ESG momentum – the missing piece of the puzzle?
11th February, 2021
A distinctive feature of Davy Global Fund Management (DGFM) is an innovative, investor-led approach to ESG integration. A significant part of that process looks not just at a company’s ESG profile but also the direction of travel – “ESG momentum”. Our research shows that ESG momentum may have a beneficial performance effect.
In this paper, we explore the drivers of ESG momentum and how we as investors can use engagement as a positive influence on corporate management. Using engagement in this way not only provides a potential source of alpha but also helps us to encourage responsible corporate behaviour.
What’s the evidence for ESG momentum as a performance driver?
To demonstrate the link between improving ESG momentum and better share price performance, we first created and compared the performance of two equity portfolios: one comprising companies with positive ESG momentum and the other with negative ESG momentum. To maintain objectivity, we use the company-specific ESG ratings of MSCI, a leading provider of ESG analysis. MSCI grades companies based on their management of, and exposure to, sector-specific ESG risks and opportunities. It applies an S&P-style rating system, with AAA representing the best possible rating and CCC representing the worst.
The positive momentum portfolio comprises companies with improved ESG ratings, which we define as an upgrade in MSCI’s ESG rating, e.g., moving from A to AA. Similarly, for the negative ESG momentum portfolio, we created a portfolio of stocks that have been downgraded, e.g., moving from AA to A.
Constructing the ESG momentum portfolios
Timescale: Once companies had been upgraded or downgraded, they remained in the portfolio for 18 months. These 18 months represented a period of momentum during which both portfolios were updated monthly.
Portfolio weighting: For the purpose of this study, we weighted portfolio constituents equally, assuming that all momentum moves are of equal relevance. This removes any size bias that would be created by weighting the portfolio by market cap.
Performance: We calculate performance by measuring the alpha between the two portfolios. A significant positive net effect would indicate that positive ESG momentum has a performance benefit over negative momentum, and vice versa.
Findings of our study
Our results indicate a positive performance effect for ESG momentum, with the positive momentum portfolio outperforming the negative momentum portfolio by 13.9% in EUR terms over the three-year period observed.
Cumulative alpha of a positive ESG momentum portfolio versus a negative ESG momentum portfolio
Cumulative total return in EUR, 1 October 2017 – 30 September 2020. Sources: MSCI, Davy Global Fund Management.
Q&A: Is negative ESG momentum more influential than positive ESG momentum?
A notable finding from our study has been the strong performance of the positive momentum portfolio, which delivered 22.6% on a cumulative basis over the period observed. The negative momentum portfolio had a much smaller overall impact over the three years, delivering an 8.7% return cumulatively over the same period.
Summary performance of long-short ESG momentum portfolio
|Since inception (30 September 2017)|
|Positive momentum book||22.6%|
|Negative momentum book||8.7%|
Q&A: How does positive momentum fare versus the broad market?
We established above that positive ESG momentum is more impactful than negative momentum, but how does positive ESG momentum perform against the broad market? For this analysis, we weighted the positive ESG momentum portfolio by market cap and compared the performance versus the MSCI World Index over the same three-year period.
The resultant performance indicates that a portfolio constructed of positive momentum alone may not outperform the broad market, returning 8.1% versus the market return of 8.6% (annualised) over the period observed. However, examining the performance attribution, we see that while sector allocation detracted significantly from performance, stock selection was a strong positive contributor. This shows that ESG momentum may be less useful as a top-down input to identify sectors but may be an effective tool in highlighting stocks with the potential to outperform.
In other words, ESG momentum should not be considered in isolation. However, as demonstrated above, it can become a powerful tool when considered within a wider investment process.
Attribution breakdown of positive momentum portfolio versus MSCI World over the three-year period
As at 30 September 2020 in EUR. Sources: MSCI, Bloomberg PORT, Davy Global Fund Management.
How does ESG momentum impact investment returns?
An important question requiring further research is exactly how ESG momentum impacts investment returns. One answer may come in the form of the “halo effect” (Thorndike, 1920), a construct from social psychology that has been extended to investing. Through the halo effect, companies perceived as particularly virtuous may benefit from a bias in the eyes of investors. As a result, their ESG virtue spreads to a positive perception of their broader business and fundamental characteristics.
A more tangible market-based explanation could be that stocks with improving ESG ratings are more likely to be bought by ESG-aware portfolio managers. In addition, the growth of passive approaches to ESG investing means that improved ESG performance may lead to companies’ inclusion in ESG indices, which in turn may drive stock prices upwards.
Further research on ESG momentum
The impact of engagement remains under-researched, particularly in the context of ESG. One of the primary reasons for this is the subjective nature of outcomes. For example, it is very difficult to attribute successful outcomes to engagement. Not all engagement results in improved ESG ratings and not all improved ESG ratings are driven by engagement. Improvement in a given area may be incidental or entirely due to management actions.
What’s more, engagement activity often has goals that may not impact ESG ratings directly. Taken one step further, deriving a relationship between engagement, ESG improvement and investment returns is a complicated task.
It may also be interesting to observe how impactful the starting point is on share performance. For example, does the market react more favourably to a CCC-rated company improving its ESG performance than a AA-rated company?
Implications of our study
Our study suggests that ESG momentum may provide quantifiable performance upside but it needs to be considered as part of a wider investment process to fully capture its benefits.
We seek to capture ESG momentum by encouraging investee companies to improve their management of ESG risks and opportunities, and thereby improve their potential to receive improved ESG ratings. The implication of our findings is that by using engagement as a mechanism for improving ESG performance, we can help companies to “self-help” towards superior share price appreciation.
Furthermore, engagement may allow investors to stoke a virtuous cycle whereby ESG research leads investors to engage with companies, which encourages companies to improve any deficiencies and is ultimately reflected in positive ESG momentum. Such momentum, as our study shows, may manifest itself in positive share price performance.
How can investors capture ESG momentum?
One of our strategies for enhancing returns through ESG momentum is to encourage companies we invest in to improve their management of the ESG risks and opportunities in their business, thereby allowing them to potentially improve their ESG profiles. The principal way we seek to achieve this is by engaging with company management. Such dialogue helps us to understand how well companies are managing their ESG risks and opportunities and can be used to drive positive change.
We approach company engagement in two ways: engaging for information and engaging for change.
Engaging for information
Engaging for information doesn’t necessarily have ESG connotations but can deepen our understanding of how a company is managing its ESG risks. For example, through examining the robustness of its data security strategy we may understand how vulnerable a company is to a large-scale data breach.
Engaging for change
Engaging for change uses corporate dialogue as an engine of progress in specific aspects of a business. In an ESG context, this can be used to stimulate improved management of an ESG risk, such as addressing board composition, energy transition or the management of human capital.
Since progress on such issues may take years rather than months, engaging company management is typically favoured by equity investors such as DGFM that have long-term investment horizons and who favour lower portfolio turnover.
A core part of ESG integration
At Davy Global Fund Management, we view engagement as a core part of ESG integration. Engagement allows us to improve our understanding of the businesses we invest in and provides a means to agitate for improvements in both ESG performance and portfolio returns. We will continue to study corporate engagement as we strive to maximise the leverage we can achieve through our engagement activities.
Data analysis provided by:
Emma O’Donnell is a quantitative analyst at Davy Global Fund Management where she is responsible for the research and development of models used in the management of our portfolios and strategies.
Warning: Past performance may not be a reliable guide to future performance. The value of your investment may go down as well as up.
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Davy Global Fund Management Luxembourg S.A. (‘DGFMSA’) is registered with the RCS under no. B124965 with the registered office at 1, rue Hildegard von Bingen, L-1282 Luxembourg, G.D. Luxembourg. DGFMSA is supervised by the CSSF as Management Company authorised under Chapter 15 of the Law of 17 December 2010 with number S00000727 and Alternative Investment Fund Manager according to the Law of 12 July 2013 with number A00000148.
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