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.
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.
Exhibit 1: Components of S&P 500 Market Value.
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.
“A-B-C”: An approach to sustainable investing
The evolving sustainable investing landscape has necessitated a new way to describe the intent of different sustainable approaches to match the motivations that individual or institutional investors might have when selecting these investments. The CIO has adopted the A-B-C Framework4 approach (see side bar) to help investors understand the sustainable and impact investing landscape. The main difference between the three categories is the strategy’s primary sustainability objective.
The S2I investment process includes elements from all three categories. Our approach is rooted in the concept that companies that are leading performers on ESG criteria benefit from developing more sustainable, and profitable, long-term business models. In addition to being better managers of their intangible asset base (as described on page 2), we believe such companies are better at developing talent, uncovering emerging opportunities, fostering innovation and managing risk.
Our proprietary scoring process penalizes companies whose products, services or practices harm workers, society or the environment. Thus, companies with significant controversies, legal liabilities, product recalls or environmental fines are unlikely to score well relative to sector peers. Conversely, we give credit to companies that are trying to solve social or environmental challenges with innovative solutions (such as water treatment, waste management, childcare, telemedicine, electric engines, wind power generation), boosting their scores. So, we tend to avoid companies that are externalizing costs to the rest of society (pollution, unhealthy products) while striving to invest in companies that contribute market-based solutions to some of society’s largest and most difficult problems.
One of the challenges of managing a sustainable equity portfolio is demonstrating its impact versus potential alternatives. We have developed a series of impact metrics to show the ESG performance of our portfolios compared to a broad-based market benchmark.
For example, the S2I All Cap portfolio has better gender representation at the executive level than the S&P 1500 and is less resource intensive (i.e., energy, carbon, water, waste) (Exhibit 2A and B). Such portfolio impact measurement helps assure that our investment process is working as intended to identify leading performers across a wide range of ESG metrics. Many companies will not score well across all metrics, but the portfolio, as a whole, consistently demonstrates stronger ESG characteristics than the overall market.
The A-B-C framework explained
Strategies that seek to reduce negative social or environmental effects and manage risk by limiting certain exposures.
Strategies that seek to support positive social or environmental practices and enhance potential for long-term competitive financial returns.
Strategies that seek to advance positive, measurable social or environmental outcomes and target opportunities where impact is intrinsic to financial performance.
Exhibit 2A: S2I All Cap Holdings Demonstrate Better Social Characteristics than the S&P 1500…
Exhibit 2B: … And Environmental Characteristics Too.
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 Women & Girls Equality Strategy (WGES)
To capitalize on the economic potential of gender equality, the Chief Investment Office has developed a comprehensive investment approach called the Women & Girls Equality Strategy (WGES). WGES allows investors to apply a gender lens to a public equity portfolio by considering a wide spectrum of criteria that focus on both gender equality and financial fundamentals. This approach gives women-focused endowments and foundations the opportunity to align core exposures in their portfolios with their stated missions. It can also enable individual investors to incorporate personal values and objectives such as equal opportunity, the role of women in the economy or the importance of women’s empowerment into their investment portfolio.
This strategy uses a two-part due diligence framework to identify industry leaders with respect to equality and empowerment. First, it looks for thoughtful, proactive corporate policies relating to women and for a commitment to use business practices to change the global landscape of rights and equality for women and girls. The second component considers a company’s track record and performance on quantifiable factors in seeking to ensure that policy decisions produce the intended outcomes.
Specifically, the WGES investment process evaluates a company’s policies on family leave and other benefits such as childcare and eldercare; commitments to pay equity for women; track records in hiring, retaining and promoting women; the composition of their workforce, from new hires through the board of directors; and career-advancement opportunities for women. The strategy also examines human rights policies governing a company’s supply chain and subcontractor relationships, whether a company’s policies specifically address the protection of women, and overall adherence to international labor standards for women and girls.
We believe investors who embrace sustainable investing practices may be better positioned to achieve their social and environmental effects, alongside competitive financial returns.
There are many factors to take into consideration when building an investment portfolio and it’s important to remember ESG factors are only one component to potentially consider and should always be used alongside fundamental analysis.
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 Religious Voice & Values (R2V)
The S2I Religious Voice & Values (R2V) portfolio starts with the same ESG scoring process as our flagships strategies. We then screen this list based on the U.S. Conference of Catholic Bishops Investment Guidelines (USCCB) (see side bar), typically removing 10 to 15 companies from consideration. We then conduct a traditional fundamental review to make sure we are buying good stocks, not just good companies. In order to avoid adding unintended risk, the resulting portfolio of 100 to 120 companies is constructed to reflect the risk characteristics of the benchmark. This risk management step is critical to making sure that unintended risk factors are not introduced into the portfolio, particularly when significant industries (defense, pharmaceuticals, biotech) are being excluded. For example, pharmaceutical companies often trade as “dividend plays,” so we seek to replace this exposure with other yield-oriented stocks in the consumer products or real estate sectors. The result is a well-diversified, institutional quality portfolio that incorporates traditional Catholic exclusions while featuring leading ESG performers in accordance with the spirit of the USCCB guidelines.
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.
1 Data from Global Sustainable Investment Association; Bloomberg Intelligence, “ESG May Surpass $41 Trillion Assets in 2022, But Not Without Challenges, Finds Bloomberg Intelligence” as of January 24, 2022.
3 The CIO’s S2I Suite ESG Scoring Process: The S2I scoring process leverages over 500 unique data points to assist with measuring how effectively companies are engaging human capital, mitigating environmental impact, and practicing good corporate governance. These metrics are then assigned an economic materiality weighting to compute a score that is intended to align with future financial performance.
4 The “A-B-C” framework that helps classify the impact objective of a sustainable strategy was adapted from The Impact Management Project (IMP). The IMP is a forum for building global consensus on how to measure, compare, and report ESG risks and positive impacts.
Securities indexes assume reinvestment of all distributions and interest payments. Indexes are unmanaged and do not take into account fees or expenses. It is not possible to invest directly in an index. Indexes are all based in U.S. dollars.
S&P 500 Index measures the performance of 500 large companies listed on stock exchanges in the United States.
S&P 1500 Index is a stock market index of U.S. stocks made by Standard & Poor’s. It includes all stocks in the S&P 500, S&P 400 and S&P 600. This index covers 90% of the market capitalization of U.S. stocks.
Russell 1000 Index
MSCI All Country World Index ex USA captures large and mid cap representation across 22 of 23 Developed Markets (DM) countries (excluding the US) and 24 Emerging Markets (EM) countries.
The Chief Investment Office (“CIO”) provides thought leadership on wealth management, investment strategy and global markets; portfolio management solutions; due diligence; and solutions oversight and data analytics. CIO viewpoints are developed for Bank of America Private Bank, a division of Bank of America, N.A., (“Bank of America”) and Merrill Lynch, Pierce, Fenner & Smith Incorporated (“MLPF&S” or “Merrill”), a registered broker-dealer, registered investment adviser and a wholly owned subsidiary of Bank of America Corporation (“BofA Corp.”).
Risk management, diversification and due diligence processes seek to mitigate, but cannot eliminate risk, nor do they imply low risk.
All recommendations must be considered in the context of an individual investor’s goals, time horizon, liquidity needs and risk tolerance. Not all recommendations will be in the best interest of all investors.
Asset allocation and diversification do not ensure a profit or protect against loss in declining markets.
Sustainable and Impact Investing and/or Environmental, Social and Governance (ESG) managers may take into consideration factors beyond traditional financial information to select securities, which could result in relative investment performance deviating from other strategies or broad market benchmarks, depending on whether such sectors or investments are in or out of favor in the market. Further, ESG strategies may rely on certain values based criteria to eliminate exposures found in similar strategies or broad market benchmarks, which could also result in relative investment performance deviating.