Integration of ESG into the Active Quantitative Equity Investment Process

The Active Quantitative Equity (AQE) team’s approach to ESG integration is based on the belief that material environmental, social, and governance risks and opportunities can impact the long-term performance of companies.

As active managers, we believe that taking a nuanced view of companies’ treatment of their key material ESG risks and opportunities provides insight into management and company quality, and can be a driver of relative stock returns over a medium- to long-term investment horizon. Our approach to the integration of ESG considerations relies on the concept of financial materiality as a driver of returns. Depending on a company’s industry and business lines, various environmental, social and governance issues take on different levels of relevance in determining long-term returns and risks.

The Development of Our ESG Signal

In 2017, AQE launched a research project to enhance and broaden our usage of ESG factors in the investment process, with the development of an innovative, materiality-based ESG signal to be embedded within our alpha model. We viewed ESG factors as an alternative, non-traditional quality signal capturing difficult-to-measure corporate characteristics, which would be diversifying relative to more traditional measures of financial quality.

In our original approach, the AQE team developed two proprietary ESG materiality maps. The first map identified the key issues within each of the environmental, social, and governance areas for each respective industry. The second map defined the relative importance of “E,” “S,” and “G” considerations for different industries.

These materiality maps were created by AQE sector experts in consultation with both internal and external ESG resources, based on extensive research, in addition to knowledge and intuition based on years of investment experience. The resulting ESG signal was implemented within the returns model for all AQE strategies in March 2018.

Since we introduced our proprietary ESG signal, the landscape in ESG investing and disclosure has evolved quickly (see Figure 1). One of the key changes in the industry took place in November 2018: the launch of the Sustainability Accounting Standards Board’s (SASB) industry-specific reporting standards. Since then, investor and company adoption of SASB standards has rapidly increased, broadening their appeal as a point of alignment with respect to financial materiality.

With this in mind, we embarked on a research project to re-evaluate how we integrate ESG into our alpha model. Our aim was to adhere to our alpha-generating objective but also to adopt the SASB financial materiality map within a returns-seeking framework.

Figure 1
Development Timeline for State Street’s ESG Signal
 

An additional benefit of adopting this framework is the ability to utilize the data framework and infrastructure underpinning State Street Global Advisors’ R-Factor™ ESG scoring system. Our R-Factor scores also help to guide portfolio-company engagement by State Street’s Asset Stewardship team, bringing AQE’s ESG investment process into even closer alignment with our asset stewardship and voting program.

The use of the expansive, company-wide ESG data framework platform enables us to leverage the multiple ESG data sources available through this infrastructure; the original AQE approach employed only one external data provider. Drawing on this ESG data framework platform also increases the breadth of our signal by increasing the number of companies for which we have ESG scores.

While we embrace the benefits and scale of the SASB framework and the ESG data infrastructure, AQE’s primary objective with respect to ESG – as with any investment idea – is to extract active return information from ESG-related considerations. Building a good alpha model is, of course, different from building a good, transparent ESG scoring system. Within our research process we have selectively adapted the raw data and framework to reflect our alpha modeling perspective,accounting for features such as comparability, breadth, weighting, treatment of data items, and outliers, all of which are necessary to effectively forecast returns.

ESG Integration in Practice: Case Study

Our ESG signal’s scores are combined with other measures of company and management quality and blended with other sources of future returns, such as valuation metrics and measures of investor sentiment, to calculate expected returns for every stock in our investable universe. As such, we do not use ESG to screen companies out of our universe. Instead, as active managers, we systematically assess ESG alongside other return and risk drivers when selecting stocks and constructing portfolios.

As an example of how ESG metrics, other return measures, and asset stewardship integrate within the investment process, let us consider the Consumer Staples sector, where AQE (in aggregate) has a sizeable overweight position. The majority of AQE’s holdings within the Consumer Staples sector are in companies with higher ESG scores according to our ESG signal, as shown in Figure 2. More than 40% of our aggregate holdings are in the top 20% of ESG scores; however, we do hold positions in some companies with room for improvement in environmental, social, and governance policies and practices, which score lower on our signal.

Figure 2
Consumer Staples Holdings in ESG-Score Quintiles

Percentage of AQE’s Total Holdings in Each Quintile

To drill down further, Figure 3 displays AQE’s expectation for returns (excluding any ESG measures), ESG assessment, and the outcome across AQE’s portfolios for three anonymized companies within this sector.

Figure 3
AQE’s Expectation for Returns, ESG Assessment, and Outcome Across Portfolios for Three Consumer Staples Firms
 

It is to be expected that Company A, which looks attractive on all measures, ended up as a large overweight position. It also makes sense that we did not choose to hold Company C, because it registers poor ESG scores and a low expected return based on non-ESG measures. The smaller underweight position in Company B, however, warrants further investigation.

The SASB industry-specific reporting standards framework comprises 26 General Issues, grouped in five Dimensions. We can drill down into the three companies’ scores across these Dimensions through our data providers; these feed into AQE’s ESG signal. Figure 4 shows the average rank out of 100 of each company across the General Issues within each of these five dimensions, with 100 being the best company within the sector.

Figure 4
Average Scores Across the Five Dimensions Within the SASB Framework for Three Stocks

Average Rank Out of 100
 

As we see in Figure 4, there are differences in scores across the five dimensions for Company A and B, but the final scores are comparable, and significantly better than the score for Company C. Company A’s ESG scores align with our overall view of the attractiveness of the company as an investment, so it makes sense that we included it in our portfolios. Company B’s non-ESG returns were not expected to be as good as those of Company A; we held Company B in our portfolios, but in an underweight position. Company C, which scored poorly on both ESG and non-ESG metrics, was not held in our portfolios.

For those companies we hold that rank relatively poorly on ESG metrics, State Street’s Asset Stewardship program of engagement and voting, which derives substantial influence from the size and scope of State Street’s holdings, adds significant value to our investment process. The Asset Stewardship team has engaged with Company B several times, for example, where the company scored relatively poorly on measures such as Environmental Management and Water Management, as well as governance and shareholder rights issues.

During the time that we have been integrating AQE’s ESG scores in our investment process, the Asset Stewardship team has engaged with 31 of the companies that rank poorly on these scores within the Consumer Staples sector alone. Such ongoing engagement with portfolio companies can have a long-term impact in improving ESG practices. We expect that asset stewardship activities will continue to generate improvement in ESG measures and drive better returns over the long term.

Closing Thoughts

A robust, financial materiality-based approach to ESG integration has enabled the AQE team to tap into a new, uncorrelated measure of company quality to boost active returns for our clients. Our upgraded ESG signal aligns with our existing integration philosophy, while embracing SASB materiality standards and State Street’s world-class ESG data and infrastructure. This enables the AQE team to increase the breadth of its data sources, increase signal breadth, and foster deeper collaboration and knowledge sharing.

We believe aligning ESG integration within the active investment process, with a broad and robust asset stewardship and company engagement program, can promote long-term sustainable returns, and higher active returns, for our clients.