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Magazine Issues » November 2014

INSIDE VIEW: Can quants be responsible investors?

Glow-sticksQuant managers could take their data capabilities to become leaders in ESG, even wielding voting power, says Asha Mehta of Acadian Asset Management.

Responsible investing – also known as environmental, social and governance (ESG), socially responsible investing, and sustainable investing – is an increasingly popular area of asset management, attracting attention from mission-oriented asset owners as well as traditional investors who seek ownership of companies that are well-governed and strategically positioned for the future.

There are generally two types of investors in the responsible investing space: “values” investors and “value” investors.

Values-based investing seeks to ensure that a portfolio is constructed to focus on firms  compatible with an investor’s ethical standards. An approach is to identify “sin stocks” and limit exposure to them.

The value-investing approach, in contrast, seeks to optimise returns, and implicitly suggests that companies with strong governance and high ethical standards have the potential to outperform the broad market. The rationale is that such companies are strategically positioned to avoid potential supply chain shocks, corporate unrest from employer disputes, fallout from potential environmental changes, and financial mismanagement. 

This group may pursue an exclusion approach to portfolio holdings, but they also seek to use responsible investing characteristics as part of an alpha forecasting process.

Today, within the evolution of ESG investing, many investors position themselves at the junction of value and values investing.

Increasingly, the ESG field has included quantitative managers. The cornerstone of quantitative investment philosophy is to use a systematic, non-judgmental approach. To this end, quantitative managers excel in the ability to fully integrate an investment thesis across a process; by design, investment criteria are systematically evaluated across the investable universe. Quantitative managers conduct this systematic analysis by using objective data points that are not influenced by the opinions and judgments of either analysts or management teams. While this makes it more difficult for quantitative managers to engage directly with companies’ management, the objectivity of such an approach, as well as its ability to process a huge volume of data, provides a strong offsetting benefit.

Taking the philosophy that stocks are likely to generate the best risk-adjusted returns are characterised by strong financial health, solid business prospects, effective corporate governance and upside potential, there is a natural fit for the investigation of ESG issues as potential investment factors.

Historically, there have been few data providers capturing responsible investment criteria, and new data providers often have history going back only a few years. However, it is clear that data scope and quality is rapidly improving. As data becomes increasingly more available and reliable, quantitative managers are well positioned to be at the vanguard in the wider incorporation of ESG concepts.

Various measures of corporate governance have been well-documented and studied for at least a decade. Research in this area has focused on a number of objective measures, including the degree of board independence, chief executive compensation levels, level of conservatism in reporting techniques, and similar issues. Investable theses have been constructed to encompass these criteria, and extensive back testing has been conducted throughout the responsible investing industry. 

A formulation capturing corporate governance criteria can be added to predictive return factors based on solid back-test results. As seminal ESG investment factors are developed, we believe quantitative managers are positioned to lead the industry in wider incorporation of these concepts.

Whether employed in a bottom-up or a top-down process, responsible investment metrics may be used to help determine exposure to a given stock, region, or industry. 

Having identified a factor that contributes to the investment strategy, a quantitative manager is able to systematically integrate this factor within this process, whether it is applied as a returns-forecast enhancer, forecast detriment, or symmetrically. On the other extreme, a fundamental manager may evaluate situation-specific responsible investing flags and take up the issue with management. There are intermediate approaches, used by both quantitative and fundamental investors, in which a company may be flagged by its appearance on a given metric and subjected to further analysis.

A typical approach to portfolio construction in responsible investing is to apply a list that controls the exposure to selected stocks or industries. 

Thematic investors will often utilise a positive inclusion list, whereas values-oriented investors apply a negative exclusion list. 

This list can either be predetermined or generated dynamically based on a given set of criteria. Such criteria might include, for example, measures related to the independence of directors, amount of carbon emissions, and level of employee satisfaction. As a company’s “score” on these variables changes over time, so might its inclusion on the list.

Given that a quantitative manager benefits from an exceptionally large universe of coverage, it is mechanically straightforward to substitute an excluded stock with a more acceptable alternative that evidences similar risk and expected return characteristics. Quantitative managers seek to achieve alpha by investing across a broad universe, so exclusion lists typically do not materially impact portfolio construction or expected return.

Additional risk controls specific to responsible investing can also be applied at the portfolio construction stage. For example, an ESG tilt may be achieved by controlling for portfolio-level exposure to a governance metric or carbon footprint level. While this may be complex to assemble in a fundamental management approach, the use of optimisation software in most quantitative processes makes it very straightforward to apply multiple portfolio-level constraints, including those that incorporate ESG criteria.

Going forward, responsible portfolio management is a continuous process. Once companies are held in an investment portfolio, quantitative managers typically have little direct interaction with management. However, proxy voting offers the opportunity to influence management practices in keeping with a socially responsible mandate.

In sum, quantitative investors, given their focus on developing objective investable theses and rigorously testing for efficacy, we believe are uniquely positioned to lead ESG investing.

Asha Mehta is lead portfolio manager at Acadian Asset Management

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