Adding Value and Expressing Values

In every issue, Undiscovered Manager profiles a noteworthy strategy that hasn’t yet been rated by Morningstar Research Services’ manager research group.

It’s a foreign-stock fund with a portfolio built by one of the biggest and most well-regarded money management firms in the world. It invests in companies on the cutting edge of technologies and industries that aim to solve some of the world’s biggest problems. It has consistently outperformed both the MSCI EAFE Index and most other funds in its Morningstar Category over the past decade.

You might think investors would be flocking to Domini Impact International Equity Fund DOMIX, given its strong track record and pedigree. But the 11-year-old offering from sustainable investing pioneer Domini Impact Investments, subadvised by venerable Wellington Management, is still flying largely under the radar with $1.1 billion in assets. That’s perhaps because environmental, social, and governance, or ESG, investment strategies have been pigeonholed as niche products.

Investor interest is increasing, and so is the number of such offerings available. However, most firms offering ESG strategies do the environmental, social, and governance screening and the investment analysis under the same roof. This fund is guided by a partnership that marries two sets of expertise. Domini handles the sustainable investing side of the ledger, screening for companies that have a positive social and environmental impact. Wellington’s quantitative investment group whittles that list down to a portfolio of roughly 160 stocks that its models suggest will outperform the market.

Domini’s method makes sense to Jon Hale, director of sustainability research at Morningstar. “It’s a much better choice than hiring their own manager in-house and allows Domini to focus on the things it is truly expert in, which is ESG evaluation of companies and fixedincome issuers, corporate engagement, and impact assessment,” Hale says.

At the Forefront That's how Carole Laible, Domini's chief executive officer, sees it: "It's coupling together very robust ESG analysis with strong financial analysis." Laible, who played a key role in the launch of the International Equity fund, joined Domini Impact Investments at its inception in 1997. Laible had established a career in the traditional mutual fund industry when she realized she wanted to work for more than money, wanted to connect investing with a higher purpose.

That led her to Domini. Firm founder Amy Domini had been at the forefront of ESG investing since 1984, when she wrote the book Ethical Investing. In 1989, she created the Domini 400 Social Index, along with Peter Kinder and Steve Lydenberg, and a year later launched an index fund to track the benchmark. (That index fund was the passive precursor of the actively managed Domini Impact Equity Fund DSEFX, also subadvised by Wellington, as is the third fund in the series, Domini Impact Bond Fund DSBFX.) Today, the firm manages $2 billion out of a loft in Manhattan’s Soho neighborhood, but will soon relocate to a larger space in the financial district.

Advisor Kathy Leonard of the Leonard-McDevitt Sustainable Investment Group, associated with UBS, has specialized in ESG investing since 1983. She says that Domini Impact International Equity gives her clients “an impact bang for their buck” because the firm not only does social screening, but is an active advocate in regular dialogue with companies: “When you get a publicly traded company to make changes, that has a huge footprint.”

Leonard notes that the fund is also easy to work into an asset allocation plan, as it doesn’t hold U.S. stocks, and its diversified portfolio is suitable for a wide variety of clients. “Some other ESG funds have themes such as ‘energy’ or ‘water’ that we or a client might want exposure to. But from an investment perspective, this fund is a nice base, and we can add to it tactically, whether with themes or with emergingmarkets exposure.”

Finding ESG Leaders The firm's 11 research professionals research ESG issues, set the firm's impact standards, and decide which stocks are eligible or ineligible for the list of potential investments that gets sent monthly to Wellington. For the international fund, Domini begins with an investment universe of roughly 1,500 large and midsized stocks, primarily in Europe and the Asia-Pacific region.

The firm’s impact investment standards can be broken down into two main focuses. There’s ecological sustainability, with a particular emphasis on climate change mitigation and adaptation. Then there’s what they call “universal human dignity,” which encompasses justice and fairness in dealing not only with the world at large, but also what they call “partners in business,” which includes employees and shareholders, as well as suppliers.

Some 200 businesses are deemed fundamentally misaligned with Domini’s standards and are thus ineligible for investment from the get-go. That includes alcohol and tobacco companies, nuclear power, weapons, coal miners, and fossil fuel owners and producers. That’s just the starting point, though.

“We’re not just looking to avoid negative companies, but in fact, we’re using these standards to find positive companies,” says Laible. Company analysis starts with assessing how closely a company’s core business aligns with Domini’s two goals. At one level, adding an ESG layer into an investment process isn’t much different than a fund manager using more common subjective criteria, such as quality of a management team. But with many specific variables at work across different industries, and many investors unfamiliar with ESG investing, Laible says the question they most often get is, “How are you doing this?”

Sometimes the process may appear obvious, as with a recent investment in German solar equipment manufacturer, SMA Solar Technology SMTGF. But with concerns about climate change at the forefront of Domini’s goals, some investors might be surprised to see Nissan Motor NSANY in the fund. (It was the fourth largest position at the end of August.)

“There is a balance between societal needs and sustainability,” Laible says. In most places around the world, people need cars to be able to work or shop. From there it becomes a matter of the automaker’s environmental impact.

Tessie Petion, a lead research analyst at the firm, notes that Nissan makes the cut for the eligible stocks list in large part because of the fuel efficiency of its fleet. So did BMW BME, she says, which is now on the eligible stocks list and was in the portfolio as of the end of August. Like many luxury car manufacturers, the company traditionally wasn’t focused on fuel efficiency but in recent years has made it a focus. “It was only at that point that they were eligible.”

Another aspect of the research assesses how companies respond to controversies. Top-10 holding Compagnie de Saint-Gobain SGO, a French cement and glass-making industrial conglomerate, was enmeshed in a water-pollution scandal in upstate New York originating from the manufacture of Teflon. For Domini, the question was how the company handled the response, Petion says: “How did they react when the contamination appeared, what did they do to try and mitigate it, were they combative or were they supportive?” In the end, Domini decided that Saint-Gobain’s response was sufficient to keep the company on the eligible securities list.

For some companies, the impact analysis ends up being largely neutral, which still allows them a place on the eligible securities list. Altogether, at midyear, there were just north of 800 stocks on the potential buy list sent to Wellington.

At that point, the investment analysis stage of the process kicks in. This division of labor insulates the ESG research from potential pressure to greenlight companies for the eligible list just because they might be a hot stock. “I’m making a decision based on whether or not a company is sustainable and meets our goals,” says Petion, “not whether or not I think it will outperform.”

Picking the Winners David Elliott, co-director of quantitative investments at Boston-based Wellington, has overseen this portfolio since 2009. He notes that Wellington will occasionally provide feedback to Domini on potential areas of the market where it thinks it doesn't have large numbers of stocks to pick from. But for the most part, "contact is limited," says Elliott. "It allows each team to do what it does best."

Wellington’s job is to apply a multifactor set of models that employs dozens of metrics to help predict which stocks will outperform. Part of the process for developing the models includes an effort to understand why certain factors work, including the biases introduced by human behavior.

While the models are complex, Elliott says there are three main pillars: momentum, value, and quality. “These three are very different animals, so you get a great diversification benefit. We provide a smoother ride to fund shareholders by combining factors, rather than just being value or momentum investors. You might have higher highs using a single theme, but you’d also have to endure very difficult stretches [when that one factor is out of favor].”

Elliott says that applying a quant process to Domini’s list of eligible stocks isn’t much different than applying it to, say, a list of stocks selected by market capitalization. In this case, though, there is a potential for portfolio tilts caused by industry representation in Domini’s eligible list— such as the exclusion of fossil fuel producers. Wellington uses risk models to identify stocks with similar characteristics, thus mitigating tracking error against the MSCI EAFE.

The fund’s performance has indeed been highly correlated with that of the MSCI EAFE index, and it has also been competitive despite expenses that rank as High within the fund’s Morningstar fee level group. Since the fund’s inception in late 2006 through October, the investor shares have returned an annualized 2.4%, compared with 2.6% for the benchmark. Over the trailing five years, the fund has shown a pronounced outperformance of 11.0%, versus 8.5%.

Adding Value The portfolio hovers on the border between large-value and large-blend, and the fund is currently placed within the foreign large-value Morningstar Category. Its returns have beaten more than 95% of these competitors for the trailing three and five years through October, and 85% of those peers for the past decade. The fund also looks strong against the large-blend category, with a 1.6% 10-year annualized return, compared with 1.0% for the foreign large-blend category.

The fund’s average weighted market cap of $15 billion is less than half that of its benchmark or average peer, both of which have much less exposure to small- and mid-cap stocks. That may partly account for its outperformance, as smaller-cap foreign stocks have generally outperformed larger caps over the past decade. That said, the fund has not been unduly volatile compared with large-cap peers: Over shorter- and longer-term periods, its standard deviation has been on par with the norm, and its 5-star Morningstar Rating at the end of October stems from high returns within its category paired with average Morningstar risk scores.

It’s also clear that Wellington’s models have contributed to the outperformance. The fund is also tracked against a Domini benchmark designed to match the risk and performance characteristics of the MSCI EAFE, but populated by the stocks in Domini’s eligible stock list. “We wanted to help investors understand what the influence [on returns] was from Domini and what the influence was from Wellington,” says Laible.

Through the end of September, the MSCI EAFE NR posted an average annual return of 8.4% over the previous five years. The Domini benchmark returned an annualized 9.9% during that time frame, suggesting Domini’s impact screening added 1.5 percentage points per year of return. The fund itself returned even more, an annualized 10.9% for the investor shares—net of annual expenses that were as high as 1.6% over that time period. That demonstrates the significant excess return added by Wellington.

“We expect Domini will add alpha over the long term and Wellington will add alpha both in the short term and in the long term,” Laible says. “The goal is to meet the needs of socially responsible investors by coupling that positive social and environmental outcome with competitive financial returns.”

Leonard would agree that this goal has been met for her clients. “The fund’s performance has been good, really good,” she notes. “We constantly monitor all funds in the space. The good news is the space is growing, but there are still only a handful of pure, diversified international funds. The others don’t have the same track record—or as strong a presence in advocacy.”

This article originally appeared in the December/January 2018 issue of Morningstar magazine. To learn more about Morningstar magazine, please visit our corporate website.