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A smart approach to combine quant factors and sustainability

A smart approach to combine quant factors and sustainability

12-06-2018 | Insight

Factor-based equity strategies can help investors achieve sustainability objectives, in addition to better risk-return characteristics. But striking the right balance between quant factors and sustainability aspects requires a smart approach.

  • Machiel Zwanenburg
    Machiel
    Zwanenburg
    Portfolio Manager Quantitative Equities

Speed read

The rising demand for sustainable investment solutions poses challenges for asset managers, who must increasingly take into account environmental, social and governance (ESG) aspects, without sacrificing returns. In this context, the ability to combine some of the highest sustainability standards with efficient quantitative, or factor-based investment approaches has become one of the key ways asset managers can differentiate themselves from the competition.

In fact, over the past few years, a growing number of research papers have been published on the interplay of factor investing and sustainability. Both academics and product providers have dived into this field of research, as awareness about the potential benefits of combining the two investment approaches increased among the investment community.

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Various approaches to sustainability integration

There are many ways to integrate sustainability in a quantitative portfolio but we have identified three main approaches. The first one is to address ESG and financial objectives independently. This means allocating a certain percentage of the portfolio to a factor based strategy, in order to meet the desired financial objectives, and the rest to an ESG-oriented strategy, to enhance the portfolio’s overall sustainability profile. However, this kind of approach may not be optimal, as integrating sustainability will frequently imply giving up on factor exposures and vice versa.

Another approach is to start by screening the market portfolio according to the desired sustainability criteria and apply a factor based strategy to the remaining universe. While this method may produce better results, it is also far from ideal. This approach is about avoiding investments in companies that score low in terms of the sustainability criteria, such as an ESG score, or a carbon footprint. But it does not focus on the end result: maximizing both returns and the portfolio’s sustainability profile.

A smarter way to ensure return and sustainability objectives are met, is to maximize factor tilts and sustainability criteria simultaneously. This can be achieved by treating sustainability as a theme in the quantitative stock selection model, or as an additional criterion in the portfolio construction process. Robeco’s in-house research and years of experience have shown it is possible to maintain the required factor tilts and ensure that financial objectives are met, while also taking into account ESG aspects, that enable us to satisfy the desired sustainability standards, as well.

A smarter way to ensure return and sustainability objectives are met, is to maximize factor tilts and sustainability criteria simultaneously

Figure 1 below shows a stylized illustration of the tradeoff investors will be faced with, when trying to meet both return and sustainability objectives. The grey line represents the different options available for investors applying the first approach: addressing ESG and financial objectives independently. Meanwhile, the blue line shows the possibilities for those who decide to maximize factor tilts and sustainability criteria simultaneously.

Figure 1: Stylized illustration of tradeoff between factor tilts and sustainability

Source Robeco

The relationship between factor tilts and sustainability represented by the blue curve can be demonstrated by running backtests on data based on existing Robeco strategies. This is illustrated in Figure 2. It shows a set of portfolios, each with a different factor/ESG profile, based on Robeco’s QI Global Developed Sustainable Enhanced Index strategy.

Figure 2: Efficient frontier of portfolios with different factor/sustainability profiles

Source: Robeco.
Simulated information ratio plotted versus the weighted sustainability score of the portfolio for different combinations of the model factors (smoothed). We compare models mainly based on the value, quality and momentum factors with models mainly based on sustainability scores.

Robeco’s QI Global Developed Sustainable Enhanced Index strategy integrates ESG by means of the tilt towards companies with enhanced sustainability profiles, compared to the average derived from the reference index. Moreover, the portfolio’s footprint for greenhouse gas emissions, waste generation, water consumption and energy use has been reduced by at least 20%. An extensive values-based exclusion list is also applied. This illustrates how improved sustainability profiles can be achieved while simultaneously capturing most of the factor based exposure provided by our quantitative stock selection model.

Building on RobecoSAM’s know-how

Robeco applies three different approaches to sustainability investing in its quantitative equity strategies. Our basic approach ensures that the ESG profile of the portfolio exceeds that of the benchmark or the reference index. Our enhanced approach applies three dimensions of sustainability integration in the portfolio construction process: exclusions, environmental footprint reduction and tilt towards companies with an enhanced sustainability profile. Finally, our advanced approach determines the attractiveness of stocks according to their scores on both sustainability and factor aspects, while still maintaining the aforementioned portfolio construction criteria.

To measure sustainability scores, we use RobecoSAM’s Corporate Sustainability Assessment (CSA). The CSA consists of an annual analysis of financially material sustainability information from approximately 4,500 listed companies. Following the first CSA conducted in 1999, Robeco’s sister company RobecoSAM compiled one of the world’s most comprehensive databases on corporate sustainability.

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