Case study by Calvert Investments
The smart beta process
In order to support a variety of investment strategies that incorporate ESG standards, we conduct research in a manner that allows the output to be used to comprehensively score certain segments of the capital markets (equity and debt) relative to ESG criteria. This enables us to develop a high-quality ESG smart beta investment process and to integrate ESG research into the traditional investment decision-making process.
Our process has four building blocks:
Firm and portfolio-level attributes
Smart beta strategies seek corporate attributes that have consistent positive performance impact across all firms sharing these attributes, as opposed to focusing on the large outperformance opportunities of a few individual firms, as some active strategies do. Smart beta generally searches for small positive moves by the dozens, if not hundreds, that when combined together can result in better, more effective overall portfolio performance. Hence, our smart beta investment process assesses attributes at the individual firm level, and understands in detail whether these firms represent the right combination of companies at the portfolio level.
Data quality and independence
Since smart beta requires firms to be assessed on the same attributes, it is crucial to systematically source high-quality, independent data.
Financial data science
Understanding how ESG attributes affect the risk-adjusted return of investment portfolios involves not just how any factor impacts a portfolio’s return variation, but also the hierarchy between the drivers (e.g. is the return variation of this equity portfolio driven more by value characteristics or corporate governance attributes?).
Scouting for disruptive data
Continuously scouting for new sources of data indicating risks and opportunities, and other technology breakthroughs, enhances the process. Any investment process that considers itself complete is at risk of losing out to someone able to capitalise on new opportunities.
This differs from a classic asset management process, where teams and research are usually separated by asset class, instead centring the process around and starting it with research in financially material ESG signals, which is shared with all asset class teams and applied to those that appear to have the highest probability of creating positive outcomes at low risk (figure 1).
Constructing the index
Based on the above process, our Calvert Water Research Index is constructed by:
- selecting constituents from water supply sectors;
- identifying companies operating in water-intensive industries or innovative water solutions providers.
To initially select index constituents from three water supply sectors (utilities, infrastructure and technology), we started with a universe of 30,000 publicly listed companies, which was filtered based on market capitalisation, float-adjusted market capitalisation and 20-day average trading volume to a long list of about 6,000 securities. This was reviewed to create a short list of firms with more than 30% total revenue or earnings derived from water-related business activities.
To select innovative water solution providers, we use our proprietary research system to identify financially material indicators of water efficiency and water impact among firms in sectors with high water intensity, such as food products, paper or semiconductors, and include organisations that offer particularly innovative solutions to the global water challenge, as defined by the United Nations Sustainable Development Goals.
To diversify the index, specialised water products and water supply sectors are weighted by a modified market capitalisation, with each of the three sectors receiving a quarter of the overall index weight. Water solution providers are equally weighted to represent the fourth quarter of the overall index. The index itself is rebalanced quarterly and reconstituted annually within a 5% maximum weight per security and a 20% maximum aggregated weight for emerging markets.
Download the full report
A practical guide to ESG integration for equity investing