Harnessing ESG as an Alpha Source in Active Quantitative Equities
At State Street Global Advisors (SSGA), we engage in environmental, social and governance investing (ESG) across a broad range of asset classes and investment styles. Approaches range from the screening of ESG themes to the full integration of ESG criteria in investment processes employed by our active quantitative equities (AQE) team. Our AQE group views ESG as a source of alpha that could lead to positive portfolio performance over time. In this article, we look at how AQE includes ESG as a measure of quality when evaluating stocks.
Why ESG Matters
In the past, a great company had to be financially sound and operationally excellent. Looking forward, we believe that great — and sustainable — companies must be operationally excellent, financially sound and ESG-proficient. Globally, how to capture the performance potential of ESG is an area of significant attention for asset managers and investors. Our Active Quantitative Equities team has been hard at work on this challenge for years and has developed its own approach to ESG analysis and stock selection.
ESG investing is based on the idea that environmentally efficient, socially responsible and well- overned firms are better positioned to withstand emerging risks and capitalise on new opportunities. This premise rests on the thesis that value creation (or destruction) is influenced by more than financial capital alone, especially longer term. Environmentally efficient firms consume fewer resources and produce less waste than competitors, helping them lower costs and generate higher returns on capital. Social factors have emerged as important proxies for talent and management quality. For example, studies show that firms with greater gender diversity provide strong corporate performance.1 The importance of good governance is as clear as ever, especially in light of recent scandals related to auto emissions, food safety and labour issues that cost firms dearly. Effective, independent boards are a threshold condition for long term value creation and can reduce the likelihood of misconduct, fraud and other ethical breaches that damage shareholder value.
Over the last half century the composition of firm value has shifted dramatically from tangible to intangible assets. Investment theory centered on determining intrinsic value was historically linked to physical assets and book value. The mosaic theory of investing — the idea that all material fundamental data could be pieced together in a mosaic to form an assessment of investment opportunity — now needs further recalibrating to reflect the increasing importance of intangibles and non-traditional factors like ESG that influence value.
The rise of ESG in investment decision making reflects a shifting economic landscape, one in which the greatest global risks facing people, institutions and economies over the next decade may come from threats outside of purely financial categories, such as the various impacts from climate change, including extreme weather events and water crises, as well as the growing risks around cyber security.2 Conventional investment analysis by itself has not adequately examined these non-traditional forces on future returns.