ESG (environmental, social, governance) investing has evolved considerably over the last two decades, from simple stock-exclusion strategies to more specialized thematic, engagement and impact-oriented solutions. Despite this strategic evolution, we believe that ESG investing is still in its relative infancy. There is no agreed-upon “best approach.” Investors have very different goals for their ESG portfolios. Going forward, we anticipate increased interest in a core-satellite framework, which would encourage investors to pair complementary ESG strategies to achieve their overall ESG investment goals.
In the core-satellite approach, a core manager such as QMA could contribute controlled ESG exposure with risk control and stable performance. A satellite, or specialist, manager could then focus on providing a positive impact with more variable performance. Such a combination in an investor's portfolio would be more likely to deliver comprehensive investment performance and a stronger ESG outcome.
While intuitive, the core-satellite approach has not thus far become a viable framework for ESG investors, due to institutional weakness in core ESG solutions. Three main factors have limited the success of core ESG strategies:
- Core ESG managers traditionally use readily observable attributes to evaluate stock attractiveness from an ESG perspective. We believe that a company's stock price already reflects the benefits of such attributes. Higher valuations, therefore, imply lower expected returns in the future for "good" ESG firms. This is an inherent cost for ESG investors. Another challenge to investors is what we call "ESG window dressing." Companies that look attractive from an ESG perspective may in fact be "bad" companies. Such traps effectively tack on another cost to ESG portfolios. With the addition of these ESG-specific penalties, core ESG portfolios struggle to deliver on their alpha promise.
- There is a sparsity of data in the ESG space. With limited data, it is impossible to evaluate the stock universe properly. Lack of ESG insights presents a challenge to achieving strong ESG exposures — the portfolio will likely be ESG in name only.
- Third, poor integration of ESG insights can drag on a core ESG portfolio's performance. Such unsophisticated approaches can result in unintended portfolio exposures, including the avoidance of whole sectors or industries. This represents yet another added cost, either through weaker excess returns or higher tracking error for ESG investors.
QMA has developed quantitative solutions to solve the challenges that have plagued core ESG strategies from the beginning: evaluating ESG attributes, expanding ESG insights and integrating insights into portfolios. This allows QMA to build core ESG portfolios capable of delivering relatively stable outperformance with an active ESG tilt.
- EVALUATE: We use a refined approach to evaluating ESG attributes. QMA includes primarily industry-specific, financially relevant and material attributes in our evaluation process. This helps us identify attributes that have more likely been undervalued by the market. In addition, we use a combination of effort, effect and controversy-based ESG metrics, which helps us avoid window dressing. Our methodology ultimately produces an alpha-neutral evaluation: an ESG-specific portfolio characteristic without a cost.
- EXPAND: We look to statistical techniques and natural language processing (NLP) to overcome limited data. Our statistical procedure utilizes a proprietary data completion technique to proxy carbon emission data, based on known return patterns and risk factors. In addition, NLP is an area of current research for the firm. By drawing on NLP techniques, we delve into information sources beyond those directly disclosed by the company. We take care to minimize false positives in the statistical techniques we use to infer a firm's ESG status. Language from conference calls and other unstructured data can help quantify material ESG issues. Both of these methods can produce valuable insights and significantly expand ESG evaluations.
- INTEGRATE: To avoid implementation-related performance drag, we use a substitution methodology. Our process integrates ESG insights while ensuring that existing alpha factor exposures remain unchanged. As illustrated below, we are agnostic if two stocks are comparable from an alpha perspective. If stock A has more attractive ESG attributes, we can easily substitute it into the portfolio and sell off stock B. When this process is replicated for the available universe, the end result is an ESG portfolio with the same alpha expectations, which also avoids the worst ESG offenders.
Our goal is to produce a more effective core ESG portfolio where the alpha and tracking error are in line with a standard core portfolio. From an alpha perspective, this is both gross and net of fees. This means that a core ESG portfolio is not more expensive for an investor. In fact, keeping with the spirit of ESG and good corporate governance, the alignment of interests between investors and investment managers is important. We embrace performance-based fees on our ESG strategies. This reflects the confidence we have that our core ESG solutions are capable of meeting performance and ESG expectations.
NOTES TO DISCLOSURE
For Professional Investors only. All investments involve risk, including the possible loss of capital.
Issued by PGIM Limited. Registered office: Grand Buildings, 1-3 Strand, Trafalgar Square, London, WC2N 5HR. PGIM Limited is authorized and regulated by the Financial Conduct Authority (FCA registration number 193418), and duly passported in various jurisdictions in the European Economic Area. Prudential Financial, Inc. (‘PFI') of the United States is not affiliated with Prudential plc, which is headquartered in the United Kingdom.
The comments, opinions and estimates contained herein are based on and/or derived from publicly available information from sources that QMA believes to be reliable. We do not guarantee the accuracy of such sources of information and have no obligation to provide updates or changes to these materials. This material is for informational purposes and sets forth our views as of the date of this presentation. The underlying assumptions and our views are subject to change.
Past performance is not a guarantee or reliable indicator or future results.
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