Integration of ESG into the Active Quantitative Equity Investment Process
In Active Quantitative Equity, we view ESG as an alternative, non-traditional quality signal capturing difficult-to-measure corporate characteristics, which are diversifying compared with traditional measures of financial quality.
We have recently upgraded our ESG signal to embrace the benefits and scale of the Sustainability Accounting Standards Board’s reporting framework and State Street Global Advisors’ leading-edge ESG data infrastructure.
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.