CUSTOMIZED RESPONSIBLE INVESTING

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1 May 2015 Jennifer Sireklove, CFA Senior Investment Strategist CUSTOMIZED RESPONSIBLE INVESTING Values-based investing has a long history in the United States, but recently there has been fast-growing interest in incorporating environmental, social and governance issues into the construction and management of portfolios. In the face of diverse issues such as climate change, lack of board room diversity, or human rights violations, investors increasingly want their portfolio to reflect an assortment of non-financial considerations. At Parametric we specialize in implementing the investor s vision for a portfolio, rather than imposing our own views. As a result, investors have turned to us over the last fifteen years to design responsible investing portfolios customized to their particular values. And as the availability of responsible investing resources has deepened, our capabilities in this area have also continued to grow. In this brief we introduce the Parametric approach to customized responsible investing. Parametric 1918 Eighth Avenue Suite 3100 Seattle, WA T F Parametric Portfolio Associates LLC. WHAT IS RESPONSIBLE INVESTING? A number of terms exist to describe responsible investing strategies including socially responsible, sustainable, mission, or values-based investing. For simplicity, we use the term responsible investing to refer to an investment process which prioritizes non-financial information about companies in order to build and manage portfolios. Generally, the goals of such a process are to ensure consistency with an investor s principles, improve returns, or influence company behavior. Three primary tools available to achieve these goals are exclusionary screens, best-in-class selection, and shareholder engagement. Exclusionary screens are the most well-known of these methods and involve maintaining a list of securities to remove from the potential investment pool. Next, best-in-class selection is a more recent approach and involves maintaining a score for each security that reflects its performance on environmental, social, or governance (ESG) issues and using this score to weight the security accordingly. Finally, shareholder engagement can be a powerful tool for expressing one s investment values, particularly for investors who are reluctant to divest, or move away from broadly diversified passive equity exposures. Responsible investing mandates that require the total avoidance of certain business involvement or company behaviors will always require an exclusionary approach. But for those investors who want only to incorporate broad ESG issues in their portfolio, but still aim for minimal tracking error, a best-in-class ESG tilt may be a better solution. A more detailed discussion of exclusionary screens and best-in-class selection is in the Appendix. PARAMETRIC CUSTOMIZED RESPONSIBLE INVESTING Responsible investing at Parametric is client driven. Our goal is to help to determine the most effective way to build a portfolio that aligns with the investor s own values, rather than dictate what those values should be. This approach lends itself to any variety of environmental, social or governance objectives and can be employed across a wide range of account sizes and types including taxable and tax-exempt, as well as portfolios that utilize active managers, or strive to track an index.

2 Although the number of options can seem vast, a customized responsible investing framework can generally be distilled down to the following key decisions: 1. Specify the type of exposure 2. Choose any exclusionary screens, if needed 3. Select a shareholder engagement approach 4. Determine whether tax-management is appropriate Below we explain each of these decisions points in greater detail. Exposures and screens are flexible and can be added or changed at the client s discretion, subject to any tracking error or taxmanagement considerations. 1. SPECIFY THE TYPE OF EXPOSURE The first step in our customized responsible investing process is to specify the desired exposure to which the various responsible investment techniques can be applied. Clients essentially choose from three options: (1) a standard index, (2) a responsible investing index, or (3) an actively managed strategy. In the case of a standard index or active strategy, the responsible investing functionality is typically fulfilled by overlaying a screen. But in the case of a responsible investing index, the exposure itself may fulfill the investor s responsible investing criteria with no further customization needed. Those interested in an index-based portfolio can choose from either a standard index, adding exclusionary screens separately, or one already designed around various responsible investing criteria including best-in-class selection and screens. Which option is best for a given investor depends on a number of considerations but, in general, a responsible investing index is most attractive to those interested in finding a streamlined way to incorporate best-in-class methodology or emphasize certain business activities such as clean tech. However, given the limited number of responsible investment indices available, a standard index may be necessary for investors looking for certain geographic exposures or styles. Furthermore, we have found that many investors are most comfortable using the exclusionary method, or selecting from among the more well-known indices. Standard Index Exposure Standard indices available at Parametric range from traditional market-weighted choices, such as the S&P 500 or MSCI EAFE, to alternative-weighted variants such as FTSE RAFI. Clients can also choose to create a custom benchmark by combining indices. The flexibility of using a standard index plus exclusionary screens approach makes it quite popular, particularly for clients whose responsible investing criteria requires restrictions rather than tilts. Responsible Investing Index Exposure Parametric currently offers a number of responsible investing indices from MSCI, NASDAQ, Russell, and S&P, but may be able to access others, subject to licensing requirements and platform availability. Responsible investing indices range from broad diversified exposure, such as the MSCI KLD 400 Social Index, that can be used as a core allocation, to narrow ones such as the MSCI Global Climate Index, allowing investors to augment their portfolio by emphasizing certain themes. Catholic values and Shariah compliant indices are designed to adhere to typical faith-based investment criteria, making them a starting point for many religious investors. Although additional 2015 Parametric Portfolio Associates LLC. 02

3 screens can be applied to any responsible investing index, many times they are unnecessary, making the implementation process less complicated. The most expedient method to employing best-in-class selection at Parametric is to choose to track an existing responsible investing index incorporating these methods. However, for larger accounts, we can develop portfolio tilts to emphasize certain client specific ESG factors while seeking to minimize tracking error. This is essentially equal to creating a customized responsible investing index. Actively Managed Strategy Exposure Investors seeking actively managed strategies in accordance with particular values typically find themselves with a rather narrow pool of managers from which to choose. Parametric s customized responsible investment approach allows investors to combine the two goals by screening the holdings of outside managers in a unified managed account or a Parametric Systematic Alpha strategy, 1 thus providing a greater range of potential investment opportunities. Parametric s mandate in this case would be to mimic the performance of the active strategy while reflecting the client s responsible investing criteria. 2. EXCLUSIONARY SCREENS The second step in the customized responsible investing process is to choose a set of exclusionary screens. This is optional in the case of the responsible investing index exposure but integral for the other types of exposures. Choosing the optimal screen for any given portfolio depends on what the responsible investing strategy is trying to accomplish and what sort of portfolio impact is acceptable. Accounts at Parametric can be screened based on a number of different sources. Clients may select from a standardized offering maintained by Parametric, choose screens that are designed by and unique to their financial advisor, develop their own screen or choose some combination of all three. Which approach is most suitable depends on many things, but screen complexity and sensitivity to tracking error are two especially important considerations. For example, for a client with a low level of desired involvement in screen design, and for whom tracking error is a secondary consideration, applying a single area business involvement screen, (such as alcohol production), using a standard Parametric screen offering may work best. However, a multi-faceted religious-based screen for a highly tracking-error sensitive client who enjoys being involved in portfolio decisions will likely be better accomplished with a more interactive, customized approach. 1 Parametric s Systematic Alpha strategies are generally modified equal-weight portfolios designed to outperform capitalization-weighted benchmarks with less risk. Portfolios are re-weighted to manage concentration risk and dynamically rebalanced through time, with the goal of enhancing returns and minimizing implementation frictions. Strategies include Emerging Markets, International, Global, U.S., Commodities, and Dividend Income. 3. SHAREHOLDER ENGAGEMENT At Parametric, shareholder engagement refers both to actively exercising voting rights as well as potentially choosing to file shareholder resolutions. Every client at Parametric today can take advantage of our responsible investing proxy voting policy or shareholder advocacy services regardless of their portfolio construction. Although the clients who are most interested in these services already tend to be applying screens or tracking a responsible investing index, it is an equally valuable tool for clients who care about ESG issues but do not choose to incorporate them into their portfolio. After all, only investors who remain invested in a security have the opportunity to vote proxies or file resolutions. Therefore, the investors who are best able to employ a responsible investing oriented shareholder engagement strategy, are those long-term investors who make the decision to remain fully invested in the broad universe Parametric Portfolio Associates LLC. 03

4 Parametric s own responsible investment policy addresses shareholder resolutions on environmental, social, economic, and governance issues, with the majority of votes cast to support greater corporate disclosure as well as a minority advocating for corporate action. We utilize research by an outside organization dedicated to responsible investing issues, when we cast votes on behalf of clients who have chosen this policy. Clients may also choose to have their proxies voted in line with our standard policy. In addition to proxy voting, we can also help clients who would like to utilize their ownership in a company to file shareholder resolutions on environmental and social issues. The resolution filing process is initiated and guided by As You Sow, an organization with a focus on energy, waste, environmental health, and human rights issues. Clients who meet certain holding requirements and agree to hold their shares during the process and for some time after can authorize As You Sow to file a resolution on their behalf. The entire process is initiated and managed by As You Sow. Clients will need to fill out the appropriate paperwork as required but do not need to personally appear at the annual meeting. Approval must be given for each resolution and is not open-ended. 4. TAX-MANAGEMENT In addition to the flexibility of our responsible investment offerings, clients may also benefit from Parametric s extensive experience managing tax-efficient portfolios. For those who elect to do so, the tax-management process is essentially the same as it is for any tax-managed portfolio; managers seek to track the pre-tax returns of the selected exposure, including any screens, while seeking to maximize after tax returns. The primary methods for this are holding securities long enough to qualify for the lower long-term tax rate, selecting loss maximizing or gain minimizing tax lots for trades, and avoiding repurchases that would disallow the loss (i.e. wash sale rule). 2 Additionally, the portfolio manager will strive to transition any accounts incepted in-kind in a taxsensitive manner. Although certain indices or the extensive use of exclusionary screens may be less conducive to tax-management, in our decades of experience we have not found a meaningful difference in the tax alpha that can be generated between accounts incorporating responsible investment criteria and those that do not. CONCLUSION Parametric s customized responsible investing approach is designed to accommodate the diverse needs of a broad range of clients. Our flexible framework allows both taxable and tax-exempt clients to craft a combination of exposures, screens and ESG tilts to reflect their values, while incorporating our extensive tax management expertise. In addition, Parametric can assist in helping the investor engage actively as a shareholder in support of their values. Parametric is dedicated to remaining on the forefront of responsible investing and welcomes the opportunity to meet the evolving needs of investors who seek to incorporate ESG criteria in a transparent, cost-effective and tax aware manner. 2 Please see Parametric s Approach to Tax Management, September 2014, for more information Parametric Portfolio Associates LLC. 04

5 APPENDIX Table 1: Summary of Offering KEY DECISION OPTIONS EXAMPLE Standard index S&P 500 Index, FTSE RAFI Index Specify Exposure Select Exclusionary Screens Shareholder Engagement Tax-Management Responsible investing index Actively managed strategy Standard Parametric screens Screens from financial advisor Design own screen Responsible investing proxy policy File shareholder resolutions Tax-efficient portfolio management MSCI KLD 400 Social Index, Russell-IdealRatings Islamic Developed, S&P Global Clean Energy Parametric Systematic Alpha SMA, Parametric Centralized Portfolio Management (UMA) Alcohol, Fossil Free, Shariah Screen created and maintained by the financial advisor and provided to Parametric Custom screen based on the investor s unique criteria, maintained by and provided to Parametric by IW Financial Cast votes in support of certain shareholder resolutions on environmental, social and governance issues Facilitated by As You Sow for interested clients Loss harvesting, gain deferral, holding period management, avoiding wash-sale rule violations, tax-sensitive portfolio transition EXCLUSIONARY SCREENS VS. BEST IN CLASS SELECTION Exclusionary Screens We use the term exclusionary screen to refer to applications in which ESG criteria is used to create an initial investment universe of eligible securities, but does not determine specifically how the individual portfolio constituents are weighted. Some providers distinguish between negative and positive screens, depending on how the screen criteria is defined, but the end result is the same: all securities that remain after the screen have their index weights increased pro-rata in the portfolio, to make up for the securities that were excluded by the screen. Screens are typically based on business involvement (e.g. alcohol production) or ESG-related performance (e.g. carbon emissions). Despite the growing interest in other methods of ESG integration, exclusionary screens remain very popular and there is a wide and still evolving variety of options. Generally, there are two types of screening methods: business involvement based or company behavior based. The first type of screen is more well-known, and involves determining which companies are engaged in certain activities, such as alcohol or fossil fuel production. Screens may be based on whether there is any involvement in the activity, or on the amount of revenues derived from the activity. As companies do not frequently change the nature of their businesses, this type of screen tends to produce fairly stable restriction lists, concentrated in particular industries. However, seemingly small differences in definitions for the same screening area can generate very different restriction lists. For example, as of October 2014, an MSCI screen based on any involvement in the adult entertainment business would exclude 21 companies from the Russell 1000, representing 2015 Parametric Portfolio Associates LLC. 05

6 5.2% of the market cap of the index, but a screen based on a minimum 10% threshold for revenue related to adult entertainment would exclude no companies. The second type of screen focuses on how the company is behaving on any number of ESG criteria and requires determining a threshold of minimum acceptance, either on an absolute or relative basis. Examples include carbon emissions, documented labor rights issues, or involvement with sanctioned countries. Restriction lists generated from this type of screen would be expected to be less static over the holding period than the first type, as company business practices are more likely to evolve over time than businesses primary activities. Or, in the case of a screen based on a relative comparison, even if a particular company s behavior remains unchanged, its position relative to its peers could shift if their business practices improved. Additionally, behavior based screens can be somewhat more qualitative than business involvement screens, making them sensitive to differences in data provider methodology. Restriction lists based on absolute behavior may be concentrated in certain industries while those based on peer relative behavior tend to be comprised of constituents from a diverse range of industries. Best-in-Class Selection An alternative approach is one in which a security s portfolio weight is directly influenced by an ESG-related score, with a better score resulting in a higher portfolio weight, subject to other exposure constraints and considerations. In this case, no securities are removed, but the lower scoring securities are de-emphasized. We refer to this process as best-in-class selection. This may also be referred to as an ESG tilt in the case of portfolios that are primarily attempting to minimize tracking error relative to a reference index. A portfolio may utilize both screens and best-in-class selection or just one of the two. Best-in-class selection enables investors to incorporate comprehensive ESG performance measurements into their portfolio in a more nuanced fashion than an exclusionary screen, which can help to control tracking error. By definition, an exclusionary approach reduces the potential investment universe, which increases the difficulty of building a portfolio that performs similarly enough when compared to one based on the non-screened universe, particularly as the number of screens increases. Although it is possible in certain instances to base the screen on a multi-faceted ESG score, rather than considering each area separately, this still results in some portion of the investable universe being restricted from inclusion. In contrast, a best-in-class selection approach does not omit securities, unless a screen is applied separately. Instead, securities which fare poorly in the scoring methodology are underweighted and the better performers are overweighted. This enables greater flexibility in terms of selecting constituents. By allowing portfolio representation across industries and risk factors, this process helps to keep tracking error within bounds acceptable to investors, while also expressing their ESG views in the portfolio. About Parametric Parametric, headquartered in Seattle, WA, is a leading global asset management firm, providing investment strategies and customized exposure management to institutions and individual investors around the world. Parametric offers a variety of rules-based, risk-controlled investment strategies, including alpha-seeking equity, alternative and options strategies, as well as implementation services, including customized equity, traditional overlay and centralized portfolio management. Parametric is a majority-owned subsidiary of Eaton Vance Corp. and offers these capabilities through investment centers in Seattle, WA, Minneapolis, MN and Westport, CT (home to Parametric subsidiary Parametric Risk Advisors LLC., an SEC-registered investment adviser) Parametric Portfolio Associates LLC. Important Information and Disclosure Parametric Portfolio Associates LLC ( Parametric ), headquartered in Seattle, Washington, is registered as an investment adviser with the U.S. Securities and Exchange Commission under the Investment Advisers Act of This material may not be forwarded or reproduced, in whole or in part, without the written consent of Parametric. This information is intended solely to report on investment strategies and opportunities identified by Parametric. Opinions and estimates offered constitute our judgment and are subject to change without notice, as are statements of financial market trends, which are based on current market conditions. We believe the information provided here is reliable, but do not warrant its accuracy or completeness. This material is not intended as an offer or solicitation for the purchase or sale of any financial instrument. Past performance is not indicative of future results. The views and strategies described may not be suitable for all investors. Investing entails risks and there can be no assurance that Parametric will achieve profits or avoid incurring losses. Parametric does not provide legal, tax and/or accounting advice or services. Clients should consult with their own tax or legal advisor prior to entering into any transaction or strategy described herein. Parametric is located at th Avenue, Suite 3100, Seattle, WA For more information regarding Parametric and its investment strategies, or to request a copy of Parametric s Form ADV Brochure, please contact us at or visit our website, 06