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Public equities: ESG information may give you an investment edge
As the old adage goes, “you cannot manage what you cannot measure.” Traditional valuation models like discounted cash flow can help assess financial risks, but they sometimes fail to capture the complete picture. Intangible assets—which are impacted by financially material ESG risks and opportunities— now compose as much as 87% of the market value of the S&P 500.1 Using alternative data sets such as material ESG factors allows us to detect otherwise underappreciated opportunities for increasing alpha, as well as underestimated risks.
There has been a proliferation of ESG data thanks to investor interest, disclosure frameworks and industry-specific standards. For example, corporate reporting on ESG metrics has soared over the past several years. In 2017, 85% of companies in the S&P 500 published a sustainability report compared to under 20% in 2011—a fourfold growth.2 In addition to company-reported metrics, specialized ESG research organizations utilize company disclosures, as well as their own research and analysis, to produce scores and ratings that assess ESG performance. With all this data, investors now have various methods for quantitatively incorporating this information into their investment process. But a key question remains: How can investors find an edge with all this information?
Our analysis and research show that there are three key ways to potentially gain an edge:
- Capturing ESG characteristics before it’s reported by ESG data providers
- Marrying quantitative and fundamental analysis can add value
- Engaging with companies to influence ESG best practices
Market prices often reflect changes in many ESG characteristics before the information is captured, assessed and reported by ESG data providers. By the time the data is reported, much of the benefit is priced in.
Capturing ESG characteristics before it’s reported by ESG data providersNuveen Quantitative Strategies, the quantitative investment specialist of Nuveen, has done and continues to do research in ESG. Our research agrees with several external studies that highlight that changes in ESG characteristics, sometimes referred to as ESG “momentum,” is more promising from an investment perspective than the static ESG rating or score. Additionally, our research uncovered something interesting. We found that market prices were reflecting changes in many ESG characteristics before the information was captured, assessed and reported by the specialized ESG data providers. By the time the data was reported, much of the benefit was priced in.
Advances in technology, in particular the growth of Natural Language Processing (NLP), have put better tools in the hands of investors to take advantage of information faster. The most up-to-date information on most companies tends to be the news— this is true for information regarding financial data as well as information about ESG issues. While the news may not cover all issues, it is the most expedient source. NLP, a branch of artificial intelligence, allows machines to interpret human language and in this context allows investors to gain insight from hundreds if not thousands of news releases. Other areas where NLP can be applied include social media and government/regulatory filings. For quants, this is a fruitful area to explore as it speeds up the availability of information. For fundamental investors, this would make a powerful, complementary tool. Some specialized ESG data organizations have already made headway into this area.
Marrying quantitative and fundamental analysis can add valueOur analysis suggests that the best time to look at ESG is from “three to six months ago.” While this may be a limitation of quantitative models relying on these scores or ratings, this analysis offers insight on how fundamental analysis can add value. The “real-time” knowledge gained from fundamental analysis through continuous dialogue with these companies may add an investment edge before the data is collected and disseminated by ESG data providers by allowing analysts to uncover details that may otherwise be difficult to discern based on public disclosures.
Engaging with companies to influence ESG best practicesFinally, the most important implication of this analysis is the proactive work that managers can do to influence and advance ESG best practices at the companies they own. Certainly, there is much to be gained by staying abreast of a company’s ESG characteristics. However, engaging and driving positive change at companies provides a far superior position than merely tracking progress or reading headlines. If and when their efforts are successful in improving a company’s ESG performance, the analysis suggests that the effort will be rewarded by the market. Proactive engagement with those companies that need the most improvement may yield the most benefit since they will offer the most opportunity for change.
By the time the data was reported, much of the benefit was priced in
Information ratio (the ratio of average annual active return to average annual active risk) using factor portfolio analysis for changes in MSCI’s governance score. MSCI governance scores from 2007 – 2014. Predicting the improvement of governance six months ahead of time (green bar) would yield an IR of nearly 1.5 while looking at governance changes after the data is available (blue bar) would yield a mixed outcome.
2 Governance & Accountability Institute, 2018
Risks and other important considerations
Investing involves risk; principal loss is possible. There is no guarantee an investment’s objectives will be achieved. An investment which includes only holdings deemed consistent with applicable Environmental Social Governance (ESG) guidelines may result in available investments that are more limited than those that do not apply such guidelines. ESG criteria risk is the risk that because the criteria excludes securities of certain issuers for nonfinancial reasons, an investment may forgo some market opportunities available to those that don’t use these criteria.
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