An Example of Innovative ESG portfolio construction
The portfolio construction process in terms of identifying ESG companies can be largely quantitative. We give an example designed to select the top 100 companies from an investable universe – the S&P 500. In our framework, the key is how to cluster the words and combinations of words to extract the fundamental elements of good governance. Based on our governance practice and academic research, we looked at numerous components, such as time orientation, people, and stakeholder management, as part of a broader review involving many clusters. This broad analysis is conducted on a dictionary of more than 7,000 distinct words grouped into three categories (three filters), which constitutes the body of our governance scores from reading companies’ annual reports. This review allows us to diagnose the governance quality of every company for ranking and comparison. We apply a fourth filter to exclude sub-industries that could skew the ESG profile of companies.
Filter 1: classical stewardship
Classical stewardship refers to the multiple word lists that we created to represent stewardship beliefs, attitudes, values and actions. We update the word lists regularly.
The dimensions that constitute stewardship beliefs include an obligation or willingness to promote good governance and take responsibility (accountability), a sense of purpose for greater achievement and social good (purposefulness) and a commitment to safeguard the future through a long-term perspective (long-term focus).
The dimensions that describe stewardship attitudes include a willingness to take care of customers (care), an ability to win trust from employees (trustworthiness) and a propensity to act harmoniously with other stakeholders (harmony).
The dimensions that indicate stewardship values include a strong passion to drive stewardship and lead with positive impact (passion), a sense of positive wellbeing to promote a vision of the future (positiveness), and a sense of psychological ownership or oneness to identify with the company (identification).
The dimensions that characterize stewardship actions include an emphasis on innovation and creativity (innovativeness), a proactive and anticipatory approach to risk management (proactiveness), and a tendency to be conservative and prudent toward debt financing (prudence).
Filter 2: resilience and agility
The resilience and agility filter refers to the multiple word lists we created to measure crisis readiness and risk management. Prudence and adaptability are at the heart of good governance. In well-governed organizations, the board will be better prepared for crises, adopt long-term strategies and incorporate risk management. Good governance drives agility with the view that the organization will adapt to both growth and recession, as well as unexpected shocks. The 2008 financial crisis and the COVID-19 pandemic demonstrated that well-governed companies were rewarded by the market. We observed that the share price of well-governed companies dropped less during the correction and then, thanks to their agility and better positioning, rebounded better and for the long term.
Filter 3: modern stewardship
The modern stewardship filter refers to the multiple word lists that we create annually to represent best-in-class stewardship, governance and ESG practices in the current year. Language evolves slowly. To achieve long-term value creation, we need to stay current with the changes in language and maintain our capability to select the best-governed companies.
Filter 4: exclusionary screening
We apply this screening to exclude several sub-industries from the investable universe regardless of their financial performance. This step is to minimize potentially negative ESG exposures based on moral values, standards, and norms. Examples include the oil, gas and tobacco industries.
Does our Integrated ESG approach work?
We created an unconventional model using NLP techniques on 10-Ks to discover ESG information embedded in corporate communications. Once we have the portfolio of stocks, we perform cross-validation to assess whether our selection will accurately capture ESG performance in practice. Cross-validation is essential to test the model’s ability to predict both financial and ESG performance with unknown datasets such as new 10-Ks.
Validation of risk and returns
A good ESG model should deliver on its promise of high returns and low risks. Typically, a fund with solid ESG integration should be expected to have lower risk exposure and above average long-term returns. Our methodology highlights important differences between well-governed companies and their peers. Based on the words they use, we find that well-governed companies are financially more conservative (controlling for size and industry), have less debt and higher liquidity, and that they invest more in innovation and are less prone to mass layoffs.
Validation of social and environmental aspects
In our model, we follow the key principle that governance drives environmental and social choices. In ESG, G drives E and S. To verify whether our selection of 100 stocks measures both environmental and social aspects, we benchmark our selection with the ESG scores from Sustainalytics and RobecoSAM. The scores from both providers range from 0 to 100, with 100 being the best performance score in social and environmental performance. We can see that well-governed companies consistently outperform the S&P 500 and bottom 100 companies across environmental and social ratings.
Total investment impact
Impact-Cubed is an independent rating company. Its ESG ratings have been used by institutional investors to report on portfolios, inform their product development and investment processes, and research and compare investment products. We used it to obtain a Portfolio Impact Footprint of our investments. To measure the overall ESG impact of our portfolio, we loaded our fund level data to match Impact-Cubed’s coverage of more than 10,000 global companies from 2018 to 2020.
The comparison shows that our portfolio was in the top quartile of companies with the most positive impact in 2019, In fact, we are approaching the maximum possible ESG and sustainability performance. This again confirms our NLP analysis of 10-Ks and our belief that governance drives environmental and social choices.
Backtest and live performance
Our methodology reconciles the paradox that traditional ESG scores or rankings do not generate alpha consistently. When looking at the issue fundamentally, there should be a causal relationship between ESG practices and stock performance, since well-governed companies paying attention to ESG dimensions would have lower risks, notably on reputation damage, and higher upside opportunities, notably by investing in clean, renewable, and emerging technologies. The problem is not about the fundamental ESG idea, but genuine measures of ESG implementation at firm level.
The UN Principles for Responsible Investment (PRI) have been widely accepted in recent years. ESG investing is becoming a mainstream investment approach. However, there is a significant hurdle to ESG analysis in terms of acquiring accurate, comprehensive, comparable, consistent, and audited information. The lack of a credible ESG ranking and scoring methodology has become a challenge for generating ESG alpha.
Our systematic approach has generated consistent alpha with lower volatility. In addition, various cross-validation test results have shown that our portfolio has a positive impact on sustainability. During the crises in 2008 and 2020, our investments experienced lower drawdowns and quicker recovery. For us, ESG integration goes beyond aspiration and has a positive impact on portfolio returns. This approach has become a key differentiator.