The PRI recently conducted a study based on portfolio analytics and ESG data provided by MSCI ESG Research to evaluate the efficacy of optimal mean-variance equities portfolios optimized with assets that had improving ESG scores (momentum strategy) versus high absolute ESG scores (tilt strategy) across the world and geographic regions, including the US, Europe and Japan. The PRI analysed relative performance in active cumulative equity returns over a 10-year period from these portfolios in which diversification constraints were applied against their respective geographic benchmarks. The study effectively tested ESG materiality in equities as a proxy for future returns by strategy and region. Below is a summary of the study’s highlights and implications.
Global results demonstrate ESG efficacy of both momentum and tilt strategies in ESG investing
ESG information offers an alpha advantage in the construction of optimal mean-variance equities portfolios across all regions, based on observed historical meaningful outperformance in active cumulative returns versus respective geographic benchmarks. The world, the US and Japan portfolios benefitted more from the ESG momentum strategy (optimized with year-over-year improvement in ESG scores as a proxy for future returns), as reflected in higher annualized information ratios relative to the ESG tilt strategy. Conversely, the Europe portfolio benefited more from the ESG tilt strategy (optimized with average absolute ESG scores as a proxy for future returns), as reflected in a doubled information ratio of 1.0 relative to the ESG momentum strategy. This observation could suggest that companies in Europe have reached their optimal levels of ESG performance faster compared to the rest of the world, while companies in the US stand to benefit from an upward trend in ESG scores, as illustrated by a momentum strategy.
|ESG momentum||ESG tilt|
In the world portfolio, the ESG momentum and tilt strategies outperformed the MSCI World Index by 16.8% and 11.2% in active cumulative returns respectively over a 10-year period (Figure 1). The ESG momentum strategy in particular showed a stronger alpha advantage with a higher active return on a cumulative and annualized basis given the same level of active risk, as well as an almost doubled information ratio of 0.72, compared to the ESG tilt strategy (Table 1). The main source of active outperformance was attributed to style and specific factors, in both ESG momentum and tilt strategies. The style factor reflects security selection (with respect to fundamental stock characteristics such as size, price and momentum) while the specific factor reflects idiosyncratic risk and return. The largest source of outperformance in the momentum versus tilt strategy came from the specific factor which had a 1.05% versus 0.23% return, respectively. Table 2 shows the active factor-based risk and return attribution of both strategies.
|ESG momentum||ESG tilt|
|Active return, annualized||1.75%||1.06%|
|Active risk, annualized||2.45%||2.45%|
|Active cumulative return||16.82%||11.23%|
|Average number of assets||215||136|
|Average number of assets, Benchmark||1677||1677|
|Average ESG score||6.8||9.8|
|Average ESG score, Benchmark||5.7||5.7|
Results demonstrate ESG efficacy of momentum strategy in equities investing
The US portfolio benefited from the ESG momentum strategy (optimized with year-over-year improvement in ESG scores as a proxy for future returns), as reflected in an information ratio of 0.69 compared to -0.06 in the ESG tilt strategy (optimized with absolute ESG scores as a proxy for future returns), which conversely did not offer an advantage. The ESG momentum strategy outperformed the MSCI US Index by 18.8% while the ESG tilt strategy underperformed the benchmark by 1.6% in active cumulative returns over a 10-year period (Figure 2).
The ESG momentum strategy showed strong efficacy with strong positive active return on a cumulative and annualized basis given a slightly higher level of active risk, as well as a higher information ratio (by a factor of 11) compared to the ESG tilt strategy (Table 3). The main source of active outperformance in the ESG momentum strategy was attributed to style, industry and specific factors, while the biggest contributor to active underperformance in the ESG tilt strategy was the specific factor. The style and industry factor reflects security and sector selection (with respect to fundamental stock characteristics such as size, price and momentum), while the specific factor reflects idiosyncratic risk and return. Table 4 shows the active factor-based risk and return attribution of both strategies.
|Active return, annualized||1.97%||-0.15%|
|Active risk, annualized 2.84% 2.55%||2.84%||2.55%|
|Active Cumulative return||18.84%||-1.63%|
|Average number of assets||138||87|
|Average number of assets, Benchmark||611||611|
|Average ESG score||6.0||9.0|
|Average ESG score, Benchmark||5.0||5.0|
Portfolio modeling parameters
Below we summarize the parameters used in constructing the mean-variance portfolios for both ESG momentum and tilt strategies.
- ESG ratings: The PRI used MSCI’s ESG Ratings6 system, which ranks companies on a scale of one to 10 (where 10 is the highest score), based on their exposure to industry-specific ESG risks and their ability to manage those risks relative to peers.
- ESG momentum versus tilt strategy company scores: The ESG score for the momentum strategy is a measure of the difference between a company’s ESG score today and in the prior year. The ESG score for the tilt strategy is a point-in-time measure of the company’s absolute ESG score.
- Portfolio limits: Diversification constraints were applied to the portfolios, including maximum turnover of 8% per month, maximum stock weight of 5%, individual active stock weights between -2% and +2% of the parent index, as well as country allocation between -5% and +5% of the parent index. Portfolios were rebalanced monthly.
- Data period: The data period for the ESG momentum strategy was from January 2008 to the middle of 2017 and for the ESG tilt strategy from January 2007 to the middle of 2017.
- Parent indexes: The parent indexes used to benchmark the regional and single country portfolios were the MSCI World, MSCI USA and MSCI Japan indexes.
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