Case study by AXA Investment Managers
Through our statistical back-tests, we see low correlation between E, S, and G data and traditional stock fundamentals. This offers asset owners the opportunity to invest responsibly without compromising their investment beliefs, taking proper account of the ESG considerations they expect to impact the long-term sustainable performance of companies. Our approach delivers best-inclass ESG integration while leaving traditional financial goals unaffected.
One area in which we have achieved this is our smart beta strategy.
Constructing a smart beta ESG strategy
When constructing our smart beta ESG strategy, we combine the following three key components (see figure 1):
All stocks in the starting universe pass through four filters, covering desired factor exposures (earnings quality and low volatility) and undesirable risks (speculative value and financial distress).
Each filter is awarded a score, all of which are then combined into a single score for each company, allowing filters to interact to improve the portfolio’s expected risk/return profile, in particular by systematically avoiding uncompensated risks.
Portfolio diversification is maintained by applying a proprietary weighting scheme that avoids the high concentration of larger companies seen in marketcapitalisation weighted indices, whilst limiting unrealistic over-exposure to the smallest companies. Our weighting scheme was designed to manage liquidity and capacity better than other weighting schemes.
3: Integrate ESG
We combine our filters, diversification weighting scheme and ESG scores to construct a diverse portfolio with both the targeted risk profile (high earnings quality and lower volatility) and strong ESG credentials.
ESG rules are implemented to exclude companies with the poorest ESG scores, the worst practices within their economic sector, and the most serious controversies, irrespective of their smart beta fundamental properties. Companies with higher ESG scores or those that are among the best in their sector are systematically up-weighted to further enhance the portfolio’s ESG profile.
Our ESG scores are determined by our proprietary ESG analysis framework, comprising six overarching factors to measure and analyse how companies are facing up to longterm societal trends and challenges that we have identified, including resource scarcity, climate change, shifting demographics, regulation, company impact and community expectations.
We select complementary providers of raw ESG scores and combine their data to compute scores for a range of ESG sub-factors. An overall score (ranging from 0 to 10) is calculated as the weighted average of ESG sub-factors. The weights are proprietary, defined contextually based on our fundamental analysis of key ESG issues facing each economic sector. For example, for a retail company, we place a greater emphasis on social considerations (human capital, business behaviour) and focus on aspects such as working conditions (health and safety), employer-employee relationships and career management.
Company A and Company B have the same overall filter score and as their market caps are the same, the same diversification weights. Neither company is worst-in-class in any ESG sub-factor or involved in any controversy, so neither are excluded from the portfolio, but Company B’s overall ESG score is much higher than that of Company A, so its weight is increased. Company C’s overall ESG score is poor, so it does not feature in the final portfolio (see figure 3).
Excluding stocks like Company C can result in rejecting approximately 30% of the starting universe (by market capitalisation). Most of this is reallocated into best in class stocks with strong fundamental profiles, like Company B, doubling the capital allocated to the best ESG companies and resulting in a diversified smart beta ESG portfolio.
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A practical guide to ESG integration for equity investing