Quant Concepts: Still Pays to Be Sustainable

We get an update on the outperformance of ESG investing with CPMS's Emily Halverson-Duncan

Emily Halverson-Duncan 25 September, 2020 | 1:45PM
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Emily Halverson-Duncan: Welcome to Quant Concepts' virtual office edition. It's ESG week here at Morningstar, meaning we're exploring different aspects of sustainable investing and how investors can get involved with the rising trend.

Recall that ESG stands for environmental, social, and corporate governance. When we talk about an ESG-friendly company, what we mean is that based on factors attributed with those three areas, this particular company looks favourable. Or in other words, appears to have sustainable practices. Today, in light of ESG week, we're going to look at a U.S. strategy, which searches for ESG-friendly stocks within the CPMS U.S. database. So, let's take a look.

As always, first off, we're going to go ahead and rank our universe of stocks. As mentioned, today's universe is the CPMS U.S. database, which holds just over 2,000 names, 2,077 as of today. In that ranking step, we're going to look at two main factors. Highest controversy level – so, what this looks at is it's a scale from 0 to 5, 5 being the worst and 0 being the best. And essentially, we're looking at any issues or any prevailing media that would suggest a company is more controversial. So, we're looking at things like press releases or anything that is prevalent right now to a particular company. If an issue from an ESG standpoint is considered to be severe, then we'd scale higher, so closer to the 5. If there's not really a lot going on in a controversial nature, they'll be on the lower side, so closer to a 0.

The other point that we're looking at for the ranking side is overall ESG risk rating. So, what this is looking at is from an ESG perspective, so looking at E, S and G factors, we're looking at factors that are specific to a company's industry and seeing how well they manage those risks. The portion that's unmanaged or that aren't managed very well is what's going to contribute to this score here.

So, in this case, the score goes from 0 to 100, 100 being the worst and 0 being the best. If they have a score of 0, it means they've managed all the risks very well. If they have a score of 100, it means they haven't managed their risks very well. So, again, we're trying to get on the lower end of that side.

Once we've ranked our universe, we're going to go ahead and apply some screens. So, the screens we've got here – highest controversy level, we want that to be less than or equal to a 2. So, again, on that scale of 0 to 5, that means we're looking for companies with a controversy level of 0, 1 or 2. Overall ESG rating, we want that into the lower third of peers, which today has a score of 22% or below. And then, we also have three factors here listed in a row, which are the social risk rating, governance risk rating and environmental risk rating. So, that exactly attributes to the E, S and G of ESG, and we're looking at them on an individual basis. So, same concept here. We're looking for the values that are in the lower third of peers, which is the better third, for each of the three component scores.

And then, lastly, we have a market cap that we want to be in the top two-thirds of peers. That is just to eliminate any really small cap names that may have less liquidity, and today those have a value of 951 million or higher.

On the sell side, we've got two sell rules here. We're going to sell if the controversy level goes above a 2. So, if the controversy level rises to a 3, 4 or a 5. And then, we're also going to sell if that ESG risk rating goes into the higher half of peers, or in other words, has a score of 30% or higher as of today.

So, we're going to go ahead and back test this. Our back test today is going to run 15 different stocks. And one thing to note about the timeframe. Most of the variables, with the exception of controversy level, only have data starting from November 2019. So, what that means is the back test timeframe, which runs from August 2009 until August 2020, it starts off only considering the controversy level, that ranking in the screen that we applied, and then starting in November of 2019, we would add in all those other factors. So, this isn't a perfect back test in that sense because not all factors are available, but it gives you a sense of how those ESG-friendly stocks would have done had you held them for that time period.

So, here we can see the results. 17.3% annualized return, which outperformed the S&P 500 by 3.1%. Turnover was on the lower side at about 43%, meaning that you're trading less than half your stocks per year. A couple of metrics I always like to look at – downside deviation, which is the volatility of negative returns, in this particular back test, the strategy's was higher at 12% compared to the benchmark at 8.5%. Usually, we like to see lower, but again given we're taking into account more or less one variable across majority of that timeframe before adding in the other ones, it's possible that would change as we get more data.

And then, of course, I like to look at this green and blue chart here to see how the model did in both up and down markets. In up markets, it outperformed 57% of the time, so more often than the benchmark. And then, in down markets it outperformed about half the time. So, again, it would be great and as we continue to build out our database, we can do more tests on ESG. But just even at a starting point you can see here there's some pretty good outperformance, and of course, you're looking for a company with good sustainable trends, which ideally as you go forward, will help to manage risks.

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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