Investment - ​Investor Engagement and Stewardship
Stewardship is often used as an overall word embracing the approach that investors adopt as active and involved owners of the firms and other entities in which they invest through voting and engagement. The name ‘steward’ is derived from two old English words — ‘stig’, meaning house, and ‘weard’, meaning guard. What in the Middle Ages referred to protection of the home, in the 21st century can apply to the protection of financial assets. The steward is the representative of the owner, responsible with acting in the owner’s interests and producing returns and long-term value from their assets.


Fiduciary duty is a requirement by the person (fiduciary) to look after another person’s assets, and they must attempt to maintain and increase the value of the assets with which they have been charged so that they are able to restore them in good order to their owner. As a steward is the representative of the owner, caring for assets on their behalf, the steward is tasked with fiduciary duty. 

Shareholder involvement is the means in which investors put into effect their stewardship obligations in keeping with the second principle from the Principles for Responsible Investment (PRI), which states:  

‘We will be engaged owners and incorporate environmental, social, and governance (ESG) issues into our ownership policies and practices’.



Stakeholder involvement is sometimes described as purposeful discussion with a specific objective in mind. That purpose will vary every investment, but often relates to improving companies’ business processes, notably in relation to the management of ESG issues.  

Given its focus on protecting and enhancing long-term value on behalf of the asset owner, engagement can span a vast range of issues that affect the long-term worth of a firm, including the following:  

Strategy 
Capital structure 
Operational performance and delivery 
Risk management
Pay
Corporate governance

ESG elements are crucial to these challenges. Opportunities and challenges afforded by ESG changes need to be incorporated in a business’s strategic thinking. A complete review of operational success must involve not only financials, but also critical areas essential to the company’s stakeholders: 

The long-term health of the firm, such as interactions with the workforce 
A culture that supports long-term value generation 
Dealing freely and fairly with suppliers and consumers
Having sufficient and effective environmental controls in place

An awareness of the whole range of significant risks facing a firm will always include ESG factors, and investors will want to engage with companies on this basis. 

Engagement Dynamics
In a 2018 report, PRI outlined three ESG engagement characteristics that it believes create value:
Communicative dynamics (the sharing of information) 
Learning dynamics (improving knowledge) 
Political dynamics (creating relationships)

Developing these dynamics needs investors to go beyond a financial understanding of the firm and its actions. Unless the steward attempts to develop communication and relationships and has a desire to learn, engagement is unlikely to be successful. 

To be successful in engagement, investors need to respect the specific conditions of the company, seeking knowledge and rapport rather than just proclaiming that business practices need to change.  

Benefits of Stewardship and Engagement
Stewardship and participation are important because they boost shareholder value and support investors in the performance of their fiduciary obligation. When done correctly, stewardship and engagement foster better information flows between investors and investees as the parties discuss and debate business-related issues.  

This flow allows them to learn from each other and to create a connection, but most crucially to encourage change when shareholders convey their thoughts on major difficulties that the firm is facing.  

Engagement helps organizations understand their investors’ (and potential investors’) expectations, allowing them to modify their long-term strategies accordingly to fit them. Engagement also enables companies to explain how their approach to sustainability links to their overall business strategy and provides an opportunity for corporations to remark on grades or scores determined by frameworks that they may believe do not reflect the complexity of an issue.   

Engagement also allows investors to work closely with a company over time on specific governance, social, or environmental concerns that the investor perceives as posing a downside risk to the business. By interacting with companies’ management — either individually or collectively — investment firms are able to push corporations to adopt better ESG practices, or at least to relinquish problematic practices.   

Effective Engagement


If involvement is to be effective in achieving change results, it needs that a clear objective is set from the start. The Investor Forum – a UK association set up to encourage collective conversation between investors and investees — explains involvement as follows:

‘Engagement is active discussion with a particular and targeted objective.… The underlying aim…should always be to protect and enhance the value of assets’.

Characteristics of effective engagement include the following:
Focus on long-term value preservation and creation
Framed by a comprehensive understanding of the nature of the company and drivers of its business model
Recognition that change is a process and should not be unnecessarily rushed
Consistent, clear, and honest messages and dialogues
Resourced correctly so that it may be delivered professionally
Resourced efficiently
Ongoing reflection so that lessons are gained to better future engagement activities

There are occasions in which engagement compels an investor to have a view. These instances include corporate acts, such as share issuances in which the investor can choose to participate or not, and planned takeovers in which the investor must decide whether to sell or to hang on to their shares. 

Voting
Voting is one part of stewardship engagement and tends to focus on corporate governance problems highlighted at shareholders’ meetings. Voting normally occurs yearly at the annual general meeting (AGM) and occasionally in between at special sessions called extraordinary general meetings (EGMs).  

questions considered for vote include frequently fundamental questions like the organization of the board, audit and oversight, CEO remuneration, and the capital structure of the company. Considering such matters with due care is part of fiduciary duty, and appropriate care may often demand active communication with the corporation to grasp the issues and convey any concerns and opinions. 

Engagement Styles 


Engagement styles differ depending on the legacy of stewardship teams. There is a distinction in thinking and strategy between investment teams with a history of governance-led involvement and those that have worked more on the environmental and social side. As material E and S concerns come from the nature of a company’s business activities, teams with this background tend to be organised by sector.

Such teams tend to focus on individual environmental and social issues and to pursue them strongly across sectors or the market as a whole. Because governance is determined more by national law and norms, firms with a governance legacy tend to focus on particular enterprises.

The beginning point for passive investors is often a particular issue and they attempt to engage with all companies impacted by that issue. 

Active investors start with a company and its business difficulties and design a bespoke involvement approach cutting across a range of issues.  

Issue-based methods to involvement are generally complemented with examples of best practices in a given area. By expecting all companies in a given sector to embrace certain best practices, investors may over time shift overall sector or industry practice advances. 

firm-focussed engagement tries to improve practice across a number of important ESG issues at a particular firm – the purpose is to boost performance of the portfolio overall, both in terms of ESG performance and investment performance.   

" " Used successfully, engagement can be a conduit for positive outcomes. It can be carried out throughout the complete range of financial asset types. The ideas and mindset of involvement and stewardship need to be applied with good reason and discretion to the diverse conditions and the levers that the investor controls. 

​Investment - The Benefits and Challenges of ESG Adherence

Perspectives for Adhering to Good Practices in ESG
There are a range of viewpoints on the purpose and value, both to investors and to society more broadly, on integrating ESG factors into investing decisions. We will explore those perspectives in the next sections.  

Risk Perspective
According to the World Economic Forum’s (WEF) top global hazards, climate now tops the risk agenda.

In 2015, Mark Carney, then Governor of the Bank of England and head of the Financial Stability Board, in a speech to financial regulators that became a cornerstone for the integration of climate change, referred to climate change as the tragedy of the horizon. In his annual letter to chief executives in 2020, Larry Fink, the CEO of BlackRock, announced that the investment firm would step up its assessment of climate change in its investment research since climate change was altering the world’s financial system.  

In a parallel letter to its clients, BlackRock committed to divesting from its actively managed portfolios any companies that generate more than 25% of their revenues from coal production and to requiring reporting from investee companies on their climate-related risks and plans for operating under the goals of the Paris Agreement to limit global warming to less than 2°C (3.6°F) above pre-industrial levels.

Fiduciary Duty and Economic Perspectives 
FIDUCIARY DUTY PERSPECTIVE
In the current investment system, financial institutions or individuals, known as fiduciaries, manage money or other assets on behalf of beneficiaries and investors. Beneficiaries and investors rely on these fiduciaries to serve in their best interests, which are often defined purely in financial terms.  

Because of the misunderstanding that ESG elements are not financially relevant, some investors have used the concept of fiduciary obligation as an excuse to not include ESG issues. But increasingly, academic studies and work performed over the past decade by progressive investing associations, such the Principles for Responsible investing (PRI), have underlined that financially material ESG considerations must be incorporated into the investment decision-making process.

Furthermore, failing to consider long-term value drivers, which include ESG problems, in investment practice is commonly regarded a violation of fiduciary obligation.

ECONOMIC PERSPECTIVE
Negative megatrends (e.g., climate change and resource scarcity) will, over time, produce a drag on economic development as fundamental inputs, such as water, energy, and land, become increasingly scarce and expensive and the prevalence of health and income inequities increases.  

The Financial Stability Board (FSB), an international agency that monitors and provides recommendations concerning the global financial system, has recognized climate change as a potential systemic risk.

The economic ramifications of environmental difficulties (such as climate change, resource shortages, biodiversity loss, and deforestation) and social challenges (such as poverty, income inequality, and human rights) are increasingly being recognised.

The Stockholm Resilience Centre has identified nine ‘planetary boundaries’ within which humanity can continue to develop and thrive for generations to come, but in 2017 found that four — climate change, loss of biosphere integrity, land system change, and altered biogeochemical cycles — had been crossed.  

A popular theory that builds on that of planetary borders is called ‘doughnut economics’, which blends planetary boundaries with the complementing concept of social limits.  

​Large institutional investors have assets, which due to their scale, are widely diversified across all industries, asset classes, and locations. As a result, their portfolios are sufficiently representative of global capital markets that they effectively own a slice of the total market. Their investment returns are consequently dependent on the continuous excellent health of the overall economy.  

Inefficiently allocating capital to companies with strong negative externalities can affect the profitability of other portfolio companies and the overall market return. It is in their advantage to act to decrease the economic risk offered by sustainability challenges to improve their whole, long-term financial performance.

Impact, Ethics, Client, and Regulatory Perspectives 
Impact and Ethics Perspective
Another rationale for adopting responsible investment is some investors’ idea that investments may, or should, help society alongside delivering financial gain. This attitude translates into emphasizing on investments with a positive impact and/or avoiding those with a negative impact.

Client Perspective
Clients are increasingly seeking for greater transparency about how and where their money is invested. This is motivated by the following: 

Growing awareness that ESG considerations influence firm value, returns, and reputation 

Increasing focus on the environmental and social implications of the enterprises in which they have invested 

Regulatory Perspective
Regardless of their ideas or convictions, some investors are being obliged to increasingly examine ESG problems. following the mid-1990s, responsible investment regulation has increased dramatically, with a boom in policy interventions following the 2008 financial crisis. Regulatory change has also been spurred by an awareness among national and international regulators that the financial sector may play an essential role in tackling global concerns, including as climate change, modern slavery, and tax dodging. 

Benefits of Adhering to Good Practices in ESG


One of the key motivations for ESG integration is the awareness that ESG investing can decrease risk and boost returns since it examines additional risks and injects new and forward-looking insights into the investment process.

Reduced Cost and Increased Efficiency
Sustainable business methods increase efficiencies by preserving resources, decreasing expenses, and boosting production. Significant cost reductions can emerge from improving operational efficiency through improved management of natural resources, such as water and energy, as well as from avoiding waste.  

Consider the impact of Unilever’s (UL:NYSE) eco-efficiency plan. Since 2008, Unilever avoided more than GBP639 million of energy expenditures, saved more than GBP106 million by improving water efficiency in their plants, and lowered costs by roughly GBP106 million by using fewer resources and producing less waste.  

Reduced Risk of Fines and State Intervention
Amid rising knowledge of climate change, dwindling energy resources, and environmental effect, state and federal government agencies are establishing legislation to safeguard the environment. Integrating sustainability into a business will position it to anticipate changing requirements in a timely manner.  

For example, a 2019 UN Environment Programme report revealed that there has been a 38-fold rise in environmental regulations placed in place since 1972. The greatest corporate fine to date was issued against BP (BP:NYSE) in the wake of the 2010 Deepwater Horizon oil spill in the Gulf of Mexico, the largest in history. BP settled with the US Department of Justice for USD20.8 billion in 2016; the total compensation ultimately paid out by the business reportedly topped USD65 billion.

Reduced Negative Externalities
The term ‘externalities’ refers to circumstances in which the production or use of products and services creates costs or advantages to others that are not represented in the prices charged for them. In other words, externalities include the consumption, production, and investment decisions of organizations (and individuals) that affect others not directly participating in the transactions.  

In the instance of pollution, a polluter makes judgments based on solely the direct cost and profit potential involved with production and does not consider the indirect costs to those afflicted by the pollution. These indirect costs, which are not borne by the producer or consumer, may include poorer quality of life, increased healthcare costs, and forgone production opportunities — for example, when pollution impairs business operations, such as tourism.

Improved Ability to Benefit from Sustainability Megatrends
There are a plethora of ramifications from the so-called sustainability megatrends. Some of the megatrends that investors are increasingly concentrating on include the following:

Urbanisation 

Technological innovation 

Demographic change and wealth inequality 

Climate change and resource scarcity 

Being able to integrate a response to these trends into business operations might be a success element for an investee organization. From the investment standpoint, these megatrends can be part of a successful portfolio construction approach.

Therefore, business leaders, investors, economists, and governments are increasingly recognising the economic implications of social challenges (such as increasing income inequality and addressing poverty and human and labour rights abuses) and environmental issues (such as climate change, biodiversity loss, and resource scarcity).

Challenges in Integrating ESG


ESG investing has undergone remarkable progress in recent years, yet barriers still remain to its further growth.  

Some investors still doubt if considering ESG problems may add value to investment decision making despite wide-spread dissemination of studies suggesting that ESG integration can assist control volatility and boost returns.

Interpretations of fiduciary obligation are partially tied to the perception of the impact of ESG investment on risk-adjusted returns. Despite regulators in several jurisdictions articulating a modern conception of fiduciary obligation, contrasting perspectives continue as to how ESG integration fits in with institutional investors’ duties. Some institutional investors remain unwilling to modify their governance processes because they see a conflict between their responsibilities to defend the financial interests of their beneficiaries and the inclusion of ESG factors.

The difficulty is not just regarding the impact of ESG investing on portfolio returns.

Screening, divestment, and theme investment methods entail ‘tilting’ the portfolio towards desirable ESG qualities by over- or under weighting sectors or firms that either perform well or poorly in those areas. Institutional investors may believe that this contradicts with their responsibilities to invest sensibly because it requires departing from established market standards.  

Despite the obstacles and concerns, there is a growing acceptance in the financial industry and in academics that ESG considerations indeed influence financial performance. An examination of more than 2,000 academic research on how ESG elements affect business ;financial performance found an overwhelming percentage of positive outcomes, with just 1 in 10 revealing a negative association.1 Various research results also indicate that engaging with firms on ESG concerns can produce value for both investors and corporations by driving improved ESG risk management and more sustainable business practices. These results give evidence that ESG problems can be financially material to companies’ performance and potentially to alpha.

Challenges Prior to Wanting to Implement ESG –

Challenges prior to incorporating ESG considerations include the following: 


The perception that incorporating ESG elements may have a negative influence on investment performance. 

The interpretation that fiduciary duty hinders investors from integrating ESG.  

The advice supplied by investment consultants and retail financial advisers has many times not been supportive of solutions that integrate ESG.  

Challenges Faced After the Decision to Implement ESG

Challenges faced when deciding to apply ESG include the following:  
A lack of awareness of how to construct an investment mandate that successfully supports ESG or lack of understanding of the needs of asset owners about ESG.  

The impression that considerable resources, which may be missing in the market or may be pricey, are needed. These include human resources, technical capabilities, data, and tools. 

A gap between marketing, commitment, and delivery of funds regarding ESG performance

​
Investment- Environmental Factors
The range of environmental factors that have a meaningful impact on investments – the ‘E’ in ESG — is large and far-reaching. Environmental dangers have continued to acquire prominence and are creating heightened concern worldwide. We shall cover three essential elements relating to the environment:    


Climate Change

Climate change is defined as a shift, directly or indirectly related to human activity, that modifies the composition of the global atmosphere, and which is, in addition to natural climate variability, observable over comparable time periods. It is one of the most complex issues facing us today. It is an issue having local manifestations (e.g., extreme weather events, such as more frequent and/or more intense tropical cyclones) and global repercussions (e.g., rising global average temperatures and sea levels), which are predicted to increase in severity over time.

The principal man-made cause of the warming of the world is increased emissions of heat-trapping greenhouse gases (GHGs).  

Greenhouse gasses trap heat in the atmosphere, boosting the atmosphere’s temperature. CO2 is the most significant contributor to the warming impact; the display below demonstrates that its concentration in the atmosphere has bounced between 200 and 300 ppm (parts per million), and presently sits at 415 ppm and growing, leading to elevated physical and transition dangers. 

Climate change will damage economies and markets in the coming decades at an accelerated rate if we do not bend the PPM curve back towards the x-axis. Additionally, climate change could influence our brains; research published in the journal Environmental Health Perspectives indicated that at roughly 945 ppm concentration of CO2 in the atmosphere, human cognitive function reduces by about 15%. With a CO2 level of 1,400 ppm, cognitive performance is expected to diminish by around 50%

Physical Climate-Related Risks
Physical climate-related risks emerge from extreme weather occurrences, either acute or chronic dangers from longer-term shifts in climate patterns — for example, increased temperatures. 

Transition Risks
Transition risks are a result of changes in climate and energy policies, a shift to low carbon technologies, and liability difficulties.  

Pressure on Natural Resources
Nearly 70% of the planet is covered by water, but just 2.5% of it is fresh water.2 Water is a key natural resource, not just for human consumption, but also for a range of agricultural, industrial, and home energy generation and for recreational and environmental activities.

Water shortage is the lack of freshwater supplies to meet water demand. The UN’s Sustainable Development Goal (SDG) 6 is the requirement ‘to ensure availability and sustainable management of water and sanitation to all’ by 2030.3 Water shortage — caused either by economic issues, such as lack of investment, or by physical repercussions connected to climate change — continues to generate substantial concern, especially among developing and emerging economies.

Biodiversity, as defined by the Convention on Biological Diversity, means the ‘variability among living organisms from all sources, including among other things, terrestrial, marine, and other aquatic ecosystems and the ecological complexes of which they are part; this includes diversity within species, between species, and of ecosystems’.

Unfortunately, global biodiversity is undergoing a catastrophic reduction. In 2019, the Intergovernmental Science-Policy Platform on Biodiversity and Ecosystem Services (IPBES) presented a historic assessment, which stated that about one million animal and plant species are now threatened with extinction, many within decades, more than at any other time in human history

Land use management strategies and forestry, commonly known as agricultural, forestry, and other land use (AFOLU), have a huge impact on natural resources like water, soil, nutrients, plants, and animals. Covering nearly 30% of the world’s land area, or little under 4 billion hectares, forests are a critical element of the carbon cycle. They convert the CO2 in the air to oxygen, through the process of photosynthesis, and are a natural regulator of CO2, with the world’s tropical forests playing a particularly vital role in sequestering carbon. The more trees, the less CO2, and the more oxygen there is in the atmosphere.

Unfortunately, deforestation is accelerating: From 2001 to 2019, there was a total of 386 million hectares of tree cover loss globally, corresponding to a 9.7% decline in tree cover since 2000 and 105 mega tons of CO2 emissions, according to Global Forest Watch

Absorbing 50 times more CO2 than the atmosphere, the ocean is the planet’s largest carbon sink, with photosynthetic micro-organisms on its surface layer providing over half of the world’s oxygen. It is one of the most important natural resources.

The OECD (Organisation for Economic Cooperation and Development) estimates that ocean-based industries provide around EUR1.3 trillion to global gross value added. Oceans supply fish and are commonly used for transportation (shipping). They are also mined for minerals (salt, sand, and gravel as well as some manganese, copper, nickel, iron, and cobalt, which can be found in the deep sea) and drilled for crude oil.

The oceans’ riches are a source of economic growth and are also known as the blue economy.6 Communities in close association with coastal ecosystems, small islands (especially Small Island Developing States), polar zones, and high mountains are particularly sensitive to ocean change, such as the rise in sea level and temperature.

Pollution, Waste, and a Circular Economy
Pollution is the leading environmental cause of disease and premature death in the world today. According to findings published in October 2017 by the Lancet Commission on pollution and health, diseases caused by pollution were responsible for an estimated 9 million premature deaths in 2015 — 16% of all deaths worldwide — which is three times more deaths than from AIDS, tuberculosis, and malaria combined and 15 times more than from all wars and other forms of violence.

New research published in the journal Environmental Research in February 2021 demonstrates that the combustion of fossil fuels is a substantial source of airborne fine particulate matter and a key contributor to the worldwide burden of mortality and disease.   

Water pollution occurs when contaminants (such as toxic chemicals or microbes) are introduced into the natural environment through the ocean, rivers, streams, lakes, or groundwater. Water contamination can be caused by spills and leaks from untreated sewage or sanitation systems and industrial waste discharge. 


The circular economy is an economic model that tries to reduce waste and to conserve the value of resources (raw materials, energy, and water) for as long as feasible. It is an effective model for organizations to examine and manage their operations and resource management since it is an alternate method to the use–make–dispose economy. The circular economy is built on three principles:   


Design out waste and pollution

Keep products and supplies in use
Regenerate natural systems

Use of these principles can help lessen demand on natural resources and lead to more sustainable behaviors. Companies who employ these principles may also be a more tempting investment possibility for those concerned with environmental problems. 

Social Factors


Social factors – the ‘S’ in ESG — can be divided between those effecting external stakeholders (such as customers, local communities, and governments) and groupings of internal stakeholders (such as a company’s employees).

​Governance Factors
Corporate Governance — the ‘G’ in ESG — is the process by which a corporation is managed and overseen. Governance is about people and processes, although rules vary worldwide. Governance stems from the legal system of the country in which a corporation is incorporated.

Corporate governance is about the individuals who manage a corporation and how those people are supported by systems to exercise their responsibilities effectively. Good governance is also about building an acceptable company culture that will back the execution of excellent business performance without excessive risk-taking and via appropriate conduct of business operations.

In practice, corporate governance comes down to two ‘A’s’: Accountability and Alignment.

Accountability 


For accountability to work, people require the following:


To be granted the authority and duty for decision making   


To be held accountable for the implications of their decisions and the efficacy of the work they deliver 

Just as people are most effective when they are mindful of being answerable to someone — often their manager — in the same way, top executives need to feel accountable to the non-executives on the board of directors. In turn, that board will be most effective when its non-executive members feel accountable to shareholders for effective delivery. 

Therefore, corporate governance has a particular focus on board structure and the independence of directors. The function of the chair of the board is crucial in facilitating a balanced discourse in the boardroom. Consequently, many investors prefer that the chair be an independent non-executive director. 

​Alignment 
Alignment boils down to the challenge of the agency problem. The agency problem arises because the interests of professional managers, the agents, may not always be entirely aligned with the interests of the owners of the firm, and so the company may not be run in the way the owners want it to be run. Corporate governance seeks to guarantee that there is greater alignment in the interests of the agents with the owners through incentives, but also through suitable chains of accountability to limit the possible negative implications of the agency problem.

Accountability: Board Committees 


The three core committees of the board, normally required by corporate governance laws, are established to respond to three key challenges: accountability and the board, accountability and accounting, and alignment and executive pay.

Nominations Committee
The nominations committee works to ensure that the board overall is balanced and effective, ensuring that management is held accountable

Audit Committee 
The audit committee monitors financial reporting and the audit, delivering accountability in the accounting. The audit committee will also monitor internal audits, when this exists, and unless there is a separate risk committee, will also have responsibility for risk oversight

Remuneration Committee
The remuneration committee strives to deliver an appropriate alignment between owners and management through executive pay and benefits.   

Corporate Governance Codes 
Corporate failures and scandals have been a significant motivation for the formalisation of corporate governance and the adoption of codes. The world’s first formal corporate governance code emerged in the United Kingdom in 1992 and was based on recommendations of the Committee on the Financial Aspects of Corporate Governance in their final report7, also called the ‘Cadbury Report’ because the committee was chaired by Sir Adrian Cadbury.

Much of what the report advised is still considered best practice today and has been incorporated in codes and standards globally. The committee’s primary premise is that no one should have ‘unfettered powers of decision’. For example, the duties of chair and CEO should not be mixed.  

A formalized set of rules for good governance has emerged from the core concepts of accountability and alignment. The following themes are constant across most of the world’s corporate governance codes:   

Board leadership and company purpose
Division of responsibilities
Composition, succession, and evaluation
Audit, risk, and internal control
Remuneration

Governance vary from country to country depending on culture and historical development as well as local corporation legislation. At the most basic level, some nations, including Germany and the Netherlands, have two-tier boards with fully non-executive supervisory boards overseeing management boards. 

Others have single-tier boards, with some dominated by executive directors (in Japan). Some have a combined CEO and chair (most typically seen in the United States and France), and some lie in between these types (for example, the United Kingdom). 

Of the three ESG criteria, governance is the element most typically taken into consideration by traditional investment analysts. Academic research reveals that among the three ESG elements, governance has the closest link to financial performance. Good governance is crucial to a company’s performance, both in terms of long-term shareholder value creation and the creation of greater prosperity for society and all stakeholders. 

If a firm delivers good governance, it is more probable that it will also handle environmental and social concerns with the proper long-term attitude, and thus avoid or effectively manage important risks and capture relevant possibilities. Failures of governance can be damaging to shareholders and other capital suppliers.

​Investment- Approaches to Responsible  investing 
ESG investing is part of a range of practices collectively referred to as responsible investment or sustainable investment. Although ESG investing is concerned with how ESG concerns can effect the long-term return of assets and securities, alternative responsible investment techniques can also take into account non-financial value creation and reflect stakeholder values in an investment strategy.

Responsible investment may mix financial with non-financial outcomes and complements typical financial research and portfolio creation strategies.

The table below illustrates some of the conceptual differences between these approaches and how they range from strictly ‘finance-only’ investments, with no consideration of responsible investing factors, to the other end of the spectrum, where the investor may be prepared to accept returns lower than comparable investments in exchange for the higher positive impact that the projects and companies in the portfolio deliver.

As investors shift towards the right side of the spectrum, they are increasingly interested in aligning their capital with responsible investment possibilities in order to gain associated financial returns and/or to have a good influence by financing solutions to societal difficulties.
The Spectrum of Responsible and Financial Investing



Defining ESG Investing
ESG investing is a strategy to managing assets in which investors deliberately consider environmental, social, and governance (ESG) factors in their investment decisions with the long-term return of an investment portfolio in mind. In other words, ESG investing tries to appropriately identify, evaluate, and price social, environmental, governance, and economic risks and opportunities.

ENVIRONMENTAL FACTORS
Environmental elements are those relevant to the natural world. These include the use of, and interaction with, renewable and non-renewable resources (e.g., water, minerals, ecosystems, and biodiversity).

Social influences affect the lives of humans. The category encompasses the management of human capital, non-human animals, local communities, and clientele.   

GOVERNANCE FACTORS
Governance elements are those that involve issues connected to countries and/or jurisdictions or are normal practice in an industry as well as the interests of broader stakeholder groups.    

The Scope of ESG Investing
There is currently no common criteria for allocating E, S, and/or G to issues, and they may overlap with one another. Investors interested in investigating E, S, and/or G factors are typically concerned about the associated challenges, which the following table presents a few examples of for each factor

Corporate Social Responsibility
ESG investing and corporate social sustainability are closely intertwined. Corporate social sustainability is an approach seeking to produce long-term stakeholder value through the implementation of a company plan that emphasizes on the ethical, social, environmental, cultural, and economic components of doing business.

ESG investing understands that the development of long-term sustainable returns is dependent on stable, well-functioning, and well-governed social, environmental, and economic systems, which is often dubbed the triple bottom line (TBL). The TBL accounting theory widens the traditional accounting framework, which has previously primarily centered on profit, to include two new performance areas: the social and the environmental impact of a company’s operations

Responsible Investment Approaches
ESG is an important component of responsible investing. We will now discuss approaches to responsible investment and their characteristics. The following slides illustrate approaches that all integrate ESG factors.

Socially Responsible Investment (SRI) is a method that applies social and environmental issues to evaluate enterprises. Investors applying SRI generally grade firms using a defined set of criteria in conjunction with sector-specific weightings. A hurdle level (minimum ESG score for companies being evaluated) is established for qualification within the investment universe based on employing either the complete universe or sector-by-sector analysis. This information serves as the initial filter to produce a list of SRI-qualified companies.  

SRI rating can also be used in connection with best-in-class investments, thematic funds, high-conviction funds, or quantitative investment methodologies.      

The Best-in-Class Investment method entails selecting only those companies that overcome a set rating hurdle, developed using ESG criteria within each sector or industry.  

Typically, organizations are assessed on a variety of parameters that are weighted according to the respective sector.  

The portfolio is then created from the list of qualified companies. 

The Sustainable Investment strategy selects assets that contribute in some way to a sustainable economy — that is, an asset that minimises natural and social resource depletion.  

It is a broad phrase, with a broad variety of interpretations that may be utilized for the assessment of common ESG issues.  

It may incorporate best-in-class and/or ESG integration, which evaluates how ESG problems effect an investment’s risk and return profile.  

It is further used to characterize companies having good influence or companies that will benefit from sustainable macro-trends.  

The word ‘sustainable investment’ can also be used to imply a strategy that screens out activities considered contradictory to long-term environmental and social sustainability, such as coal mining or prospecting for oil in the Arctic regions.  

The Thematic Investment strategy entails selecting companies that fall under a sustainability-related theme, such as clean-tech, sustainable agriculture, healthcare, or climate change mitigation. Thematic funds identify companies throughout several sectors that are connected to the theme.  

A smart city fund, for example, might invest in companies offering activities or products connected to electric vehicles, public transportation, smart grid technology, renewable energy, and/or green buildings. 

The Green Investment method entails allocating funds to assets that minimize the following:

Climate change 

Biodiversity loss 

Resource inefficiency  

Other environmental concerns (e.g., low carbon power generation and cars, smart grids, energy efficiency, pollution control, recycling, and waste management)  

Green investment can thus be considered a large sub-category of theme investing (see previous slide) and/or impact investing (see next slide). Green bonds, a sort of fixed-income instrument that is particularly intended to raise money for climate and environmental projects, are extensively utilized in green investing.  

The Social Investment method directs funds to assets that address social concerns. These can be goods that address the bottom of the pyramid (BOP). BOP refers to the lowest two-thirds of the economic human pyramid, a group of more than four billion people living in poverty.  

More broadly, BOP refers to a market-based strategy of economic development that tries to simultaneously reduce poverty while generating growth and profitability for enterprises servicing these regions. The following are some examples: 

Microfinance and microinsurance 
Access to basic telecommunication 
Access to improved nutrition and health care 
Access to clean energy 


In effect Investing, investments are undertaken with the specific goal of generating positive, measurable social and/or environmental effect alongside a financial return (which differentiates it from venture philanthropy). These are frequently connected with direct investments, such as in private debt, private equity, and real estate. But in recent years, impact investing has gradually become more common in the public markets.  

Impact investments provide capital to address the world’s most pressing concerns by investing in projects and companies that may do the following: 

Offer access to basic services, including housing, healthcare, and education 

Promote availability of low-carbon energy 

Support minority owned businesses 

Conserve natural resources 

Measurement and tracking of agreed-on impact is at the heart of the investment proposition. Impact investors have various financial return expectations. Some purposely accept lower returns than comparable investments in keeping with their strategic objectives. Others pursue market-competitive and market-beating returns, often compelled by fiduciary duty. 

An ethical (also known as value-driven) and Faith-Based Investment approach refers to investing in line with certain principles, often using negative screening to avoid investing in companies whose products and services are deemed morally objectionable by the investor or certain religions, international declarations, conventions, and voluntary agreements. Typical exclusions include tobacco, alcohol, pornography, weapons, nuclear power, and substantial infringement of agreements, such as the Universal Declaration of Human Rights or the International Labour Organisation’s Declaration on Fundamental Principles and Rights at Work.  

Shareholder engagement represents active ownership by investors in which the investor strives to influence a company’s actions on concerns of ESG, either through communication or votes at a shareholder meeting. It is considered as complementary to the other techniques since it pushes firms to operate more responsibly.

All types of ethical investment, except for engagement, are ultimately tied to portfolio construction – that is, the securities a fund holds. The investing approaches mentioned above highlight the wide variety of different types of ethical investment. 

​Investment- Performance Attribution

Benchmarks constitute the basis of performance measurement, which is an important aspect of performance evaluation. By comparing the performance of a UK equity fund with the performance of an appropriate UK equity index, the fund’s investors can get an idea of how well the fund is performing relative to the market in general, both in terms of average return and in terms of risk, by calculating the fund’s tracking error or information ratio.



Benchmarks can also be utilized to analyze the causes behind the fund’s performance. By employing proper financial market indicators, the fund manager’s performance can be deconstructed to uncover the sources of returns. Depending on the nature of the fund, the performance itself could originate from the following sources: 
 Asset allocation 
Sector selection
Stock selection 
Currency exposure

Determining how much of the performance is the consequence of the choices of asset classes, sectors, individual stocks, and currencies is known as performance attribution. The following example provides an illustration of performance attribution. 

​Investment- Alpha 
Skill vs. Luck
If each person in a roomful of people randomly buys 10 stocks and holds them for five years, some of those persons may see the value of their investments rise. Does this suggest that they are skilful investors? At the same time, other people in the room may watch the value of their investments plummet. Does that suggest that they are terrible investors?

The answer to both queries is no. The stocks were chosen randomly, thus the result is entirely attributable to luck. But even when stocks are not chosen randomly, luck can play a large factor in investment outcomes, so investors need a mechanism to discern between skill and luck.  

The calculation and analysis of reward-to-risk ratios allow investors to understand the level of risk that has historically been taken to earn the total return generated by the fund. All things being equal, a manager who delivers a consistently high reward-to-risk ratio could be said to be more competent than one who consistently produces a lower ratio. Investors who invest in a fund that is managed on an active rather than a passive basis are effectively paying for the manager’s investment ability and expertise. 

Manager skill is commonly referred to as alpha. Perhaps the best approach to describe the concept of alpha is to evaluate the sources of a fund’s return, which is formed of three elements: 
Market return
Luck Skill 

Market Return Managers of passive funds attempt to provide returns for investors just as active managers intend to produce returns. But passive managers are not attempting to generate value by picking stocks that they feel will outperform other securities. Instead, they typically acquire and hold in the appropriate amounts only those securities that are contained in their benchmark. Although this procedure involves some expertise, it is not so much investment skill as effective management. When the value of the benchmark rises, the value of the passive fund monitoring it should also rise; conversely, when the value of the benchmark declines, the value of the passive fund should also fall. Therefore, over time, the fund should deliver a return (before the deduction of costs) equivalent to that of the set benchmark

Given that most actively managed funds are benchmarked against market indexes, such as the S&P 500, and fund managers will own many of the same securities that are in the index, some of the return generated by an actively managed fund will come from market movements due to the benchmark. Arguably then, investors in actively managed funds should not pay higher fees for fund returns that are generated by the market rather than by the investment acumen of their fund manager because investors can get market returns more cheaply by participating in passively managed funds.

Luck
Some of the return earned by a fund is the consequence of luck rather than discretion. The prices of financial assets held in funds are altered by events that cannot be expected by a fund management, such as natural disasters or geopolitical events.  

Skilful fund managers may be unlucky on sometimes while unskilled fund managers could experience some good luck. Because luck tends to equal out over the long term, it is crucial that investors are able to separate luck from expertise. But it is not always easy to do so. 

Skill A skillful fund manager is able to contribute value to a fund over and above changes to the fund’s value that are driven by market movements and that might have been achieved by a passive fund manager.  

Because luck may even out over time, a skilful manager is one who contributes this value consistently over time. Outperformance over the returns from a relevant market benchmark that are the result of manager talent and not luck is often referred to as alpha. 

Distinguishing Between Sources of Return 
Investors strive to discern between these three sources of fund returns. To do so, reward-to-risk ratios, such as the Sharpe ratio and the information ratio, are evaluated together with other indicators, such as a fund’s alpha, beta, standard deviation, and tracking error. A careful review of these variables over multiple time periods can assist investors decide whether outperformance has lasted over time and whether there is evidence of manager talent.  

Investment- Tracking Error and Information Ratio 

The tracking error of a fund reveals how the performance of the fund deviates from the performance of its benchmark. The tracking error so informs you how much active risk the manager took. 

The tracking error is measured by taking the standard deviation of the discrepancies between the returns on the fund and the returns on its benchmark. The bigger these variances, the more active risk was taken and the worse the tracking inaccuracy. A passive fund may be expected to have a very low tracking error relative to its benchmark index because the management is aiming to duplicate an index. But for an actively managed fund, the tracking error should be larger.  

Tracking error can also be utilized to build another widely used reward-to-risk ratio known as the information ratio. The information ratio tells you how much benefit a manager generated given the amount of active risk they took relative to the benchmark. In other words, did a manager’s wagers against the benchmark pay off? The ‘reward’ element of the information ratio is the difference between the total return of the fund and the return of an applicable benchmark index over the same period. The ‘risk’ element of the information ratio is based on the tracking error of the fund — that is, its departure from the performance of the benchmark. It is calculated as follows: 

​Investment- Risk-Adjusted Returns
Most investors aim to gain as much profit as possible for as little risk as feasible. Therefore, if two investments have a total return of 10% and the first investment has very little risk while the second one is quite dangerous, the first investment is better than the second one on a risk-adjusted basis.  

Standard Deviation 
Risk can take numerous forms. The risk we refer to throughout the rest of this module is investment risk. In Course 3, Investment Instruments, you learned that investment risk is commonly quantified based on the unpredictability of returns, and a common measure of variability is the standard deviation. The standard deviation of returns represents the variability of returns around the mean (or average) return — the larger the standard deviation of returns, the higher the variability of returns and the higher the risk.

There are at least two reasons why investors care about historical variability (the standard deviation of past returns). First, prior variability of returns might be indicative of how variable returns may be in the future. But it is vital to be aware that variability can alter over time and that there is no guarantee that future returns will behave like past returns. 

Second, the variability of returns may impair the attainment of an investor’s objectives. Pension funds invest to create the returns necessary to pay their beneficiaries, insurance companies invest to generate returns to meet the claims on their policies, and people invest because they usually have a future spend in mind. Investing in a fund whose returns vary dramatically over time could possibly disturb investors’ plans. If returns are substantially negative one year, then the investors’ commitments, such as paying pensions, may be harder to meet.  

Downside Deviation 


Standard deviation is a measure of the variability of returns around the mean. Sometimes there is a positive deviation — that is, the return is more than the mean — and sometimes there is a negative deviation — that is, the return is less than the mean. Which of these two sorts of variation do you think investors would be more concerned about?

Well, psychologists and economists have discovered that investors loathe losses more than they prefer similar gains. So, investors can be moderately happy with earning an investment return of +10%, but quite upset about achieving a return of –10%. Because of this asymmetry in the way investors see the dispersion around the average, some investing professionals utilize a modified version of standard deviation known as downside deviation.



Downside deviation is computed in almost precisely the same way as standard deviation, except instead of utilizing all the deviations from the mean — positive and negative — downside deviation is calculated using only negative deviations. In other words, it is a measure of return variability that emphasizes primarily on outcomes that are less than the mean. Downside deviation may also be evaluated by focused on outcomes that are below a defined return target. 

The following illustration demonstrates the standard and downside deviations of returns associated with investing in a diversified fund of global stocks and in a diversified fund of global bonds. 

As we see, the downside deviations are lower than the standard deviations; this outcome is expected because downside deviations only consider the negative variances. Investors who are confined in their willingness or ability to endure losses will likely prefer the bond fund given its 3.8% downside deviation and reduced chance of losses against the equity fund with its 10.4% downside deviation and larger predicted losses.  

Reward-to-Risk Ratios 


Investors seek to earn a large return rather than a low return on their assets. That said, all things being equal, they also prefer lower risk (less variability of returns) over higher risk (more variability of returns).


In other words, investors are interested in optimizing the return on their investments while simultaneously striving to limit the dangers. That is, they choose investments that offer a high return per unit of risk — assets with a high reward-to-risk ratio. The measurement of a reward-to-risk ratio allows investors to compare the performance of one investment with another on a risk-adjusted basis.

A reward-to-risk ratio is a measure that takes the following basic form: 

​The higher the value of the reward-to-risk ratio, the better the risk-adjusted return – that is, the higher the return per unit of risk.  

A commonly used reward-to-risk ratio is the Sharpe ratio, so-called because it was initially suggested by Nobel Prize–winning economist William Sharpe.1 A fund’s reward is measured as the fund’s excess return, which is equal to the difference between the fund’s total return and the return on a ‘risk-free’ investment. The risk-free investment return is usually the return from investing in short-term government bonds because in most nations, government bonds are the assets that entail the lowest level of risk. The measure of fund risk is the standard deviation of the fund returns. The Sharpe ratio is determined as follows:

​Another often used reward-to-risk ratio is the Treynor ratio, introduced by Jack Treynor.2 The measure of fund reward is the same as that used in the Sharpe ratio, but the measure of fund risk is different. The measure of fund risk is the beta of the fund — beta being a measure of the fund’s systematic risk (also called market risk). Systematic risk was explored in the Investment Management module of this course. Thus, the Treynor ratio is a measure of the fund’s performance in relation to the degree of market risk assumed by the manager. The Treynor ratio is determined as follows: 

​Example: Calculation of Sharpe and Treynor Ratios 


Suppose that over a year, the overall return of a fund was 10% and the return from investing in government bonds (‘risk-free’ assets) was 4%. Also assume that the standard deviation and beta of the fund’s returns over this period were 5% and 1.8, respectively.

The Sharpe ratio for this fund is 

​The Treynor ratio for this fund is
 

​Each of these ratios can be compared with the same ratios for similar funds to evaluate the fund’s performance. As stated previously, the higher the value of the reward-to-risk ratio, the better the risk-adjusted return — that is, the higher the return per unit of risk. 

The Sharpe ratio — along with other reward-to-risk ratios, such as the information ratio — is a key indicator for determining the quality of the returns provided by a fund. A fund with high returns but with significant risk might be said to have delivered worse-quality returns than a fund with similarly high returns but with substantially reduced risk. Reward-to-risk ratios, such as the Sharpe ratio, are one of the key quality control checks that investors can apply to their investment returns. Such ratios are also beneficial for comparing and analyzing investments.

​Investment -Benchmarks and Relative Returns 
Benchmarks and Relative Returns 

By measuring relative returns — that is, returns compared to an appropriate benchmark — investors can decide if they could have made more money in other investments for a similar degree of risk. Assessing returns on a relative basis allows investors to analyze their opportunity cost and determine whether their investments are delivering suitable returns. 

Many investors wish to compare the performance of their fund with that of a financial market benchmark, such as a stock index. It is widespread practice in all businesses, and indeed in many spheres of life, to benchmark or compare performance. Olympic sprinters, for instance, may compare themselves to a time benchmark or a close competition. Beating the time standard or the rival allows them to determine how they are performing.  

" " Fund managers may use a benchmark not only for assessment, but some, such as index fund managers, may also manage their funds to a benchmark. This means that managers must periodically compare the composition and performance of their funds with the composition of a financial market index, such as the FTSE 100 Index or the S&P 500 Index. For investors, understanding the financial market index that a fund uses as a benchmark can offer them some sense of the return and risk that they can expect from investing in that fund.



When choosing a manager for a separately managed account mandate, institutional investors will often define the financial market benchmark that they intend to use to judge the performance of the investment manager. For example, a US stock manager may be asked, or ordered, to actively manage a portfolio of US equities for a client and instructed that they will be ‘benchmarked against’ the S&P 500. As another example, a manager may simply be a passive index fund manager tracking the S&P 500 as the reference index. Alternatively, a manager can be given a specific mandate reflecting style or sector preferences. In this situation, a style or sector index may be chosen as the suitable benchmark.  

To assist investors reach their objectives, a benchmark should meet specific requirements.
Investable
The benchmark should be constituted of assets that can be bought and sold by the fund manager. For passive fund managers, it would be impossible to match the benchmark if it featured assets that they could not buy. For active fund managers, not being able to invest in some of the benchmark’s components could limit their potential to outperform it.

Compatible
The benchmark should have an appropriate composition and level of risk for the investor. In other words, it should meet the investor’s objectives. For example, for investors who desire to invest in assets that carry little credit or default risk, a financial market index of government bonds might be compatible (based on previous performance) with investor preferences. A benchmark composed of corporate bonds would not be compatible.

Transparent
The guidelines regulating the construction of the benchmark should be explicit. This transparency should extend to the weighting of individual benchmark constituents, to the mechanism used to generate benchmark returns, and to the process used to add and remove constituents to and from the benchmark over time.

Pre-Specified
The benchmark should be defined before an investment is made so that the fund management is aware about the fund’s objectives and so the fund manager may create a portfolio accordingly.

Indices 


Several companies publish financial market indexes that allow investors to compare the total return earned by a fund with that generated by the wider market.


For most equities exchanges across the world, there is at least one index that represents the bulk of its stocks. In addition to these broad indices, stock indices that evaluate performance of industrial sectors are also available, both within a given country and globally. These indices make it possible, for instance, for investors to compare the performance of a fund of global information technology (IT) equities with the performance of a fund of Indian IT stocks, as long as the indexes have been built using the same technique.  



Index providers also supply a wide selection of bond indexes. Bond indices are offered for several types of issuers located in various locations, including in developed and emerging countries. In addition to aggregate bond indices that are designed to cover the bond market as a whole, bond indices exist for bonds classified by maturity, credit rating, currency, and industry, among other categories. Many index providers, such as FTSE International, S&P Dow Jones, and MSCI, produce indexes for practically every asset class, including cash, currencies, commercial property, hedge funds, private equity, and commodities, as well as for bonds and equities. 

Relative Returns 
The large selection of financial market indices available enables investors to compare the performance of their fund over time against an independent benchmark. In brief, a benchmark index allows investors to evaluate relative returns.

Some investors compare their fund’s performance with that of the fund’s peers. For example, investors may compare the performance of one European equities fund with that of other European equity funds.


Each fund is granted a performance ranking within its particular sector of the financial markets. Funds that are in the top 10% of performers among their peers during a certain period are said to be top-decile performers. Funds’ performance is often collected and assessed by independent organisations, such as Morningstar, who then publishes the data, allowing investors to examine the rankings of their particular funds relative to those of other funds that they may have chosen.

Investment - Measures of Return 
Absolute Returns Absolute returns are the returns achieved over a specific time period. Absolute returns do not consider the risk of the investment. 

Total Return
The performance of a security, such as an equity (stock) or debt (bond) security, over a defined time period — called the holding period — is referred to as its holding-period return or, as is frequently referred to in industry practice, its total return.

The total return measures the entire gain or loss that an investor owning a security achieves over the defined period compared with the investment at the beginning of the period. The return over the holding period comes from two sources: changes in the price (capital gain or loss) and income (dividends or interest). 

The total return from owning an ordinary or common share of a company comes from a change in the price of the share between the beginning and the end of the term as well as from the dividends collected over the course of the period. The change in the price of the shares throughout the time is the capital gain or loss element of the return. The dividends received over the time constitute the income element of the return. Similarly, the entire return from owning a bond comes from changes in price (capital gain or loss) and from generating interest income.

The following example explains how total return is computed. As always, you are not responsible for computations, but the presentation of equations and calculations may increase your knowledge. 

Example: Total Return 
An investor buys one ordinary share in Company A on 1 January at a price of GBP100. On 31 December, Company A pays a dividend per share of GBP5, and an ordinary share of Company A is selling for GBP110 on that date.

In this scenario, the holding period is one year – from 1 January to 31 December. The return achieved by the investor from the growth (appreciation) in the share price throughout this period is calculated as follows: 

​But the total return should also include the dividend given to the investor. The return achieved by the investor from the income received on the share is as follows: 

​The total return is the sum of the capital and income components (i.e., 15%). Mathematically, this total can be shown as: 

​The return of an investment fund over the course of a given time is typically made of the capital gains or losses on all of the assets held during that period plus any income produced on those assets over the same period. Examples of income include dividend income from equity securities, interest income from debt securities, and rental revenue from commercial real estate. 

Cash Flows and Time-Weighted Rates of Return 

In the total return calculation example, the income (the dividend) was received at the end of the holding period. The timing of the receipt of this payment, plus the fact that no additional investments were made over the period, makes the calculation of the return reasonably uncomplicated. But in practice, determining a fund’s overall return is more complex.

In particular, funds may consist of hundreds of distinct investments that pay income at different times over the holding period, and investors may make further investments (cash inflows) in and withdrawals (cash outflows) from a fund throughout the holding period. In other words, there is a steady movement of cash into and out of most investment funds. Additional investments and withdrawals by investors will alter the calculation of the performance of the fund. The following example shows this principle.

Example: Effect of a Deposit on a Fund’s Investment Performance 


Suppose that an investment fund has a value of USD100 million on 1 January. By 31 December, the fund has risen in value to USD110 million. The increase in the value of this fund comes from changes in the values of the securities owned in the fund and from income collected during the year. The overall return of the fund is 10%, computed as follows:

​ But imagine that one of the fund’s investors contributed an additional USD5 million into the fund on 30 June. This contribution means that some of the changes in the fund’s value over the year were not from the performance of the securities or the income on these securities but were instead attributed to the receipt of extra investor money. In other words, a total return of 10% overstates the fund’s investing performance. 

Flows of money into and out of funds throughout time can be accounted for by breaking the measuring period into shorter holding periods. A new holding period starts each time a cash flow happens – that is, each time money flows into or out of a fund. If there is just one cash flow during the holding period, the measurement period will be divided into two shorter holding periods. If there are two cash flows, there will be three holding periods, and so on. In actuality, investor cash inflows and outflows may occur on a daily basis, in which case an annual holding term is broken into daily holding periods. 

The next example explains how the total return is computed when a cash flow happens during the holding period. There are two ways used to combine returns. The first way is to calculate the arithmetic mean by summing the two six-month returns. But this approach does not consider compounding; in the time value of money discussion in Course 3, Investment Instruments, you learned that compounding is the process in which interest is added to the principal and reinvested to generate its own interest. The second way is to calculate the geometric mean, which does consider compounding and is the preferable option.  

Example: Calculation of a Fund’s Return When There Is a Contribution 


Suppose that the fund from the prior example had received one investor cash contribution of USD5 million at the close of business on 30 June. No additional cash inflows or outflows happened in the time. The holding time of one year can be broken into two periods of six months. The overall return is computed as follows:

First, compute the six-month total return for the period from 1 January to 30 June, before the additional contribution.  

Next, compute the six-month total return for the period from 1 July to 31 December, including the cash influx of USD5 million that raised the value of the fund on 30 June. 

Finally, calculate the annual total return by adding the two six-month total returns.

There is one more piece of information required to determine the return over each of these two six-month periods: the valuation of the fund on 30 June immediately before the intake of USD5 million.

Date Fund’s Value
1 January.         $100 million 
30 June            $98 million
 31 December.  $110 million

The overall return during the first six months (1 January to 30 June) is computed as follows: 

​On 30 June, the fund’s worth is USD98 million, a fall in value of USD2 million from the 1 January fund value. But on this date, the fund receives a cash inflow of USD5 million. Therefore, at the commencement of the second holding period on 1 July, the fund has a value of USD103 million ($98 million + $5 million). On 31 December, the fund has a value of USD110 million. Thus, the total return for the second six-month period (1 July to 31 December) is determined as follows: 

​The fund’s investors may prefer to know the return achieved by the fund throughout the full calendar year rather than during each six-month period. Using our present example, the fund return was –2.0% for the first six months and 6.8% for the last six months. The fund’s compounded return for the year is computed as follows: 

Fund return = [(1 – 2.0%) × (1 + 6.8%)] – 1 = 0.0466 = 4.66%

The fund achieved an annual total return of 4.66% between 1 January and 31 December.  

Returns determined in the way shown in the above example are known as time-weighted rates of returns. The time-weighted rate of return computation separates the entire measurement period (e.g., one year) into sub-periods reflecting one month, week, or day of that year. The timing of each individual cash flow specifies the sub-periods to employ for calculating sub-period total returns. Each sub-period has its own independent rate of return. These sub-period returns are then utilized to compute the return for the total period. By computing total returns in this manner, investor cash inflows and outflows do not skew the assessment and reporting of a fund’s investment performance. 

To compare the performance of one fund from one year with the next year or to compare the performance of one fund with another fund necessitates that returns be measured on a consistent basis over time and across funds.

In 1999, a set of voluntary investment performance criteria — the Global Investment Performance criteria (GIPS®) — was proposed for this purpose. Investment management firms around the globe have accepted the GIPS standards, and organisations in more than 40 markets sponsor and promote the GIPS standards, which were designed by and are maintained by CFA Institute. In most circumstances, the GIPS guidelines demand the adoption of a time-weighted rate of return technique since time-weighted returns are not skewed by cash inflows and outflows.