In this Indices insights article, we show that incorporating sustainability does not constrain the potential for alpha. Indeed, active investors can still benefit from similar levels of market breadth, even after excluding stocks that contribute negatively to the UN SDGs.
The potential to outperform market indices is the key advantage of active investment approaches, including popular styles such as growth or value. With investors increasingly seeking to integrate sustainability, active managers are tasked with generating alpha for their clients while simultaneously incorporating their sustainability preferences. The question is whether exclusions based on sustainability aspects can dilute the relative advantage of an active approach.
In the previous ‘Indices insights’ article, we looked at whether the integration of sustainability considerations has an impact on passive investors’ financial objectives. From our analysis, we demonstrated that it is possible for passive solutions to exhibit risk-return characteristics that are similar to those of the market even when high carbon emitters or companies that negatively impact the SDGs are excluded. We also saw that these sustainable passive solutions can enjoy the diversification benefits of market-cap weighted indices.
In this article, we will examine to what extent the integration of sustainability affects active investors. The application of sustainability screens reduces the size of the investment universe, which therefore could constrain the alpha potential of an active solution. Indeed, active investors have a greater chance of delivering alpha if the distribution of stock characteristics within an investment universe is more dispersed, i.e., reflecting higher market breadth.
To assess this, we analyzed the distribution of stock characteristics – including market capitalization, valuations, quality and risk – for two separate investment universes: one consisting of thousands of stocks globally (full universe), and the other comprising the full universe minus stocks with poor sustainability attributes (sustainable universe). More specifically, the sustainable universe excludes companies that contribute negatively to the SDGs, determined by Robeco’s proprietary SDG framework.
As shown in Figure 1, we found that the stock characteristics for the two universes were virtually identical. This is reflected by the blue ellipses (sustainable universe) almost completely overlapping the orange ellipses (full universe).
More specifically, the centers of the ellipses indicate the average size, value, quality or risk characteristics of the two universes. Therefore, how the ellipses are rotated around their centers provides an indication of the correlation between stock market caps and their corresponding valuation, quality or risk metrics. Given that each pair of ellipses is rotated in a similar angle, we can conclude that applying the sustainability filter – using the SDG criteria – does not result in concentrated exclusions within specific market segments, for example stocks with low valuations or high quality.
Finally, the similar-sized areas within the blue and orange ellipses as well as the dispersion of the blue and orange dots indicate that the breadth of the investment universe is similar after the sustainability screen is applied. Put differently, the opportunity set for active investors is not significantly impacted by excluding companies based on their negative contributions to the SDGs.
We also scrutinized how stocks are distributed across 3x3 groups sorted on size and value, size and quality, as well as size and risk. We observed that the distribution across the full and sustainable universes was markedly similar, as depicted in Table 1.
For instance, 2.2% and 2.5% of the stocks are large caps with low valuations in the full and sustainable universes, respectively. These similarities hold for all the other groups as the differences in distribution are typically very small. Although it is difficult to see, this is also reflected in Figure 1 by the distribution of the blue and orange dots within each of the nine blocks (groups) in the three separate charts.
For our analysis, we based our investment universes on the constituents of the MSCI World Investable Market Index as at the end of December 2021. Regarding stock characteristics, we used the log of market caps for size, log of book-to-price ratios for value, gross profits-to-assets ratios for quality, and historical 36-month market betas for risk, all sourced from FactSet and rescaled to have a mean of zero and unit standard deviation. We excluded financials from our study when analyzing the size and quality traits.
To construct our sustainable universe, we applied a sustainability screen based on Robeco’s proprietary SDG framework. The framework provides a clear, objective, consistent and replicable approach to measuring the contributions that companies make to the 17 SDGs. More specifically, we excluded companies that contribute negatively to the SDGs. While our full universe consisted of roughly 6,000 stocks, our sustainable universe comprised approximately 4,700 names.
Similar to the Morningstar Style Box and Morningstar Ownership Zone analyses, we then produced scatterplots of the stocks in three dimensions based on their size and value, size and quality, as well as size and risk characteristics. We also added the breakpoints of the market cap and secondary characteristics to split the universes into 3x3 groups, using the 10th and 90th percentiles. These breakpoints are denoted by the vertical and horizontal lines in the plots. Additionally, we calculated ellipses for each pair of characteristics covering 95% of the stocks in the relevant universe that are closest to the average.1
Based on our findings, we conclude that an SDG-based sustainability screen has virtually no effect on the dispersion and distribution of stock characteristics, when we analyze an investment universe in the context of several stock attributes that are typically deemed relevant for explaining differences within the cross-section of stock returns.
Furthermore, we find that the integration of sustainability leaves investors with ample investment opportunities. This is particularly important to active investors who aim to generate alpha for their clients and adhere to their sustainability preferences. In the next ‘Indices insights’ article, we will put this notion to the test within the context of factor investing, by analyzing the effect such sustainability screens have on expected factor premiums.
1 A universe which is less dispersed will have an ellipse covering a small area versus a universe which is more dispersed.
In defining sustainability, investors have a multitude of dimensions and metrics they could consider. For example:
ESG scores typically put more focus on the operations of a business, whereas SDG scores also incorporate the impact that the business' products and/or services have on society.
We see client sustainability objectives increasingly moving towards avoiding controversial businesses (values-based exclusions) and including those that provide sustainable solutions (impact investing). In the first few articles of our Indices Insights series, we will empirically show how the different sustainability metrics (negative screening/exclusions, ESG, SDG) relate to the increasingly impact-oriented client sustainability objectives.