Unearthing Alpha in Impact Investing - Europe Focus

Short Summary

Impact investing, a strategy that marries financial returns with positive societal and environmental impacts, has been facing headwinds in the public markets over the past 12-24 months. Yet, several areas of impact investing have continued to demonstrate strong alpha. Leveraging our partner dataset from Clarity AI along with factor models from Qontigo Axioma, we explore these categories within the Vanguard FTSE Europe universe and highlight where European investors looking to incorporate impact into their investment process can expect to see strong alignment with financial returns.

Long Form

The past two years have been challenging for impact investing in the public markets¹. In 2022, energy concerns brought on by limited fuel supplies into Europe due to the Russia/Ukraine war changed consumer mindset regarding access to clean sources of energy. Concerns over which funds and/or companies are engaging in greenwashing have created unnecessary noise in the Impact space. Total assets under management in ESG funds fell by about $163.2 billion globally during the first quarter of 2023 from the year before². But is that the whole story? At Omega Point, we approach the above with a healthy dose of empirical skepticism. Our data science platform and expansive partner databases allow us to cast an alternative lens on the Impact Investing landscape. In particular, leveraging the impact dataset from our partner, Clarity AI, we create a set of proxy portfolios within the Vanguard FTSE Europe universe that capture the relative movements of securities with high/low exposure to Clarity’s impact categories. Those portfolios help us uncover micro-trends within the Impact Investing world that aren’t visible by simply looking at the macro flows into ESG funds and highlight that alpha is still strong within several impact categories. Why Europe? As a leading region in Impact Investing, we wanted to identify whether investor attention has truly shifted away from this approach or has crystallized to particular areas of importance.

Clarity AI Impact Measurement Methodology

Clarity AI takes a unique view on capturing impact across various issues in the ESG and impact investing space. The particular module that we focus on here, the ESG Impact module, assesses the positive or negative impact on society (i.e., health, environment, individuals’ income, world GDP) from company operations across several societal challenges related to Environmental, Social, and Governance impact categories.

‍Clarity AI Impact Challenges‍

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Companies are evaluated in terms of their positive or negative impact on society across these challenges. Each challenge is represented by an underlying metric, which is then converted to a dollar value of impact from the company’s operations (normalized by the size of the company as measured by revenues). For example, the Climate Change challenge is represented by Scope 1 and Scope 2 greenhouse gas emissions. Based on the US Environmental Protection Agency’s estimate of the social cost of carbon applied to the amount of company emissions, Clarity can derive a dollar value of impact to society from the company’s operations as it relates to the Climate Change challenge. Once all companies’ impacts are calculated, the final challenge score is calculated by distribution across the Clarity AI coverage universe for each of the challenges. A score of 1 points to a company with the worst impact and a score of 100 points to a company with the best impact.The challenge impacts are also aggregated to the pillar level, i.e., Environmental, Social, and Governance, as well as the overall ESG level and then percentile ranked across the universe to generate the score across each of these pillars and for overall ESG impact.The Clarity AI methodology for assessing ESG impact has several unique value-adds compared to other commercially available impact datasets. Many other ESG data providers consider the financial risk to companies from a lack of sustainable business practices; however, Clarity AI considers the impact on society from the level of sustainability embedded in company operations. In other words, Clarity AI seeks to understand and quantify the impact of a company on society rather than the other way around. This allows investors to capture the true impact of their investment decisions.

Designing Proxy Portfolios with a Focus on Europe

We design proxy portfolios for Clarity’s impact challenges covering our Universe below using the following parameters:

• Universe: Vanguard FTSE Europe
• Rebalancing: Monthly rebalanced
• Market exposure: zero net market exposure
• Long side: equally weighted names within the Vanguard FTSE Europe universe that are in the top quintile of Clarity’s impact category.
• Short side: equally weighted names within the Vanguard FTSE Europe universe that are in the bottom quintile of Clarity’s impact category.
• Factors: Clarity.ai ESG Impact challenges and composite challenges. Note that Biodiversity Loss is omitted from this analysis since this factor only applies to certain industries that extract raw materials and therefore do not provide enough coverage to derive a broad proxy portfolio.

‍One final note on sector exposure: to determine whether sector exposures had a meaningful contribution to out(under)performance in each impact category, we built another set of proxy portfolios with near-zero sector net exposure.

Results

Using the Axioma Worldwide Linked Medium Horizon model, we can measure the returns of our proxy portfolios and decompose the drivers of performance. This helps us understand if there is a true signal in the Clarity impact data or if the performance can simply be replicated by other widely understood style, sector, country, or currency factors.As a baseline comparison, we first calculate the return attribution of the FTSE Europe index (proxied using VGK, the Vanguard FTSE Europe ETF). The FTSE Europe return is calculated in excess of the market returns from the risk model in order to create an apples-to-apples comparison for our market-neutral long/short proxy portfolios.A view of our broad proxy portfolios shows that several of the impact categories not only have strong performance but also have a strong alpha opportunity that outperforms the FTSE Europe universe. The Water Scarcity portfolio performed nearly 15% over the trailing 12 months, with two-thirds of this return coming from alpha performance. Several other proxy portfolios were solid performers as well, including the composite ESG, composite Environmental, and Waste Management portfolios. Employee Training performed well in overall terms, but the vast majority of the return was driven by factor performance. Although the Governance portfolio was not a strong total return performer, it does have a very attractive alpha performance.

A common idea exists that impact investing is highly tilted to certain sectors and industries, such as Information Technology. To address this concern, we built a complementary set of sector-neutral proxy portfolios to see if the performance from our broad proxy portfolios persists when sector tilts are removed.Generally speaking, we see much more muted returns across the board when we control for sector exposures; however, some of the portfolios still show desirable total and alpha performance traits. In particular, the sector-neutral Water Scarcity portfolio is able to capture almost half of the total return and over 80% of the alpha return of its broad-based counterpart. Interestingly, Employee Fatalities perform much better in the sector-neutral context, especially for alpha performance.

Given how well the Water Scarcity portfolio performed, we can review the return profile in more detail to get a better sense of the behavior of this impact category. A view of the broad proxy portfolio performance over the trailing 12 months shows very consistent performance with minimal drawdowns. This is very encouraging, given the market headwinds faced over the past year.‍

Water Scarcity HML Portfolio Return - June 2022 to June 2023‍

Similarly, we can view the return profile of the broad Water Scarcity portfolio versus the sector-neutral version to see if there are any meaningful differences in the performance behavior. Despite the slightly lower performance when controlling for sector exposure, we see that the alpha is still consistent and robust across both portfolios. Drawdowns were less than 3%, and the total Sharpe ratios were 2.43 and 1.58, respectively; the alpha Sharpe ratios were even stronger at 2.33 and 2.11, respectively.

‍Water Scarcity HML Portfolio Returns - Broad vs Sector-Neutral‍

Conclusion

The analysis above highlights that despite market headwinds and recent negative sentiment around thematic ESG investing, there are still pockets of the market that can provide alpha opportunities for investors in the impact space. In particular, we found that the Water Scarcity theme offers strong and reliable total and alpha returns, both when looking at the general Europe universe as well as when controlling for the sector. Several other themes offer attractive returns, including composite ESG, composite Environmental, and Waste Management. These returns tended to offer not only overall outperformance but also higher risk-adjusted performance and lower drawdowns compared to the general European market.Extensions of this analysis can look to other regions outside of Europe as well as country-neutral proxy portfolios to understand how these themes align or differ with the results shown here. If you’re interested in leveraging Clarity AI ESG Impact dataset or discussing more around Omega Point’s capabilities for analyzing thematic investing trends, please don’t hesitate to reach out to us!

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Resources

¹ Articles highlighting the challenging environment for impact investing:

https://www.schroders.com/en-us/us/intermediary/insights/esg-weathering-the-market-headwinds/

‍‍https://www.reuters.com/business/sustainable-business/bear-market-puts-esg-investing-its-first-big-test-2022-07-13/

^‍2 https://edition.cnn.com/2023/04/28/investing/premarket-stocks-trading/index.html