Recognizing ESG’s Power
It is becoming widely accepted that Environmental, Social and Governance issues affect stock returns. Many investors are now looking to do more than express their values through ESG investing – they are looking to improve performance.
At Confluence Analytics, we go even further. We show that ESG-based investing can be used to capture positive alpha from “good” ESG stocks and to reduce risk by identifying stocks that are likely to have negative ESG-related performance.
Initial Considerations
Incorporating ESG (or “sustainability”) principles into asset management in a way that is performance and risk-driven, as well as broad-based and objective (in contrast to active stock-picking), is no easy task. Asset managers and investors must consider the following:
The primary goal(s) of ESG performance-based investing – For example, is the goal to generate the best performance for an acceptable amount of ESG risk at the fund level? Are some industries or companies off-limits? There are numerous possibilities.
How to achieve the goal(s) – This could involve screening out companies or entire sectors, or buying only the “best” or “least bad” companies based on ESG criteria in all sectors, or underweight or even short companies with “bad” ESG scores and overweight “good” companies relative to a benchmark, and so on;
How to weight E, S and G – Are they equally important to performance and risk? How is that determined? If not equal, how should each element be weighted?
Data or metrics to use – How to relate a company’s ESG score or ranking from a given data source to performance? What defines what is “good” or “bad”? What is in the top/bottom half or quartile?
Setting Investment Goals AND Constraints
Clearly, creating a rules-based approach for ESG investing that captures ESG-related performance and risk is a challenge. We use ESG data, analytics and alpha signals to construct unbiased strategies designed to accomplish just that.
We begin with an investable universe, often a total market index. Using our signal of forward-looking, ESG-related excess returns (adjusted for market and sector), we remove stocks with negative readings (the “Laggards” and “Concerns” in the adjacent matrix).
Then, we optimize returns using the remaining constituents (“Leaders” and “Prospects”) based on constraints such as sector weightings. ESG Factor inputs and the alpha signals are updated quarterly, triggering a rebalance.
Optimizing and Streamlining Our Process
As noted before, it is no easy task to incorporate ESG principles into asset management in a way that delivers performance, mitigates risk, and achieves a client’s objectives regarding sustainability. This calls for an approach that is systematic, based on clear signals from sufficient data analysis, and optimized to each individual clients’ values and/or risk profiles. Hence, “custom indices” built using a streamlined, optimizable process are the best way to integrate ESG for investors. Below is a simplified illustration of how Confluence handles its index process.
Risk Mitigation PROMOTES Alpha Generation
Our data, analytics and tools allow investors to achieve ESG objectives without sacrificing performance or taking on hidden risks. To prove this point, we tested our index process numerous times using a variety of constraints – one particular example is shown below:
Takeaway: Confluence shows that ESG investing can both enhance performance and mitigate risk. In fact, we believe that superior performance is more often driven by managing risk than by picking specific “winners”. Our methodology is customizable to various equity universes and strategies that “tilt” ESG signals using bespoke criteria. Contact us to discuss how our optimized approach to ESG investing can meet or exceed your specific goals.