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A Systematic Approach to ESG Integration

26th August, 2020

Two questions investors often ask us are: “How do you integrate ESG principles into a systematic portfolio?” and “Does this add value?” We address these questions in this insight.


The Davy Global Fund Management investment philosophy focuses on identifying Quality businesses through a Quantamental process that also integrates environmental, social and governance (ESG) criteria – “QQE”.

Quality: We believe companies that are long-term winners demonstrate high quality in their profitability, persistence, protection and people. Quantamental: We seek to capture the best insights from different investment styles by combining the consistent, wide breadth of coverage of our quantitative model with the in-depth fundamental analysis of individual companies. ESG: We seek a further investment edge from assessing how companies are responding to growing environmental, social and governance business risks.

Our primary tool for QQE investing is our proprietary multi-factor Quality model. This consists of four pillars: Profitability, Persistence, Protection and People. The model seeks to invest in companies that are best able to generate higher-than-normal returns on an ongoing basis, and whose management teams allocate capital efficiently and manage business risks effectively.

One of the biggest business risks facing companies today is how well they can respond to the challenges of ESG. We believe there is a strong correlation between high-quality companies identified by the Davy Quality model and the ESG score of companies as assessed by, for example, MSCI.

ESG scores are a relatively recent development compared with long-established credit quality ratings. Companies only started to collect reliable ESG data in the last few years and businesses are at different stages of developing and implementing their strategy. It isn’t easy to capture all these moving parts in a single ESG score. Our challenge as investors is to evaluate such scores in a broader context that more accurately assesses companies’ ESG capabilities.

Systematic integration of ESG

Quantitative approaches to incorporating ESG have traditionally often relied on blunt, exclusion-based principles. For example, companies with low ESG scores (as determined by firms such as MSCI or Sustainalytics) are removed from the potential investment universe. Entire sectors deemed out of alignment with ESG principles, such as oil or tobacco companies, are similarly excluded.

One of the problems with this approach is that it cannot account for the “flight path” that companies may be on. Management strategies and developments could be carrying companies a long way from their current ESG scores.

Rather than being rigidly rules based in excluding companies because of poor ESG scores, we prefer to allow for the possibility that a company’s direction of travel might be moving it in a better (or worse) direction. We think of this as “positive ESG integration”. This approach can help us identify businesses that have robust ESG credentials. By not excluding companies or sectors, this also allows us to keep our investment universe as large and diverse as possible.

Notwithstanding our overall finding that high-quality companies generally manage their ESG risks well, this isn’t always the case. For example, some companies are well run and score highly on quality but may be late in formalising their ESG strategies, or might still be grappling with implementing ESG (for example, Facebook). Conversely, some companies have embedded strong ESG principles but are still early in their lifecycle (for example, Salesforce), which could impair their rating from a quality perspective.

Implementing positive ESG integration

To account for anomalous situations such as Facebook and Salesforce, we take the output from our Quality model and adjust it up or down depending on companies’ ESG profiles.

If a company scores well on ESG criteria, we can give a positive boost to its overall Quality score to reflect its focus on managing long-term business risks. Conversely, companies that perform poorly on ESG have their Quality scores reduced to reflect the increased risks.

We use the adjusted Quality scores to select stocks and adjust weights within the portfolio. This allows us to include companies with slightly lower Quality scores but exceptional ESG profiles. Similarly, companies that score well on Quality but have poor ESG profiles might fail to meet the criteria to be included within the portfolio.

Whether strong ESG credentials lead to companies having high quality overall or whether high-quality companies by nature adopt good ESG remains open to debate. However, we believe that approaching ESG integration in a positive way can be the best of both worlds. First, we do not limit our investment universe. Second, we can seek to combine the best insights from both ESG and Quality ratings.

Does positive ESG integration add value?

We have been point-in-time tracking (see note) our Quality model since January 2016. This allows us to assess the impact of positive ESG integration, where we adjust the Quality rank upwards or downwards depending on ESG data (which we call Davy ESG Quality). We find that since the model’s inception (14 January 2016), a positive ESG integration strategy has added 5.0% to total returns compared to the unadjusted output from the Quality strategy.

Figure 1: Total return of the Davy ESG Quality, Davy Quality and the MSCI World Index, 14 Jan 2016 to 30 June 2020, in EUR terms.

 

 

Davy ESG Quality Index

Davy Quality Index

MSCI World Index

2016*

14.47%

13.50%

19.23%

2017

13.86%

13.10%

8.10%

2018

1.86%

0.87%

-3.60%

2019

37.39%

36.61%

30.82%

2020 YTD**

6.61%

7.11%

-5.55%

*Model starts 14 January 2016

** YTD as at 30 June 2020

Note: In point-in-time tracking, data is collected at the time, over the period rather than downloaded at the end of the period.

 

Authors:

Jeremy Humphries is a Fund Manager for Davy Global Fund Management and is responsible for quantitative research and portfolio management. He develops the quantitative models used in the investment process employed across the firm’s investment strategies.

 

Emma O’Donnell is a Quantitative Analyst in the Global Equities investment team. Emma is responsible for the research and development of models used in the management of our portfolios and strategies.

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