latamen
Smart sustainability integration in Quant Equity

Smart sustainability integration in Quant Equity

12-09-2016 | Insight

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.

  • Bart van der Grient
    Bart
    van der Grient
    Reseacher
  • Machiel Zwanenburg
    Machiel
    Zwanenburg
    Director, Portfolio Manager

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.

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.

Stay informed on Quant investing with monthly mail updates
Stay informed on Quant investing with monthly mail updates
Subscribe

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

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.

Important information

The Robeco Capital Growth Funds have not been registered under the United States Investment Company Act of 1940, as amended, nor the United States Securities Act of 1933, as amended. None of the shares may be offered or sold, directly or indirectly in the United States or to any US Person.

This website is intended for use only by non-U.S. Persons outside of the United States (within the meaning of Regulation S promulgated under the Securities Act of 1933, as amended (the “Securities Act”)) who are professional investors. By clicking “I Agree” below and accessing the information on this website, including any subdomain thereof, you are certifying and agreeing to the following: (i) you have read, understood and agree to this disclaimer, (ii) you have informed yourself of any applicable legal restrictions and represent that by accessing the information contained on this website, you are not in violation of, and will not be causing Robeco or any of its affiliated entities or issuers to violate, any applicable laws and, as a result, you are legally authorized to access such information, (iii) you understand and acknowledge that certain information presented herein relates to securities that have not been registered under the Securities Act, and may be offered or sold only outside the United States (within the meaning of Regulation S under the Securities Act) and only to, or for the account or benefit of, non-U.S. Persons (within the meaning of Regulation S under the Securities Act), (iv) you are a non-U.S. Person (within the meaning of Regulation S under the Securities Act) located outside of the United States (within the meaning of Regulation S under the Securities Act) and (v) you are a professional non-retail investor.

Access to this website has been limited so that it shall not constitute directed selling efforts (as defined in Regulation S under the Securities Act) in the United States.

Nothing contained herein constitutes an offer to sell securities or solicitation of an offer to purchase any securities in any jurisdiction.

We reserve the right to deny access to any visitor, including, but not limited to, those visitors with IP addresses residing in the United States.

This website has been carefully prepared by Robeco Institutional Asset Management B.V. (Robeco). The information contained in this publication is based upon sources of information believed to be reliable. Robeco is not answerable for the accuracy or completeness of the facts, opinions, expectations and results referred to therein. Whilst every care has been taken in the preparation of this website, we do not accept any responsibility for damage of any kind resulting from incorrect or incomplete information. This website is subject to change without notice. The value of the investments may fluctuate. Past performance is no guarantee of future results. If the currency in which the past performance is displayed differs from the currency of the country in which you reside, then you should be aware that due to exchange rate fluctuations the performance shown may increase or decrease if converted into your local currency. For investment professional use only. Not for use with the general public.
I Disagree