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Smart sustainability integration in Quant Equity

12-09-2016 | Insight | Bart Van der Grient, Machiel Zwanenburg

All Robeco Quantitative Equity strategies integrate ESG factors. To measure sustainability, we use the scores based on RobecoSAM’s Corporate Sustainability Assessment. Recently, RobecoSAM has introduced the Smart ESG score. This is more suitable for investment purposes, as it removes undesired biases and gives more weight to elements with more predictive power for future returns.

Speed read:
  • All Robeco Quant Equity strategies integrate ESG factors
  • The risk-return profile remains unchanged, while ESG risks are avoided
  • Smart ESG scores are unbiased and build on RobecoSAM’s externally recognized CSA

All Robeco Quantitative Equity strategies integrate ESG factors (Environment, Social and Governance). A key feature of our SI approach is that companies with a favorable ESG score have a higher chance of ending up in the portfolios as we ensure that the portfolio’s weighted ESG score is at least as as that of the benchmark or reference index. This implies that we also positively screen stocks, contrary to an exclusion policy which only allows for negative screening.

This integration of sustainability factors in our investment processes helps us to remove undesired risk exposures which do not add to return. Examples of these risks include liability risks because of pollution or reputation risks as a result of human rights violations.

To measure sustainability, we use RobecoSAM’s Corporate Sustainability Assessment (CSA). The CSA consists of an annual analysis of the sustainability performance of more than 3,800 companies, covering most major indices. Following on from the first CSA conducted in 1999, RobecoSAM has built one of the largest proprietary databases for corporate sustainability.

‘The Smart ESG score eliminates known biases such as market cap, industry and region’

RobecoSAM has further developed its sustainability scoring with the introduction of the Smart ESG Score. This score is designed to be better suitable for investment purposes, as biases in the ESG data that typically affect the financial performance of ESG data are removed and the financial materiality of the ESG scoring process is enhanced by giving more weight to ESG indicators with more predictive power for future returns. Since July 2016 we have incorporated the Smart ESG scores into the quantitative strategies.

An example of undesired exposures is a potential regional bias. ESG disclosures are more developed in Europe than in the USA or Asia. An ESG scoring methodology that relies heavily on available data would score European companies higher than average. Not correcting for these differences would result in a large permanent tilt towards Europe in a global equity portfolio without any evidence that this tilt to Europe will lead to either higher returns or a less risky portfolio.

Smart ESG: sustainability scores tailored to investment strategies

Traditional ESG scores are broad, often aggregating hundreds of individual indicators into a single score. Exposures resulting from individual questions can lead to biases at the total score level, which are not always desired. Take for example large cap companies; in all major sustainability datasets they tend to score above average. Why? Maybe simply because large companies are more likely to bear the costs of sustainability reporting departments.

The Smart ESG scores build upon RobecoSAM’s existing sustainability data by eliminating known biases such as market cap, industry and regional biases. By removing these biases, RobecoSAM is also able to better pinpoint which ESG indicators are the most financially relevant for different industries, sharpening the focus on financial materiality. This results in an unbiased and financially material ESG score – or Smart ESG score – which is more suitable for investment purposes.

We can explain the Smart ESG scores in two steps. First, to remove undesired exposures, companies are compared only to those with similar characteristics (e.g. same region and same sector). Biases induced by the heterogeneous and diverse nature of sustainability data are effectively removed.

In a second step, question weights are improved using a predictive model of expected investment success. Evidence from RobecoSAM’s sustainability database is incorporated into the scores. Going forward, the weighting of all indicators that make up the sustainability score are thus based on both quantitative and qualitative information, by combining the expertise of sustainability analysts with quantitative empirical results. Examples of topics with more predictive power are corporate governance within the banking sector, and operational eco-efficiency in the Airlines sector.

Advantages of moving to Smart ESG scores

The key advantage we see in the switch to Smart ESG scores is that they build upon the existing sustainability data by eliminating known biases such as market cap, industry and regional biases, which aligns with our integrated risk management approach. We find it more efficient to address undesired exposures at an early stage, rather than postponing this risk management to the portfolio construction phase.

Our portfolio construction algorithm aims to maximize the exposure of the portfolio to the highest ranking stocks, while applying strict concentration limits on relevant risk factors and controlling portfolio turnover. By ensuring that the sustainability scores themselves are unbiased, these unintended market risk exposures are already neutralized before the portfolio construction process.

In addition the Smart ESG scores are better tailored to their usage as investment tools. They incorporate evidence from the data, and combine analysts’ expectations with empirical results. In line with RobecoSAM’s conviction that material nonfinancial factors contribute to better informed investment decisions, the approach ensures that the model increases (reduces) the weights of the criteria which have shown to be able (not to be able) to forecast stock return.

Unchanged risk-return characteristics

Switching to the RobecoSAM Smart ESG scores results in similar risk/return characteristics of the strategies. And just as important, we find that the exposure to the quantitative models does not change when the enhanced scores are used. The reason is that for each attractive stock that does not score well on the sustainability factor, there are sufficient sustainable alternatives.

We consider the integration of sustainability factors a form of prudent risk management. With our enhanced form of ESG integration we avoid the risk of being overexposed to less sustainable companies, without introducing other undesired exposures. This is in line with our general risk management philosophy to avoid all risks that are not rewarded with higher returns.

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