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Integrating sustainability into factor credit strategies

Integrating sustainability into factor credit strategies

13-09-2016 | Research | Frederik Muskens, Jeroen van Zundert, Mark Whirdy, Patrick Houweling, PhD

The objective of our factor credit strategies is to maximize the portfolio’s factor exposure at low cost while limiting risks. An important risk dimension is sustainability. In this article we explain how we integrate sustainability into our investment process.

Speed read:
  • Maximizing factor exposure while improving sustainability
  • A combination of positive and negative screening
  • Company scores relative to industry-size peers
Sustainability has an explicit role in our factor credit strategies. It is incorporated in two steps of our investment process. First, our fundamental credit analysts identify any unacceptable Environmental, Social and Governance (ESG) risks in our quantitative bond ranking. And second, when constructing or rebalancing a portfolio we ensure that the portfolio scores at least as strong on sustainability as the reference index.

Our primary objective is still to have optimal factor exposure, and we do so while controlling the sustainability of the portfolio. Contrary to negative screening, our sustainability integration follows a symmetric approach where we not only dislike sustainability laggards but also prefer sustainability leaders. Moreover, imposing restrictions at portfolio level avoids potential adverse effects that might lower expected returns.

Factor exposure and sustainability
Sustainability is a broad topic, ranging from effective environmental policies to solid employee satisfaction levels, and from decent corporate governance to a positive brand image and reputation. Whereas a portfolio holding in one or two mediocre companies would not be a reason for immediate alarm to most investors, a strong portfolio exposure to unsustainable companies poses a serious risk, as sustainability risks could materialize in the future.

Our goal is to harmonize two objectives: having maximum factor exposure and limit the exposure to unsustainable companies. At times these two objectives might contradict; financially attractive bonds are not necessarily attractive from a sustainability perspective (or vice versa). Maximizing the sustainability of a portfolio may lead to a deterioration in the factor exposures, thereby lowering expected returns. To avoid these unintended effects, we evaluate a bond’s attractiveness and the company’s sustainability at the same time. Companies with higher sustainability ratings have a higher chance of ending up in the portfolio than companies with low sustainability ratings. Implicitly we want to be rewarded with a financial premium when we invest in bonds of less sustainable companies. Thereby we can have optimal factor exposure in a sustainable way.
 
We integrate sustainability into two steps of our investment process. First, after we have ranked bonds using our quantitative multi-factor ranking model, our fundamental credit analysts check whether the top-ranked bonds have any additional risks that are not captured by the model. In this step, unacceptable Environmental, Social and Governance (ESG) risks are identified, in which case the bond rankings are overruled. Second, when constructing or rebalancing the portfolio we require the portfolio to have a (weighted) average sustainability score that is at least equal to that of the reference index. This implies that bonds from companies with a favorable sustainability score have a higher chance of being bought.

Drawback of negative screening
We rank companies from most sustainable to least sustainable. We systematically prefer companies with high sustainability scores to companies with lower scores. Negative screening on the other hand (i.e. excluding the least sustainable companies from the investment universe) only focuses on the worst ESG-rated companies. Moreover, it might lead to unexpected results. As no limit is set on the overall portfolio sustainability, the portfolio might even score below the reference index. In our approach we prevent this by directly controlling the portfolio sustainability score.

Our sustainability scores are provided by RobecoSAM. RobecoSAM has one of the largest proprietary corporate sustainability databases with nearly 4,000 companies. Founded in 1995, RobecoSAM was one of the first asset managers to focus exclusively on sustainability investing. Every year since 1999, dedicated sustainability researchers obtain financially material information from a range of public sources and directly from companies by inviting them to the annual Corporate Sustainability Assessment survey.

RobecoSAM follows a best-in-class approach. Companies receive a score between 0 (low) and 100 (high) on environmental, social and corporate governance factors and are ranked against other companies in their industry. To fairly compare companies with different sizes and potential resources, we control the RobecoSAM scores for company size.

Empirical results: higher sustainability without sacrificing returns
Figure 1 shows the impact of our sustainability integration on the portfolios’ average sustainability score, return (i.e. the excess return over duration-matched government bonds) and volatility. Panel a shows the results for our Global Multi-Factor Credits strategy, Panel b shows the results for the Global Conservative Credits strategy. Before explicitly targeting the portfolio’s sustainability the strategy already has a score that is on average higher than that of the reference index. Our preference for low-risk credits in the Multi-Factor Credits and Conservative Credits strategies implicitly leads to a preference for low ESG-risk credits as well. In 80% (89%) of the months the Global Multi-Factor Credits (Global Conservative Credits) strategy has a score that is already above that of the reference index.

The impact of our sustainability integration can be seen in the difference between the portfolios with and without the minimum sustainability score. When we set a lower bound on the portfolio’s sustainability score and require it to have a sustainability score that is equal to or above that of the reference index, the sustainability scores of the portfolios further increase, while the excess return and volatility stay virtually unchanged. Because we invest in a large investment universe with a high number of attractively ranked bonds, it is possible to be more selective in which bonds to buy and still keep the desired factor exposure.

Figure  1a  |  Global Multi-Factor Credits portfolios with and without sustainability integration
integrating-sustainability-into-factor-credit-strategies-1.jpg  

Figure  1b  |  Global Conservative Credits portfolios with and without sustainability integration
integrating-sustainability-into-factor-credit-strategies-2.jpg   

Note: Results in Figure 1a are based on historical simulations of the Global Conservative Credits strategy, from January 2002 to December 2015. Results in Figure 1b are based on historical simulations of the Global Multi-Factor Credits strategy, from January 2002 to December 2015. The restricted portfolio results are based on the strategy with a required sustainability score that is at least as high as that of the reference index. The unrestricted portfolio results are based on the strategy without an explicitly required sustainability score. The reference index is the Barclays Global Aggregate Corporates Index. Sustainability scores are the average (industry- and size-adjusted) sustainability scores. Excess returns are calculated as the return over duration-matched government bonds. Returns, volatilities are calculated on monthly data and subsequently annualized. Strategy returns are net of transaction costs, but gross of management fees. The value of your investments may fluctuate. Results obtained in the past are no guarantee for the future. Source: Robeco, RobecoSAM, Barclays.

Conclusion: maximum factor exposure at higher sustainability
Our approach leads to a further improvement in the portfolio’s sustainability score without negatively impacting the portfolio’s performance.  We require the portfolio to have an average sustainability score that is at least equal to that of the reference index, systematically preferring companies with high sustainability scores to companies with lower scores. By making a trade-off between factor exposures and ESG risks, we can achieve both objectives: having maximum factor exposure and simultaneously limit the exposure to unsustainable companies.

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