ESG Breakout Performance Trends

Since the kickoff of our “Summer of Sustainability,” we’ve been truly encouraged by the feedback we’ve received from our readers. It’s apparent that not only has interest in ESG among investors been growing over time, but that allocators are increasingly demanding that money managers incorporate an ESG framework in their strategies. Because ESG is such a potentially nebulous concept, it’s vital that we establish a measurable and rigorous approach to finding a way to invest in ESG. This week we’ll take a look at the individual pillars of ESG by measuring performance of our individual Environmental, Social, and Governance portfolios.Starting this week, we’ll be flipping the order and diving straight into our Factor Spotlight discussion, then sharing our weekly market and factor (US and worldwide) updates.Environmental, Social, & Governance BreakoutsThis week, we’re going to take a look at performance trends over the past five years for the Environmental, Social, and Governance portfolios that we’ve built using OWL Analytics’ ESG data and KPI hierarchy.Methodology:‍

• Take OWL Analytics’ 12 main KPIs (hierarchy below) and create equal weighted portfolios that are long the top 200 and short the bottom 200 companies in the Russell 1000, ranked by their exposure to those KPIs.
• Bucket and aggregate each of these 12 portfolios into one of the three higher level portfolios that they belong to.
• Create a sector neutral version of each of those portfolios to remove sector bias, then measure performance from 2014-2019.

Environmental (Sector Neutral) Portfolio: 2014 - 2019

The Environmental portfolio saw positive performance during this period, up almost 2.94%. Of that return, 2.82% was factor driven, while 0.12% was derived from alpha. This portfolio had a huge gap up towards the end of 2015, drifted upwards for the next few years (barring a steep tumble in mid-2016), and then took a pretty big fall in 1H2018 (-2.9%). That decline was driven by -1.44% contribution from alpha and a simultaneous (-2%) drawdown in the Size factor (this portfolio had 0.3+ exposure to Size). It appears to be recovering since then.

‍Social (Sector Neutral) Portfolio: 2014 - 2019

The Social portfolio was up nearly 4.7% during this period, with 4.47% of that performance coming from factors, and 0.22% from alpha. This portfolio had generally drifted up since 2014, then peaked at +5.6% in Oct 2017, then took a severe tumble over most of the next year. That 2018 tumble can be mostly attributed to negative alpha contribution (-3.31% from 1/1/18 - 9/4/18) as well as collateral damage from the crash in Size. The recent trend is one of very sharp performance growth, mostly driven by the rebounding Size and Volatility factors.

‍Governance (Sector Neutral) Portfolio: 2014 - 2019

Governance was the best performing portfolio by far, with 8.7% of the overall return driven by factors, and 3.91% from alpha. Other than one period around mid-2015, the trend for this grouping has been overwhelmingly positive, with return appearing to get even better during the market correction at the end of 2018.

‍Conclusions

‍It’s clear that for now, the strongest leg of the ESG triumvirate is the Governance portfolio, which vastly outperformed its peers. It may be obvious, but the market has always had an appetite for well-run companies with limited risk for fraud. An investment in any of these portfolios would have made you money, however, and it appears that the recent trend in all three portfolios is getting more positive. We suspect that as sustainability continues to calcify its role as a staple of modern investing, these portfolios will do well, and potentially see more alpha enter into the mix.

This week's market and factor update:

‍US Market (7/12/19 - 7/18/19)

• US equities saw their worst week since the end of May, as the realization struck that the July Fed rate cut might be 25 bps rather than the 50 bps that investors had wanted.
• News on Friday that Iran had seized two British oil tankers in the Strait of Hormuz also contributed to softness in equities as geopolitical risk in the region remains heightened. The US claimed to have downed an Iranian drone the day before.
• We saw a strong start to Q2 earnings season, with earnings generally topping forecasts as companies tended to provide conservative guidance. Some investors expect some volatility when the bulk of the industrials sector reports, as those companies will likely focus on the negative impact of trade wars.

Here’s how factors have moved over the past week in both US and global models, using our normalized return indicator:

‍US Model

• Earnings Yield was the biggest winner this week, popping back into positive territory for the first time since mid-May.
• Market Sensitivity and Volatility continued their dramatic rally since early June, when both were around -1.5 SD oversold. Volatility is now flagged as an Overbought factor.
• Momentum saw more of the same, falling 0.42 standard deviations to land exactly at the mean.
• Size has rallied back from a trough of -1.73 SD below the mean on 6/4, and now nears an Overbought label at 0.95 SD above the mean.

‍Global Model

• Profitability was the biggest winner this week, moving into positive space and currently sitting around the mean.
• Growth continued its rapid decline, falling 1.16 standard deviations over the past two weeks.
• Momentum has already surpassed the mean and continues to fall, much as we expect to see in the US.
• Value and Market Sensitivity are both approaching Extremely Overbought territory at +1.93 SD above the mean.

Regards,
Omer