Environmental, Social, and Governance (“ESG”) are the prime categories for measuring the sustainability of a company’s practices. They also hold useful, though hard-to-find, insights.
RELEVANCE TO PERFORMANCE
Traditional ESG metrics focus on corporate sustainability, and provide ratings systems that measure a company’s practices or impact.
Such impact-oriented ratings, however, typically don’t integrate performance data. So, they may miss which ESG factors are materially linked to returns.
It is necessary to go deeper, and merge ESG metrics with performance data, to understand ESG’s relevance to both sustainability and returns.
Note: (Click to enlarge.) The chart above shows that, in data measured from 2013-2018, Social factors were the most material to returns, while composite ESG “Total” Scores are nearly immaterial.
REVEALING PATTERNS AND TRENDS
ESG’s relevance to returns is made even more powerful when you can see how the various factors’ impact shifted over time (see the chart below) and begin to understand precisely when each one mattered most. Further machine-driven analysis of the patterns and trends within ESG data reveals key metrics that have predictive qualities. This innovation allows investors to see into the future through the lens of ESG — not only in terms of sustainability, but also performance.
HARNESSING THE POWER OF ESG
Knowing when and how much certain ESG factors affect companies’ market returns is only useful if strategies, based upon those analytics, can then be generated and deliver outperformance. To prove that potential, we constructed a basic portfolio of the Top 10% of companies, ranked by analyzing their alpha-generative ESG factors, from a total US equity universe and ran a multi-year backtest. Results shown below indicate that meaningful outperformance is achievable.
USING ESG TO INVEST LONG & SHORT
While capturing outperformance using ESG factor analysis is certainly achievable going long only (see above), it can also be used to target stocks for shorting. The charts below illustrate that ESG laggards in alpha-generation (the bottom 10%) produce substantially poorer returns, and open a 7.5% return spread between themselves and the leaders.