Gerold Koch joined DWS in 2006 with 4 years of industry experience. Prior to his current role, Gerold was responsible for the Institutional Investment Specialist team in the Americas, with a focus on active fixed income. Previously, he developed and managed derivatives overlays that offer risk mitigation solutions for pension funds. Before that, he was a structurer and a portfolio manager for derivatives-based corporate credit portfolios. Prior to joining, Gerold worked as a fixed income portfolio manager and analyst at Aquila Capital. Gerold has a Master’s Degree (“Diplom-Kaufmann”) from University of Hamburg and ESC Bordeaux; CFA Charterholder; Series 7 and 63 Licenses.
Christopher P. Skroupa: Regarding the launch of DWS’s newest index fund, tell us about the fund and its focus on ESG?
Gerold Koch: The Xtrackers MSCI EAFE ESG Leaders Equity ETF (NYSE Arca: EASG) is the newest addition to our suite of Environmental, Social and Governance (ESG) exchange-traded funds offered globally. This launch of the first Xtrackers ESG ETF available in the US, is a part of our strategy to make more ESG products available to investors globally, across asset classes and investment vehicles.
DWS has a long track record in the world of ESG investing. We are a proud pioneer of responsible investing – in 1997, we were the first major financial institution to offer sustainable strategies aimed at generating viable returns with real and measurable social and environmental outcomes. Earlier this month, we launched the first ever ESG money market fund in the US. As a global asset manager, it is crucial for us to enable clients to invest in a sustainable future by incorporating ESG factors into their investments, across all major asset classes.
Our newly launched ESG ETF provides investors further transparency into company performance, beyond traditional financial analysis, and will allow them to efficiently invest in companies with a high ESG rating located in developed markets outside the US and Canada. We will follow this launch with two additional ETFs available in the US – one focused on international developed and emerging markets regions, and another a pure emerging markets fund. We see a lot of value in ESG for international stocks, particularly in emerging market investments. In addition, the funds’ fees make them an easy substitute for investors who want to align their investment style with their values.
Skroupa: In investing in an index, how do you assure that ESG value filters through the investment process?
Koch: DWS has significant expertise in creating ESG portfolios, which we apply in our due diligence process when reviewing indices. For our new ESG ETFs, we are working with MSCI, using their ESG Leaders methodology. Through our partnership, we customized the index for the specific needs of the markets that our funds target. The index methodology excludes companies with controversial products, services or business practices and then selects the strongest ESG rated companies in each sector until 50% market capitalization is reached. There is a broad range of other ESG index providers in the market that we work with, in particular, if they have high quality internal ESG research capabilities.
That being said, our primary source for ESG data is the DWS ESG Engine, our proprietary software tool. The ESG Engine incorporates data from seven, different third-party ESG data specialists and covers 13,000 issuers in developed and emerging markets globally. With up to 3,000 data fields per issuer, we now have more than 1 billion ESG data points available to us, which makes this a very powerful tool for investments across fixed income and equities.
For index-based investments, the ESG Engine is primarily used for institutional investors. The tool enables us to identify issuers that don’t align with investor values, which may mean the reduction or exclusion of gun manufacturers, companies with high carbon emissions, poor data security, insufficient corporate governance, or human rights violations etc.
Skroupa: How do you believe ESG will impact long-term fund performance?
Koch: Ties between ESG criteria and long-term corporate performance have been an area of academic and investor interest since the beginning of the socially responsible investing movement in the 1970s. In 2015, DWS conducted a meta-study along with the University of Hamburg that examined approximately 2,200 academic studies that had looked at the relationship between ESG and financial performance.
The results of the study show that the business case for ESG investing is empirically very well founded. Roughly 90% of studies find a nonnegative relation between ESG and financial performance and the large majority of studies exhibit positive findings that appear stable over time. Not surprisingly out of E (Environmental), S (Social), and G (Governance), the G factor displays the strongest correlation, followed by the E and then the S factors. In addition to positively impacting fund performance, ESG can uncover non-financial risks that may become costly for companies in the future, in effect turning them into financial risks – for example, a firm can experience an unforeseen environmental crisis caused by poor production processes and magnified by weak disaster management procedures.
We can see these effects in the past performance of ESG indices. In particular, we can observe outperformance in emerging markets stocks due to the weaker corporate governance of many emerging markets issuers vs. their peers in developed markets. Avoiding these issuers may pay off. For example, the MSCI ESG Leaders EM index has outperformed the regular MSCI EM index in the last 1, 3 and 5 years, with the 5 year outperformance being 2.43% per annum (at just 13 bps higher volatility).
Lastly, ESG may also uncover long-term systemic risks which traditional risk metrics may not consider, such as risks that may be associated with climate change. Over the past few years, we have seen hurricanes, flooding and forest fires intensify in strength and frequency. These events can lead to costly interruptions of the value chain of companies or make some of their factories and other facilities worthless.
Skroupa: What impact will climate change have on investors’ portfolios and what should investors be doing to protect against this?
Koch: Globalization has led to a situation where many companies headquartered in developed markets have significant portions of their operations conducted in locations vulnerable to environmental risks. These risks are highest near the equator and, in particular, in South-East Asia. The effects of changing climate will lead to major costs by disrupting the companies’ value chains: rising sea levels, flooding from extreme rainfall, tropical storms, extreme heat, and wildfires can all lead to interruptions of sourcing inputs, production and marketing of the companies’ goods and services.
In addition to damages, lost revenues and additional direct costs, there will be longer-term financial implications for companies associate with the transition to a low(er)-carbon economy over the next decades, associated with tighter carbon emissions regulations. These factors may lead to lower demand for oil and gas and higher refinancing costs for corporate issuers due to fossil fuel-divestments which we have seen from leading institutional investors around the world.
The good news is, by acting now, investors can take steps to protect their portfolios against climate change-related risks. First, they need to identify companies that are not prepared for a transition to a lower carbon economy. Then, they should know where the vital components of the value chain of companies they invest in are located – not only where the headquarters is or where their shares are traded, but where a company’s manufacturing facilities and other operations are located. Location matters! Overall, investors should avoid or underweight companies with elevated climate-related risk.
We partner with climate specialist Four Twenty Seven, who help us to assess climate-related risks. They have developed a framework to measure the risk to over 2,000 companies globally, assessing their supply chain, markets and the 1 million facilities they own and operate (each with their own specific location-based risks).
By systematically using this data, combined with inputs from another vendor for transition risk, DWS has developed a smart-beta framework that can be applied to a broad variety of investment universes. This approach is available to investors, ranging from European stocks (where the risk is the lowest), US stocks (with an average risk) to emerging markets stocks (where the risk is the highest).
