Sustainable Investing - Quantified

The past few years have seen the emergence of ESG (Environmental, Social, & Governance) investing. The trend has taken hold as fund managers, allocators, and the general public now place increasing levels of import on sustainable investment. The difficulty with any new investing framework is being able to separate signal from noise, and to that end we’re happy to introduce our ESG factor framework - courtesy of our data partner OWL Analytics. Today, we’ll show how we can empirically demonstrate how these factors have performed via an aggregate ESG portfolio that we’ve constructed.

First, let’s take a look at the past week's market and factor action:

US Market (6/21/19 - 6/27/19)

• All three major indices closed down on the week, although stocks closed higher on Friday (led by banks after encouraging results from the Fed’s second round of stress tests).
• The S&P 500 had it’s best June since 1955, and is now up 17.5% YTD. Now, investors remain focused on the outcome of Trump and Xi’s meeting at the G-20 meeting in Japan.
• Consumer spending rose moderately in May while prices edged higher, suggesting a slowdown in economic growth and underscoring the chances that the Fed cuts rates in July.
• The U.S. Treasury yield curve has now remained inverted for more than a month, with the 3-month T-Bill offering a higher interest rate than the 10-year.

Starting this week, we’ll also be including global factors in our weekly normalized return update, so you can see how these factors are trending both in US and worldwide models. Here's how these factors have moved over the past week, using our normalized return indicator:

• Size saw the biggest normalized gains in both the US and worldwide models.
• Market Sensitivity and Volatility were also big winners in both models as they continued to revert to the mean from recent low points.
• In the US, Earnings Yield and Profitability both saw substantial positive movement, suggesting that investors have been buying high quality names.
• Growth continued to revert in both models, with US Growth nearing the mean, and global Growth descending out of Overbought territory.
• Momentum was again the week’s biggest loser as it continued the ongoing fall from recent Extremely Overbought peaks in both models.
• US total risk (using the Russell 3000 as proxy) moved down slightly from 13.81 to 13.6%, while global risk (using the ACWI as proxy) ticked down from 12.23% to 12.07%.

‍Summer of Sustainability

‍We’re kicking off a series on sustainable investing, a subject that we at Omega Point care deeply about and are excited to share with you. Our data partner for ESG factors is OWL Analytics, an alternative data company that aggregates and optimizes over 100 million ESG data points from 400+ sources of ESG research. This broad analytical foundation eliminates much of the subjectivity inherent in tracking a non-standardized investment themes.

The purpose of measuring companies against these ESG factors is to quantify how well a company manages their material risks and opportunities relating to their impact on the environment, their stakeholder relationships, and their internal governance procedures. This week, we’ll start by taking a look at how the aggregate ESG portfolio (original and sector-neutral) has performed over the past decade.

‍Methodology:

1. We took OWL’s 12 main KPI’s, then made 12 portfolios that are long the top 200 and short the bottom 200 companies in the Russell 1000, ranked by exposure to each of those KPI’s. These portfolios are equally weighted, and rebalanced once a month.
2. We then aggregated them into 3 more portfolios by category: Environmental, Social, and Governance, as well as one “super-aggregate” portfolio named “Composite ESG”.
3. We then created a sector neutral version of each portfolio, to see what happens when sectors are equally weighted. This is done to remove inherent biases, such as Oil & Gas companies constituting the majority of the short book in the “Pollution Prevention” portfolio.

The hierarchy is as follows:

Performance - Composite ESG

‍Here’s how the original aggregate portfolio and the sector-neutral aggregate portfolio have performed over the past 10 years, and over the past 5 years.

Since 2009, the “absolute” Composite ESG portfolio is up by ~12%. When neutralizing for sectors, it’s essentially been flat (+0.28%). This makes logical sense, because in the absolute version, it’s possible that much of that performance was the result of overweighting certain sectors (Tech, for instance), and underweighting others.

Over the last five years, however, we can see that the positive performance trend in the sector-neutral portfolio has accelerated, suggesting that ESG returns are becoming less concentrated at the sector level, and are now part of a broader lift. This is supported by a report out of Deutsche Bank that looked at more than 100 academic studies of sustainable investing and determined that companies with high ESG ratings exhibited market-based outperformance in 89% of the studies and exhibited accounting-based outperformance in 85% of the studies.

In just this simple analysis, we have empirical evidence that it’s not only possible to use ESG factors to target specific or wider ESG trends, but that it’s becoming increasingly possible to make money investing in them as well. We’ll continue to comb through this data to find insights that can be helpful to your process.

Regards,
Omer