ESG investing – it’s all about the how

ESG is playing an increasingly integral role in discretionary investment managers’ toolkits. However, until recently quant managers haven’t had the data to invest on the basis of ESG factors alone.

While the ‘what’ and ‘why’ of ESG investing are widely accepted, the challenge of how to invest successfully on the basis of ESG remains unclear. CFM’s investment strategies are quant-based and use a scientific approach to financial markets — can ESG factors really contribute to quant-based strategies?

It’s important to understand the shifting sands of ESG investment to be ready and prepared to offer insights into how ESG investment strategies may affect a portfolio.

The idea that returns might suffer when ESG factors are incorporated has been largely debunked among institutional asset holders and investors.

Corporate reporting on these factors still has a way to go, but is improving, and this makes it easier for managers to build ESG factors into their investment processes without negative consequences. But does it follow that incorporating ESG factors will generate alpha?

This is a question which investment managers are increasingly called on to answer when investors request sustainable and responsible investment portfolios.

Investors expect managers to be able to articulate the implications of incorporating ESG into the portfolio, and explain the likely, or probable consequences for the portfolio and what the impact (if any) will be on performance.

These can be difficult questions to answer, made even more so when investors want to understand how ESG factors are incorporated.

Three central tenets of ESG investing

Before we look at how ESG is incorporated, it’s important to start with the three central tenets which govern any discussion of ESG investing: what, why and how.

The ‘what’ covers definitions of what environmental, societal and governance factors are, and the ‘why’ covers why are they important.

There has been much written and agreed about the ‘what’ and the ‘why’ of ESG (although there is still room for improvement in answering the ‘what’). These questions do not need to be re-visited here.

However, the fact that BlackRock CEO, Larry Fink has repeatedly said that sustainability is the key issue for investors points to the fact that ESG considerations are very much at the centre of mainstream investment thinking.

It’s not surprising, as there can be few who will argue that socially responsible investment is a bad thing, that tobacco companies serve a communal purpose, or that the manufacture of land mines contributes to the well-being of society.

So, why is ESG now central to so many investment conversations? I would argue that it has in part been driven by the visible effects of climate change, but also by self-interest in the form of general increased understanding of how sustainability-related factors can affect economic growth, asset values and financial markets generally.

Governments have a critical role in taking significant and bold action into the real economy by implementing carbon taxes, scaling up subsidies for green projects and technologies, and cutting back on fossil fuel subsidies.

This is now a prerequisite for green or green-minded investments and portfolio decarbonisation efforts to deliver financial gains.

Lack of action by governments may translate to the green investing wave as yet another bubble, which may sound unduly pessimistic but there is real risk associated with governments believing the mandatory disclosure regimes they are just starting to impose would be enough to do the job. This would be a very dangerous illusion.

At the investor level, change is being driven by activism, via demands that businesses lower their carbon footprint, and shareholder questions about the promotion of a more dynamic workforce by companies.

This includes at a senior level, being more attuned to social trends and creating a more effective, agile, less ego-driven management culture.

The real challenge: How can quant investors incorporate ESG factors?

If we start from the position that incorporating ESG factors is important — the next challenge to address is how to do that.

Part of the problem is that no one wholly agreed- upon definition of ESG exists – rather it is understood as the incorporation of ESG metrics into the security selection and allocation process.

Broadly speaking, there are seven commonly employed ESG strategies which provide these metrics:

1. Negative/exclusionary screening
   
2. ESG integration
   
3. Corporate engagement
   
4. Norms-based screening
   
5. Positive/best-in-class screening
   
6. Sustainability-themes investing
   
7. Impact/community investing.
   

Implications for quantitative, systematic managers

For quant managers, there are two hurdles:

1. Any proposed trading strategy must pass a minimum statistical threshold.
   
2. The strategy must underpinned by a strong economic rationale.
   

While ESG has always passed the second hurdle, for all the reasons outlined above, it is the first which has created challenges.

To put it bluntly, the overarching problem has been the challenge of pointing to an evidence-based positive connection between moral (in the form of ESG) and financial value.

To do this, a robust analysis of ESG factors is necessary – and therein lies the rub. ESG data has improved over time, however, it is still frequently inconsistent, reported and judged differently, with analysts using competing databases with different methodologies.

Any inconsistency between frameworks and reporting creates challenges for quant investors, who need to compare apples with apples to get meaningful answers.

So it’s this lack of consistent, comparable data that continues to be a significant stumbling block for quantitative investors looking for statistically significant patterns in an ESG-tilted strategy.

A comparison between accounting and environmental impact standards highlights the problem we face very clearly.

In Europe and the US there are accounting standards which everyone agrees to; for example, what constitutes a sale and what is an accrual. These standards are rules-based, and not open to interpretation.

Environmental impact, on the other hand, is not clear cut. There is not yet one universal agreement on what constitutes environmental impact for a given company or industry.

It will take a concerted effort from companies, investors, regulators and political authorities to change this, but happily, there is widespread agreement among the financial industry and non-government organisations that the quality of ESG data should be improved.

A few organisations are making good progress — including the Sustainable Accounting Standards Board (SASB) which helps companies identify climate-related risks, and other policy initiatives exist which are driving an increase in corporate disclosures related to ESG.

Using technology to solve the data challenge

The good news for CFM as a quant-based, scientific investor is that collecting inconsistent or 'dirty' data and scrubbing it clean is our bread and butter.

It’s less good news for discretionary fund managers who may struggle to interpret it. The bad news is that when it comes to ESG there is not enough data.

We simply don’t have sufficient history, and this makes back testing strategies (a central part of our investment process) more difficult, and the answers our data offers up less meaningful. The longer the data set, the more likely it is to yield robust and testable answers.

Our response to this challenge is to use technology to collect, store and analyse vast reams of data from traditional and well as alternative data sets, to use machine learning to identify meaningful ESG factors, and artificial intelligence to listen to the billions of conversations going on in the financial ecosystem and outside it.

Our aim is to judge the materiality of specific factors to the price mechanism – looking long-term into the future and making judgements about which of the ESG themes will drive change and affect value and price the most.

This plays into our investment process because it allows us to make tactical allocations to the ESG factors we know are material and invest systematically based on more than one thematic. In this way, we seek to uncover hitherto unknown trading strategies, and an opportunity to find alpha.

Importantly, challenges do persist for discretionary and quant managers when it comes to incorporating ESG factors into their investment strategies in ways which contribute positively to alpha generation.

The wholesale integration of ESG into a quant-based investment portfolio still has inherent limitations, but there is reason to be optimistic about better standards of disclosure and more consistent data on which to make those decisions.

We remain committed to contributing to continuing developments in the industry, because we believe that armed with the right data, ESG can and will be a future driver of quantitative systematic returns. 

Never miss an insight

Enjoy this wire? Hit the ‘like’ button to let us know. Stay up to date with my content by hitting the ‘follow’ button below and you’ll be notified every time I post a wire.

Not already a Livewire member? Sign up today to get free access to investment ideas and strategies from Australia’s leading investors.