Quant Concepts: ESG in Volatile Times

CPMS's Emily Halverson-Duncan checks in on the performance of responsible investments through the crisis - with a pleasant surprise

Emily Halverson-Duncan 28 August, 2020 | 1:59AM
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Emily Halverson-Duncan: Welcome to Quant Concepts' virtual office edition. ESG continues to be a rising trend among investors, in particular among the younger generation. This demographic remains focused on what they are consuming and its sustainability. Earlier this year, we explored how ESG can add value in volatile times, looking at how a strategy with an ESG consideration performed through the volatility of COVID. Today, I'd like to check in on the same model and see how it's weathered since the market has recouped much of its losses. This strategy will search for Canadian dividend stocks with an ESG overlay. So, let's take a look at how to build that.

Jumping into CPMS here, we're going to do the same thing right away which is to rank our universe of stocks and here, we're looking at the 696 stocks that are ranked within the CPMS universe. In this step, the factors we're going to look at – five-year dividend growth, so that's going to look at whether a company has been growing its dividends over the long term. Annual dividend momentum compares what a company was paying for dividends last year versus what it is paying this year. And again, we want to see a growth trend there to see that they are either maintaining or ideally increasing their dividends. Quarterly earnings surprise – this is a bit of a growth or momentum indicator that we've added in as well and that's looking at whether a company has beat or missed on their projected earnings estimate. And then, lastly, overall ESG risk which is an ESG-specific factor. This scales from 0 to 100 with 0 being the best and 100 being the worst. So, with a score of 0, that indicates that a company is managing its risks well and it doesn't have a higher risk percentage. And at a 100, it's the opposite. It's not managing its overall risks very well from an ESG standpoint and it would be considered very risky. So, in this case, we actually want lower values.

Once we've ranked the universe, we're going to go ahead and apply some screens. So, some of the screens that we've got here – expected dividend yield, we want that to be greater than 1.5%. Five-year dividend growth, we want that to be positive, again, indicating they are growing dividends. One of our other ESG factors we're looking at – highest controversy level. We want that to be less than or equal to a 3. What that means is this score scales anywhere from 0 to 5, 0 being the best, 5 being the worst. So, you can think of it as a higher score means there's more controversies associated to that company. Zero means there would be no or little controversies associated to that company. So, when we are capping it at 3, that means we want it to be pretty neutral or better in terms of a controversy score. Annual cash flow momentum and quarterly earnings surprise, we want those to be positive. Overall ESG risk rating, which we talked about on our last screen, we want that to be in the lower third of peers which is the better third of peers which today has a value of 24 percentile or below. Five-year beta, which is a measure of sensitivity, we want that to be less than or equal to 1. And then, lastly, expected dividend growth, we want that to be greater than or equal to 0. So, what that indicates and what it's looking at is what a company pays in dividends versus what it's expected to pay in dividends. If that is negative, that would indicate a company has recently cut their dividend payout, and in that case, that's not a company that we would want to own.

On the sell filter, we've got five-year dividend growth, if that falls below 0, we're going to sell the stock from the model. If that controversy level goes above a 3, meaning it's 4 or a 5, be too controversial, we're going to get rid of it from the portfolio. The overall ESG risk rating, if that goes into the higher half of peers, we'll sell that out, and that has a value of 29 or higher. And then, lastly, if that expected dividend growth goes below 0, again, meaning the company has cut their dividends, we're going to sell the stock.

So, once we've applied all of that, we can jump in and see how the back test went. Our back test here holds 10 Canadian stocks and the benchmark we're using is the S&P/TSX Composite. As we can see here, the time period we ran for this from August 2009 to July 2020. That particular start date is actually based on the ESG factors. The controversy score has a back history from August 2009. The overall ESG risk rating is a little bit later. It's actually from 2019. So, what would happen there is when you're running the back test, the overall ESG risk rating gets ignored until it's actually added in. But you still have that controversy rating running the whole time. So, you still have that ESG component. And what we can see how the back test did across that timeframe is 15.4% which is an outperformance of 8.6% over the TSX, which is quite strong. Turnover is really low at 18%. So, on a 10-stock model what that indicates is you've got less than about two trades a year, so a pretty low turnover for anybody managing this on their own. One metric I just want to look at here would be the Sharpe Ratio which is the excess return over the market compared for units of risk and that is 1.3, which is very strong for a Sharpe Ratio. Sharpe Ratio tends to be anything over a 1 would be indicated as a positive metric and in this case, 1.3 is obviously quite strong.

A couple of other things to look at – downside deviation for the strategy is 6.9 versus the benchmark is 8.2. Downside deviation is looking at the volatility of negative returns. So, seeing a lower number there is very good. And then, lastly, the green and blue chart that I always like to look at. In up markets the model outperformed 64% of the time and in down markets it actually outperformed all of the time, 100% of the time, which is extremely, extremely strong for any type of a model and definitely shows the power of ESG and how it can help manage in more volatile times. And that's where we saw this model doing well earlier this year and it continues to do well this year. And hopefully, if there is more of an increase in volatility, we'll see the same outperformance here.

For Morningstar, I'm Emily Halverson-Duncan.

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Emily Halverson-Duncan  Emily is Director, CPMS Sales at Morningstar

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