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Harnessing the power of ESG risk premia in systematic investing

Jessica Phalafala, Quantitative Analyst, Prescient Investment Management

Socially responsible investing (SRI) has undergone a profound evolution since its origins in colonial America, where religious groups abstained from investing their endowment funds into anything associated with the slave trade. Centuries later, it transformed into mutual funds screening out investments that were directly or indirectly associated with gambling, alcohol and tobacco.

SRI was further used as a tool to express the moral values of institutional investors and their support for historical movements. As a case in point, during the apartheid regime in South Africa, many global mutual funds screened out companies that were engaging in business in the country.

At the dawn of the 21st century came a heightened global awareness of the myriad of acute challenges we face as a planet, ranging from climate change, socio-economic inequalities, and the rise of unjust and exploitative institutions. This heightened the awareness of the need to introduce responsible investing methodologies that were significantly more extensive and far-reaching than the traditional screening approach.

The term Environmental, Social and Governance (ESG) investing was first coined by the United Nations Global Compact in 2004 and involved the systematic integration of these factors into the investment processes of financial institutions. ESG investing has since gathered significant momentum and continues to gain traction in line with the fundamental shift in investor perceptions as they recognise the material impact ESG factors can have on investment returns.

The United Nations-supported Principles for Responsible Investment (UNPRI) were launched in 2006, with just over 60 signatories representing $6.5-trillion in assets under management. Support for the UNPRI has since exploded, and now it has more than 3 000 signatories, representing $103.4-trillion in managed assets, all of whom are committed to integrating ESG factors into their respective investment processes.

This remarkable growth in ESG investing can be ascribed to the growing evidence that ESG-related performance may be a proxy for company productivity and stability, thereby providing an additional source of excess returns. Risk premia strategies have been used for decades in systematic investing as a method for harvesting excess returns.

This is achieved by investing in factors that have been proven academically and in practice to provide the investor with a positive payoff for undertaking the risk associated with each factor. Commonly used risk premia include the value risk premium, which is the excess return derived from companies that are trading at a low-price relative to their fundamental value; the momentum risk premium, which favours stocks that have displayed a sustained positive return trajectory over a given period; and the market risk premium, which is the differential between the market yield and the risk-free rate of return.

These factors have all been proven to yield higher long-term risk-adjusted returns. The overwhelming evidence confirms that using ESG factors in the portfolio construction and security selection process based on factor analysis and risk premia strategies allows investors to yield additional risk-adjusted returns.

The logic that value-creating ESG-related practices contribute to company outperformance upholds the thesis. For instance, a well-managed company that adheres to environmental and social regulations is less likely to face litigation, the higher costs associated with the management and disposal of hazardous waste and elevated employee injury rates.

Therefore, ESG factors may provide better insight into the probability distribution of company returns in the same way as the traditional risk premia incorporated in classical asset pricing frameworks. Also, ESG factors are strong candidates for inclusion in long-term factor investing. They display strong explanatory power over a wide range of securities, offer a positive payoff over reasonably long horizons, have a significantly low correlation with other factors and, above all, they make intuitive and economic sense.

In identifying ESG factors as risk premia, the systematic investor needs to move beyond traditional screening methodologies and policy implementation towards a rules-based, scalable and measurable ESG integration strategy. To do so requires practical, quantifiable metrics  that can be readily integrated into an existing investment process, together with other strategies to construct a well-diversified portfolio.

To this end, we have developed the Prescient ESG Scorecard which is an in-house risk analysis tool designed to evaluate and measure the ESG risks and opportunities associated with the credit and equity counterparties in which we invest. It is a data-driven and systematic scorecard that rates companies relative to their sector-specific peers while accounting for industry materiality and market cap biases. We employ over 60 metrics to gain granular insights into the proficiency of the ESG practices of the underlying counterparties.

Each of the metrics is conscientiously identified and selected to address a broad range of globally recognised material ESG themes. These themes include board and workforce diversity, board structure, water usage, greenhouse gas emissions and the safety of employees, to name a few. A combination of extensive ESG research, active engagement with our investees and this cross-sectional scoring tool has significantly enhanced our ability to integrate ESG into our investment process alongside the traditional risk premia we consider. It also enables us to interrogate practices that historically eluded systematic investors.

The last decade has seen ESG find a permanent place in everyday investing. Its rise in popularity has shown no signs of slowing down, with Bank of America forecasting a “tsunami of assets”, as much as $20-trillion, flowing into ESG funds in the US alone over the next two decades.

At Prescient, we believe it is  our responsibility to preserve our clients’ capital by deploying it in a manner that promotes sustainability and delivers on our goal to achieve superior risk- adjusted returns. We accomplish these two goals by managing absolute and relative downside financial risk, as well as non- financial operating risk. We consider ourselves well-equipped to deliver on these twin objectives given our comprehensive responsible investing philosophy and approach, as well as our expertise as a seasoned systematic investor.

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