ESG + Quants – A Match Made In Heaven?

Although still relatively niche, investment allocations based on ESG (environmental, social and governance) based motives are growing. While these investments offer investors conscience-based return alongside their monetary gains, there are solid arguments from a portfolio theory perspective to support this shift in allocations – specifically a new source of low correlation alpha to add to investor portfolios.¹

 

ESG Investments – Delivering Alpha

Recent research from BAML provides an indication of how rewarding this segment of investments can be – arguing that based on back-testing, ESG screening in investments would have led to higher returns vs. screening on quality alone over the period of 2005 to 2017. The analysis also demonstrates that ESG investing would have delivered significantly lower correlations with returns driven by fundamental signals like ROE, P/E and Growth.¹

Indiscriminate Return Enhancements

 

In fact, there are gains to be made across the board when it comes to investment style. The  analysis shows for dividend investors, an ESG overlay on a high dividend yield strategy would have enhanced returns by close to 3percent per year over the back-testing period. Equally promising, growth investors would have generated an extra 1.5 percent of return per year if applying a screen for stocks that rank well on ESG combined with strong earnings estimate revisions. Meanwhile, ESG screening added 1.7 percent of returns per year to price momentum strategy returns. Finally, from a value investor perspective adding an ESG factor to a low forward P/E screen would have delivered a further 2 percent per annum of return.¹

So Where (and When) do Quants come in?

ESG strategy allocations have grown rapidly over the past decade, with assets rocketing almost four-fold since 2008 AUM levels of close to $18Mn to nearer $75Mn AUM in 2017. Meanwhile, with assets in quantitative mutual funds and factor-based ETFs growing at a 13% and 30% annualized rate, respectively, since 2012, fundamental factor-based investing has also become an investor favourite in recent years.
With growth predominantly driven by active mutual funds, ESG growth remains subdued in quant fund spaces. The BAML research highlights that the overlap between ESG and quantitative investing remains limited – identifying a maximum crossover for 2017 of 14% between P/E momentum-based investing with ESG, using responses from an Institutional Factor Survey. While ESG only makes up under 1% of total smart beta ETF assets according to Bloomberg. However, although allocations remain low, growth rates are surging with ESG smart beta ETF growth far outpacing any other smart beta category over the last five years – delivering a 5 year CAGR of AUM growth of over 55% from 2012 to 2017.¹

^{Robot Hedge Funds Are Crushing CTAs}

Bridging the Gap

With opportunities on the table how will quants be drawn into the ESG space? The BAML research suggests that activism may be able to bridge the gap between ESG and quant-factor based investment – going as far as to suggest that this trend may already be happening. For example, in January of this year, Jana Partners and the California State Teachers’ Retirement System —collectively owning about $2bn of Apple Inc. shares — publicly called on Apple to better address children’s excessive smartphone usage and its potential impact on their mental health.¹

Perhaps the biggest driver will be the trend of funds increasingly being ranked by investors, both institutional and otherwise, based on a widening range of ESG factors. For example, Finnish pension fund, Varma (allocating over $7bn to hedge funds), have required managers to abide by strict ESG criteria. Further to this, Blackstone recently took a large step towards ESG allocations – requesting hedge funds they invest with to divulge gun investments information. Looking more broadly, activist campaigns targeting Russell 3000 companies’ corporate governance increased by 40% in 2017.¹

^{Passive Investing ETFs Account For 6% Of Market But Active Managers Still Rule}

With attractive rates of enhanced returns to be captured and investor pressure mounting, we can reasonably expect significant, further growth in ESG investments over coming years.¹

Source:
¹Environmental, Social & Governance (ESG), BAML, 20th March 2018