News | p.3

SUPPORTING FAIR TRANSITION

N° 18 - february 2019

THE SRI CHRONICLES

From an academic point of view | p.4 et 5

WHAT DO ACCOUNTING AND FISCAL WIGGLE ROOM MEAN FOR INVESTORS?

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WHAT HAVE WE LEARNT FROM THE SUBPRIME CRISIS? There are some commemorations that we could really do without. Between 2007-2009, the worst financial crash since 1929 resulted in the Lehman Brothers bankruptcy and the Madoff scandal. People working on markets at the time will have the event etched in their memories. But 10 years later, what lessons have been learnt?

For the most optimistic souls, the glass is half full. The global finan-cial system is today more robust than it was then. There is now less use of derivatives which bypass clearing houses. Banks are subject to tougher capital constraints. And the largest, or systematic, banks even have to comply with higher constraints. Variable remuneration packages are now more supervised and feature bonus/malus clauses. Individual investors will also be reassured to discover that 70% of the money stolen by Bernie Madoff’s scheme was eventually recouped. And the crisis was a reminder that the essential role of finance is to help the real economy and societies grow.

For the most pessimistic, the glass is half empty. Almost all the people responsible for the crisis have avoided prosecution, mainly by reaching amicable settlements. Huge financial segments like shadow banking and other dark pools are still only lightly regulated while Donald Trump’s administration is working towards scrapping the financial regulations introduced since 2008. Above all, nothing has been done to solve the global problem of private and public debt, or specific problem areas like student debt and auto loans in the US. In short, there are still many areas of risk and the scope for governments to intervene has shrunk.

If there is one lesson from this crisis before the next one breaks (yes, there will be another one!) it is that governance is absolutely essen-tial, whether among governments issuing debt or private companies selling bonds or equity. In its broadest definition, governance includes business ethics, executive management standards and corporate governance. It is the natural link between financial and extra-finan-cial analysis. Let’s pay tribute to Warren Buffet. One of the Sage of Omaha’s golden rules is that a long term, or “forever”, investment means buying companies run by honest people.

Happy reading.

Edmond de Rothschild Asset Management is a co-sponsor of the Sustainable Finance and Responsible Investment Chair which is co-managed by Ecole Polytechnique and the Toulouse School of Economics, and is a co-sponsor of the FIR - PRI european research awards.

JEAN-PHILIPPE DESMARTINHead of the Responsible Investment Team

EDITORIAL

Sustainable Finance and Responsible Investment Chair

3ASSET MANAGEMENT - THE SRI CHRONICLES

SUPPORTING FAIR TRANSITION

After the recent COP24 in Poland, everyone knows that the fight against global warming is essential. But Warsaw’s insistence on governments signing a “Just Transition” declaration and the “yellow vest” unrest in France are reminders that there is more to energy transition than the sustainable development pillar alone.

The need to combat global warming has never been so urgent. The latest report from the Inter-governmental Panel on Climate Change (IPCC) on changes to the climate (October 2018) highlights the harmful consequences of temperatures rising by 1.5°C. Political leaders are working behind the scenes and the COP24 provided a clear idea of how to implement the Paris Agreement. Many countries are already rolling out measures to reduce carbon levels in their economies. Ne-vertheless, the conse-quences will not be neutral for the populations and areas concerned.

Poland, for example, still derives 80% of its electricity from coal-fired power stations and 85,000 miners’ jobs could be threatened. Coal mine closures have triggered strikes and big protests both in Poland and Germany. In France, yellow vest protests were

set off by a rise in the carbon tax on fuel, an event that showed how ecology taxes can actually make inequality worse. All these examples underline the necessity of creating a just transition to deal with the social challenges of energy transition.

SOCIAL MEASURES TO HELP POPULATIONS

This concept is already included in the introduc-tion to the Paris Agreement which stipulates that

stakeholders must strive for a just transition for the working population and create decent and good jobs. Energy transition must therefore be accompanied by social measures for populations. Existing initiatives include the Just Transition Fund in the US. It was set up by charitable foundations to help former miners in the Appalachian mountains and fund low-carbon solutions. Elsewhere, several economists are arguing for governments to launch a Green New Deal, an economic stimulus programme to fight against climate change and social inequality.

But difficulties over energy transition must not end up delaying the process. Achieving energy transition will itself create jobs and growth. OECD estimates suggest that it could add 5% to growth in G20 countries by 2050. And the International Labour Organisation (ILO) reckons that the Paris Agreement could create 24 million jobs.

At the same time, Nobel prize-winner Joseph Stiglitz in a recent article* says that slowing down the transition process would increase the burden for future generations. “It is better to leave a legacy of financial debts, which our children can somehow manage, than to hand down a possibly unmanageable environmental disaster.”

* https://www.project-syndicate.org/commentary/yellow-vests-green-new-deal-by-joseph-e-stiglitz-2019-01

NEWS

SEVERAL ECONOMISTS ARE ARGUING FOR GOVERNMENTS TO LAUNCH A GREEN NEW DEAL

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Due to their growing size and preferential access to asset mana-gement, institutional investors play a crucial role in the world eco-nomy. However, we know little about what type of firms they prefer to hold in their portfolios. In a recent paper, the author examined which investors liked firms that took advantage of the financial and accounting leeway embedded in the regulatory framework1.

There is limited but buoyant literature that examines which factors

besides performance matter for institutional investors2: some shun

away from sinful industries while others invest according to their poli-

tical or sustainability preferences. Could it be that investors also care

about how much firms exploit the “wiggle room” or leeway available

in the regulatory environment? If so, which investors prefer firms that

aggressively exploit regulatory loopholes, and which prefer firms that

are cautious? And do these preferences have implications for portfo-

lio performance?

To answer these questions the author retrieved the portfolio holdings

of all US institutional investors for the period between 1995 and

2017. The exploited wiggle room (WR) of the firms in their portfolios

captures the degree to which these firms

take advantage of the leeway available

within existing regulations. WR covers

legal corporate practices like tax plan-

ning, financial reporting, and earnings

management. For example, an aggres-

sive firm might have a relatively high

number of subsidiaries in tax havens,

opaque financial statements and opts for

“window-dressing accounting.

To extract the revealed investor prefe-

rences, Marco Ceccarelli aggregated

the WR exploited by the firms in their

portfolios. To see which investors pre-

ferred more cautious/aggressive firms,

he differentiated between investors with

a long (>2yrs) and a short (<1yr) invest-

ment horizon, low (<3%) and high (>17%)

portfolio rotation, and their fiduciary duties (banks, pension funds, in-

surers, investment advisers and endowments). Portfolio performance

PLAYING BY THE RULES INSTITUTIONAL INVESTOR PREFERENCES FOR REGULATORY EXPLOITATION

WHAT DO ACCOUNTING AND FISCAL WIGGLE ROOM MEAN FOR INVESTORS?

FROM AN ACADEMIC POINT OF VIEW

MARCO CECCARELLI

Is a PhD candidate in Finance at the Swiss Finance Institute and the University of Zurich. His research lies at the intersec-tion of sustainable finance and investments.

WHICH INVESTORS PREFER FIRMS THAT AGGRESSIVELY EXPLOIT REGULATORY LOOPHOLES, AND WHICH PREFER FIRMS THAT ARE CAUTIOUS?

5ASSET MANAGEMENT - THE SRI CHRONICLES

is based on portfolio

alphas and exposure to

idiosyncratic volatility.

SHORT-HORIZON INVESTORS PREFER CAUTIOUS FIRMS

It is reasonable to assume that when investors hold

stocks only for the short-term, they will prefer cau-

tious firms since these are more transparent about

their financial performance. The data confirms this

hypothesis, as short-term investors have a portfolio

WR which is 3.7% smaller than short-term investors.

Similarly, frequent traders have 3.3% less portfolio

WR than high-rotation portfolios.

PUBLIC SCRUTINY DOES NOT ENCOURAGE CAUTION

Some investors like banks, insurers and pension

funds are subject to public scrutiny and should,

therefore, be more likely to hold cautious firms. This

is because aggressive firms might be more inclined

to break the law or be involved in corporate scan-

dals, which would translate into substantial adverse

publicity for the investor. However, the data show

that exposure to public scrutiny is not enough to

make investors hold cautious firms.

MARKET CONDITIONS, FINANCIAL ADVISOR MISCONDUCT, AND THE VALUE OF TRUST

From previous studies, we know that the value in-

vestors place on trust is unusually high during times

of high market uncertainty and after instances

when the consequences of untrustworthiness

become salient. In this paper, the author shows

that when the VIX is high (>30), all investors shift

their holdings towards

more cautious firms as

these appear to be more

trustworthy. The same

happens after an investor

fires a financial advisor

due to misconduct. The

exploited WR of the firms in his portfolio decreases

by over 4 percentage points.

WR EXPLOITATION DOES NOT RESULT IN HIGHER PORTFOLIO ALPHAS

One might think that aggressive firms would out-

perform cautious ones since they face a lower tax

burden and are better able to mask poor figures.

However, the data suggest that this intuition is

unfounded as high portfolio WR has a negative

correlation with portfolio alpha. However, there is

also a negative correlation between portfolio WR

and exposure to idiosyncratic volatility. Investors

that hold more aggressive firms will underperform

but their returns will be less risky.

To sum up, investor preferences for companies that exploit the regulatory wiggle room are varied. Some investors care not only about re-turns but also how these returns are achieved, particularly so when their trust has been violated. Additionally, these preferences have repercus-sions on performance. A portfolio of firms that fully exploit the regulatory environment achieves smaller alphas but is less exposed to idiosyncra-tic risk.

Further information on: https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3247044

1. For the full article, see Ceccarelli, 2018, “When Companies Use Their Wiggle Room, Which Investors Care?” Working paper, Swiss Finance Institute Research Paper No. 18-62.

2. Institutional investors are large, professional US asset managers that manage at least USD 100,000. They include banks, corporate and public pension funds, investment advisers, insurance firms and endowments

WHEN THE VIX IS HIGH, ALL INVESTORS SHIFT THEIR HOLDINGS TOWARDS MORE CAUTIOUS FIRMS AS THESE APPEAR TO BE MORE TRUSTWORTHY

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COMPANY MEETINGS RECOMMENDED READING

AIR LIQUIDEAir Liquide is a global producer of industrial gases like oxygen, nitrogen and hydrogen. The group has succeeded in integrating its corporate social responsibility policy into its global strategy.

At a Climate Market Day at the end of No-vember, the group unveiled new climate tar-gets, reaffirming its environmental ambitions. It now promises to reduce carbon intensity in its operations by 30% between 2015-25. The group also intends to offer its customers more low-carbon solutions like hydrogen production or cogeneration, and nudge the economy towards sustainable mobility based on hy-drogen, all of which would allow it to double its target markets.

Air Liquide also has a proactive social policy. Its stress on workers’ healthcare and safety has helped slash its accident count in recent years. The group is also keen to promote diversity; the number of women employees in an historically male-dominated industry rose to 29% in 2017.

The group’s governance also boasts a re-markable culture of respect for minority inves-tors, particularly evident in its decision to stick to its one-share, one-vote policy. Integrating its sustainable development principles into its strategy has been facilitated by the long-term vision that has made the group so successful over the years.

The information about the companies cannot be assimilated to an opinion of Edmond de Rothschild Asset Management (France) on the expected evolution of the securities and on the foreseeable evolution of the price of the financial instruments they issue. This information cannot be interpreted as a recom-mendation to buy or sell such securities.

CLIMATE OF HOPEMichael Bloomberg & Carl PopeSt Martin’s Press No French translation as yet (272pp, $15)

A GLIMMER OF HOPE FOR THE CLIMATEReports on the recent COP24 in Poland are not exactly encouraging for the climate. This is why we recommend Climate of Hope, published in the US in 2017. The book was written by two personalities who complement each other, the Californian ecology activist Carl Pope and business man Michael Bloomberg, New York’s former mayor and possible candidate in the 2020 US Presidential election.

They have produced a refreshing book. Across 7 chapters, they optimistically present a num-ber of practical solutions for individuals, cities, companies and investors to take charge of their future and that of the planet by working to improve the climate and complying with the Paris Agreement.

We particularly recommend the book for cli-mate pessimists.

74% The percentage of plastic packaging which is not recycled in France. It is sent instead to dumps or is incinerated. Source: Citeo, a household packing and paper recycling company. September 2018.

202 yearsThe time needed to achieve labour gender equality at the current rate.Source: World Economic Forum. December 2018.

THE RESPONSIBLE INVESTMENT TEAM IN ACTION

January 2019. Non-binding document. This document is for information only.Any reproduction, disclosure or dissemination of this material in whole or in part without prior consent from the Edmond de Rothschild Group is strictly prohibited. The information provided in this document should not be considered as an offer, an inducement, or solicitation to deal, by anyone in any jurisdiction where it would be unlawful or where the person provi-ding it is not qualified to do so. It is not intended to constitute, and should not be construed as investment, legal, or tax advice, nor as a recommendation to buy, sell or continue to hold any investment. Edmond de Rothschild Asset Management or any other entity of the Edmond de Rothschild Group shall incur no liability for any investment decisions based on this document. This document has not been reviewed or approved by any regulator in any jurisdiction. The figures, comments, forward looking statements and elements provided in this document reflect the opinion of Edmond de Rothschild Asset Management on market trends based on economic data and information available as of today. They may no longer be re-levant when investors read this communication. In addition, Edmond de Rothschild Asset Management shall assume no liability for the quality or accuracy of information / economic data provided by third parties. Edmond de Rothschild Asset Management refers to the Asset Management division of the Edmond de Rothschild Group. In addition, it is the commercial name of the asset management entities of the Edmond de Rothschild Group.

EDMOND DE ROTHSCHILD ASSET MANAGEMENT (FRANCE)47, rue du Faubourg Saint-Honoré, 75401 Paris Cedex 08

Société anonyme à Directoire et Conseil de Surveillance au capital de 11 033 769 euros Numéro d’agrément AMF GP 04000015 – 332.652.536 R.C.S. Paris

www.edram.fr

With the rapid growth of responsible investing, it is essential to offer financial professionals training courses on the challenges involved. The Edmond de Rothschild Group has taken up the challenge by joining up with Swiss Sus-tainable Finance to provide e-learning.

Together, we have devised Responsible investing in a chan-ging world, an e-learning tool comprising four modules. The first defines sustainability and

what it means for the financial sector. The second explains the key role institutional investors play in the sustainable value creation pro-cess and its effects on investment companies. The third looks at the sustainability integration process in business models and company strategies. The fourth shows how responsible investing improves the value proposition for private banking clients. For its own staff, the Edmond de Rothschild Group has added a fifth module which details its responsible investment offer.

The e-learning course exists in French, English and German and provi-des interactive theoretical content alongside more practical exercises. The theoretical part retraces the development of responsible inves-ting and helps understand the current RI market. It also features case studies to inform staff of actual examples of responsible investing in finance. For example, the second module case study puts us in the shoes of a fund manager who has to pick companies for a socially res-

DEMYSTIFYING RESPONSIBLE INVESTING THROUGH E-LEARNING

ponsible portfolio. The course also has a quick quiz lasting less than 10 minutes to test how much has been learnt.

The e-learning course’s main goal is to demystify responsible investing for financial professio-nals and explain why the theme has become so important in the financial sector. For Kate Caccia-tore, the group’s head of sustai-nable development, “Instead of taking a technical approach to explaining responsible investing as so many courses do, we are trying to help financial sector mindsets change more rapidly so that RI sustainability is per-ceived as a source of economic growth and investment returns.”

Responsible investing is a major issue for Edmond de Rothschild, both for its impact on the global economy and on the Group’s own performance. Our ambition is to support the transition process towards a sustainable economy and pla-net by harnessing our expertise and influence as an investor.

KATE CACCIATOREGroup’s Head of Sustainable Development

EDMOND DE ROTHSCHILDBOLD BUILDERS OF THE FUTURE.

WE DON’TSPECULATE

ON THEFUTURE.WE BUILD IT.

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