Active Quantitative Equity (AQE)

Companies and investors are increasingly focused on the factors that influence sustainability. We, as investors, are seeking practical and effective ways to incorporate ESG (environmental, social, and governance) considerations into portfolios. Our investment intuition: that ESG could serve as a quality metric that would indicate management’s focus on long-term growth prospects and the company’s exposure to regulatory and public-relations risk.

A 10-person working group with a wide range of investment experience and expertise conducted a thorough analysis of the current data sources, external research, and academic literature on ESG to form a hypothesis: “Behaving in a sustainable way should lead to better long-term performance. Firms that rank poorly on ESG may be more prone to chronic organizational issues and may be more exposed to regulatory risk and to the prospect of public scandals. This, in turn, could adversely affect stock valuations.”

The group determined that tailoring their ESG analysis by industry would provide the greatest insight. The group consulted multiple experts to identify consistent ESG themes across industries. These insights were used to create a proprietary AQE “materiality map,” which identified the relevant ESG-related characteristics, by industry. Before testing the map, the team identified the important lenses through which to view its effectiveness. The time horizon for expected payoff was one such lens: To the extent that the map helped to predict performance, would it do so over, say, the next week? The next year? Longer? The team expected the map to help to predict outcomes over periods longer than one year.

To construct a model based on the AQE materiality map, the team sourced data from well-established, highly-respected vendors, analyzing its quality before making a final decision on data sources. The map was then applied across the different specific ESG indicators to generate ESG scores for every company in the investable universe. The team ran extensive tests using historical data to assess whether the results of the new model were consistent with their hypothesis and expectations. The team also tested the impact of incorporating ESG into our stock-selection model, which is employed by all AQE strategies.

Having demonstrated that inclusion of the ESG signal did, in fact, enhance our stock selection model, the team presented its findings to State Street Global Advisors’ Technical Committee and to its Investment Committee for rigorous evaluation and verification of research protocol. Following this intensive evaluation, the ESG signal was ready to be incorporated into the model. As a result, the team now proactively includes ESG-related information in evaluating the alpha potential of thousands of stocks globally.