Shaping the portfolio with an ESG materiality profile

To identify any relationship between environmental, social and governance scores and investment returns, our research team initially conducted detailed due diligence work using scores from several research providers. We found a lack of consistency between vendors, and the results from the back-testing implied that a portfolio ranked directly on such an indicator would not significantly out-perform over historical data.

Given the weak results we decided to take a step back and approach the problem again from the angle of materiality. We researched three to eight key environmental and social issues facing each industrial sector over the next three to five years, e.g. water scarcity in the food and beverage industry, labour rights and the social right to operate in extractive industries and governance and public trust in the banking industry.

Based on these key issues, we then developed a sectorfactor matrix, comprising 30 sectors by 27 factors, for each of the six regions in which we invest, and used our data vendors to fill in the matrix. Once we finished selecting the proxies to use in building our factors, we weighted each factor. We varied the weight of environmental factors by estimating the relative monetary value of all environmental externalities relative to social and governance factors.

In determining the overall ESG score for each firm (“ESG Profile” in figure 1), our ESG-integrated quant model analyses the firm’s ESG data, feeds in the ESG data associated with the key issues for its industry and calculates the corresponding proprietary factors. The sector matrix’s weightings are then applied to the proprietary factors to calculate the ESG Profile.

In terms of determining our investment view of a particular company, the ESG Profile represents our longer-term, “conviction” component. Other alpha sources represent our shorter-term components (up to a couple of weeks’ time) and adjust our portfolio to reflect our tactical views on our universe of stocks.

The below table shows how our ESG Profile is added to other alpha sources, in this case Pattern of Analysts Revisions, Earnings Forecasts, and Mean Reversion, to arrive at our final portfolio and the final position size. Koninklijke DSM, for example, has a 30bps short position in the portfolio. Without the negative Sustainability Profile, held in part due to a larger environmental impact per unit revenue than its peers, the portfolio would have held a long position of about 10bps.