With the COP26 conference concluding as I write this, I thought it might be an opportune time to highlight some of our thinking on “sustainability” and how it is used in the Active Quantitative Equity (AQE) team’s investment process, as well as to share some current observations about the signals and themes that markets are rewarding in the current environment.
When AQE evaluates companies on one of the core themes1 that we deem most important – Quality – environmental, social, and governance (ESG) characteristics form a meaningful part of our evaluation. This is because we believe that select ESG characteristics can be considered a proxy for long-term forward planning and thinking in companies, and can signal a different kind of resilience from that which is found on financial statements.
The kinds of ESG characteristics that we take into account are generally those that would be considered material for the future financial performance of a company. Examples would include: green buildings for real estate; animal treatment policies for consumer apparel, cosmetics, or food; and bribery and corruption policies for financials.
Using these characteristics, we create sustainability scores for the companies we are evaluating and use those scores to complement our other Quality metrics, which in many (but not all) cases are gleaned from financial data. We began using sustainability in our investment process in 2013 (focusing on governance, to start with) and broadened our approach to create our current sustainability signal in 2018.
When tracked as a standalone signal, sustainability delivers very strong results, both over the last year and the last three years. In fact, over the last three years, when compared with our core themes (Value, Sentiment, and Quality), sustainability delivered the highest return and had the lowest volatility. So far in 2021, sustainability has had the second-highest return and the highest risk-adjusted return. See Figure 1.
We don’t think so. In fact, our sustainability signal is positively correlated with our Value theme, which means that sustainable companies are more likely to be cheaper on our measures. Within the developed market universe, companies in the top quintile of our sustainability scoring are, on average, within the top 40% of our Value scoring. Companies in the worst quintile of our sustainability scoring are, on average, in the bottom 40% of our Value scoring (i.e., they are more expensive).
While many of AQE’s preferred segments (i.e., those with the highest expected returns) also have good sustainability scores, there are market segments with great sustainability scores that we don’t currently find attractive, for example, European telecoms, utilities, and real estate companies. Also, within our preferred segments there are pockets where sustainability is only average, for example, North America and APAC energy and tech stocks. See Figure 2.
The sustainability signal clearly captures something different from the measures of Quality that we derive from financial data. Over the last three years, the correlation of the monthly returns of our sustainability signal2 with those of our broader Quality theme has been relatively low, measuring 0.2. Sustainability is a valuable characteristic to track, along with many other others. It doesn’t dominate, but it has performed solidly and with lower variability than other signals in recent years.
1Value, Quality, and Sentiment are the core themes we deem most important.
2Measured as quintile spread returns within the developed market universe.
The information provided does not constitute investment advice and it should not be relied on as such. It should not be considered solicitation to buy or an offer to sell a security. It does not take into account any investor’s particular investment objectives, strategies, tax status or investment horizon. You should consult your tax and financial advisor. All information is from SSGA unless otherwise noted and has been obtained from sources believed to be reliable, but its accuracy is not guaranteed. There is no representation or warranty as to the current accuracy, reliability or completeness of, nor liability for, decisions based on such information and it should not be relied on as such.
The views expressed are the views of Active Quantitative Equity through November 8, 2021, and are subject to change based on market and other conditions. This document contains certain statements that may be deemed forward-looking statements. Please note that any such statements are not guarantees of any future performance and actual results or developments may differ materially from those projected.
Investing involves risk including the risk of loss of principal. Quantitative investing assumes that future performance of a security relative to other securities may be predicted based on historical economic and financial factors, however, any errors in a model used might not be detected until the fund has sustained a loss or reduced performance related to such errors.
The returns on a portfolio of securities which exclude companies that do not meet the portfolio's specified ESG criteria may trail the returns on a portfolio of securities which include such companies. A portfolio's ESG criteria may result in the portfolio investing in industry sectors or securities which underperform the market as a whole.
Investing in foreign domiciled securities may involve risk of capital loss from unfavorable fluctuation in currency values, withholding taxes, from differences in generally accepted accounting principles or from economic or political instability in other nations.
Investments in emerging or developing markets may be more volatile and less liquid than investing in developed markets and may involve exposure to economic structures that are generally less diverse and mature and to political systems which have less stability than those of more developed countries.
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Tracking Code: 3907241.1.1.GBL.RTL
Exp. Date: 11/30/2022