability Board are working to develop standards to ensure that data is reported consistently from company to company and industry to industry. As a result, investors now have access to a rich data set on workforce diversity, employee health, product safety, carbon emissions, water/ energy usage and waste, as well as community investment and programs that enable positive impact across their ecosystem.

Why is this new source of data so important? Part of the answer lies in the changing nature of the U.S. economy. During the 1970s, most of the value accruing to public U.S. companies was represented by tangible assets: machines, factories, inventory and so forth. But as we have shifted toward an information-driven economy and as much of  the nation’s productive capacity has moved offshore, tangible assets have been largely superseded by intangible assets on the balance sheets of S&P 500 companies. Indeed, in 2020, 90% of the total assets of U.S. companies derived from intangibles such as brand, reputation, supply chain, employees, intellectual property and customer base (Exhibit 1). Investors can no longer rely exclusively on traditional financial analysis to evaluate the risks and opportunities facing today’s tangible asset-light companies. But by including ESG factors in their analysis, investors are better able to determine which companies are also effectively managing their (increasingly important) intangible asset base.

The CIO’S socially innovative investing strategy

Our Chief Investment Office’s (CIO) Socially Innovative Investing suite of strategies incorporates an active, proprietary method for reviewing companies across a wide spectrum of criteria that weigh both S2I performance and financial fundamentals.

We aggregate raw data from third-party providers and implement an objective S2I scoring methodology³ to identify leading performers in each economic sector. The S2I scoring process leverages over 500 unique data points to measure how effectively companies are engaging human capital, mitigating environmental impact, and practicing good corporate governance.

• Environmental stewardship. What policies does the company employ for interacting with the environment? How effective are companies at managing their environmental footprint and the associated risks? Considerations include climate change policy, greenhouse gas reduction, energy consumption, water management, alternative energy procurement and waste mitigation.
  
  
• Human capital engagement. How does the company treat all of its stakeholders (employees, shareholders, customers, suppliers and the community)? Considerations include hiring practices focused on diversity and inclusion (especially in leadership roles), fair and equal compensation practices, employee health and wellness benefits, employee satisfaction, human rights throughout the supply chain, customer privacy, supply chain diversity, and product safety.
  
  
• Corporate governance. What are the standards and procedures regarding its role  as a corporate citizen? How does it treat shareholders? Considerations include shareholder voting policy, accounting practices, executive pay, management accountability and board independence.

Measuring a company’s actual commitment to these pillars involves a two-part review of stated policies and performance accountability.

• Policy review. We view progressive corporate policies, generous employee benefits and robust disclosure as indicators of good management and long-term value creation. Further, robust disclosure is the first step toward broad accountability.
  
  
• Performance accountability review. Because good intentions  don’t  always  result in positive outcomes, we utilize objective measures to assess actual performance against stated goals, societal norms and peer comparisons. We also consider whether companies’ products or services address specific societal needs (e.g., environmental solutions or access to healthcare) and whether they have avoided costly fines, lawsuits and controversies.

When weighting the relative importance of these factors, we consider “economic materiality” as it applies to different industries. Materiality refers to the assessment of which ESG factors are relevant to a company’s business activities and drivers of future financial success. For example, we place more weight on corporate governance factors  for financial services companies, carbon emissions factors for energy companies, and water management factors for utilities. These assessments play an important role in our investment process, as they help mitigate greenwashing and produce a potential buy list of stocks we believe represent the best corporate performers across a broad range of  ESG criteria. The final scores are normalized by sector as we intentionally include leading performers in all sectors of the economy, even those that have poor reputations for ESG performance (e.g., energy, materials or utilities).

Following the S2I scoring process is a fundamental review to ensure that the CIO is purchasing good stocks, not just good companies. We seek companies with strong and stable returns on capital, conservative balance sheets, and healthy free cash flow generation. This review leads to a targeted list of 100 to 120 stocks that are attractive from both a fundamental and an ESG perspective. Finally, we conduct a portfolio construction exercise designed to minimize external risk factors and provide broad diversification. The goal of this step is to allow the S2I scoring process to drive the   relative performance of the portfolio while neutralizing other potential market influences. The ideal result is a diversified portfolio of strong companies that we believe can deliver attractive risk-adjusted returns over a long-term investment horizon.

In addition to our two flagship domestic S2I portfolios, S2I All Cap and S2I Large Cap, CIO offers five focus area portfolios highlighting different sustainability themes.

CIO’S environmental stewardship & sustainability (E2S) & carbon reserve free (CRF) portfolios

Environmental challenges and opportunities are increasingly in investors’ consciousness, so the CIO S2I suite offers two related strategies: Environmental Stewardship & Sustainability (E2S) and Carbon Reserve Free (CRF). Both strategies seek to identify companies within the S&P 1500 universe with leading environmental policies and practices compared to their industry peers. The two-part due diligence framework examines corporate disclosure of policies relating to the environment and considers a company’s track record and performance on quantifiable factors to ensure that policy decisions produce the intended outcomes. While this “scoring” process takes into account a variety of environment, social and governance (ESG) factors, environmental metrics have a more significant contribution to the overall company assessment. The  E2S portfolio seeks to invest in the top-performing companies in each economic sector, even those industries with a poor reputation for environmental performance. Companies that provide “green” solutions are often looked at favorably within the context of the  S2I framework; however, it is unlikely that a speculative renewable energy company will qualify for inclusion, due to size, maturity or other fundamental factors.

For investors who choose to divest from fossil fuels, the CRF portfolio uses the same rigorous stock selection methodology while removing energy and fossil fuel-burning utility companies. In order to avoid adding unintended risk, the resulting portfolio is constructed to reflect the risk characteristics of the benchmark. This final step aligns the portfolio to the overall market, with the exception that its environmental performance may be considered superior, allowing the potential for more favorable risk-adjusted returns over the long term.

CIO’s Social Equality & Inclusion Strategy

While WGES is tightly optimized around gender equality factors, CIO has designed its Social Equality & Inclusion strategy as a broader diversity and inclusion approach that incorporates ethnicity, Lesbian, gay, bisexual, and transgender (LGBTQ), disabled, veteran, and human rights issues as well. This strategy seeks to identify leading companies that are actively building a culture of equality and have demonstrated success at promoting disadvantaged populations into leadership positions. The CIO conducts a comprehensive assessment of human resource policies, employee benefits, disclosure practices, and objective performance data to determine which companies are achieving these successes along the following factors: workforce diversity & leadership, employee development, protection for human rights, comprehensive family benefits, equal opportunity/pay, supply chain diversity, community engagement, and access to finance & healthcare for disadvantaged populations.

Companies are held accountable for performance across their supply chain, as well as how they impact their local communities (both positive and negative). Our goal is to look beyond simple head count numbers, to determine which companies have built a sustainable culture of social equality that will likely translate into tangible economic results.

CIO’s S2I International

In response to client demand, the CIO launched an international version of the flagship S2I strategy in 2020. This new strategy is benchmarked to the MSCI All Country World Index ex USA, which currently includes a 75% allocation to developed markets and a  25% allocation to emerging markets. The investment process is largely identical to the domestic S2I flagship strategies, except that S2I International scores are normalized by economic development region so that emerging markets companies are only compared to other emerging markets companies and vice versa. We make this adjustment in order to account for the higher levels of ESG disclosure in some regions (primarily Europe)  than lesser developed areas. Our goal is to match the allocation to emerging and developed markets of the underlying index, along with sector allocation and traditional market risk factors.