A little more conversation and a lot more action

There’s a lot of talk about the importance of environmental, social and governance issues in investment decisions, but is there sufficient action? And if there is, what does that action look like, and can it deliver on performance as well as moral objectives?

According to the latest MSCI 2021 Global Institutional Investor survey, around 79% of investors in the APAC region increased their ESG investments while 57% said they expect to have “completely” or “to a large extent” incorporated ESG issues into their investment and operational processes by the end of 2021. (1)

In Europe, total funds under management within an ESG fund, strategy or product has now reached a record €1.1 trillion (2)  while in the U.S, ESG investing now accounts for one-third of total U.S assets under management, according to the U.S SIF Foundation’s Report on U.S Sustainable and Impact Investing Trends. (3)

It’s clear that ESG has finally moved into mainstream investment management because it is no longer possible to ignore the science of climate change, nor deny the conclusion that we are at a tipping point in terms of the global environment.

Action needs to be taken, now. The fact that this is acknowledged at the highest levels of the investment world is an encouraging signal that climate (and other ESG risks) are increasingly seen as investment as well as moral risks.

Can ESG really be a performance driver?

Ever since the investment world started to take ESG seriously, the conundrum has always been the strong disconnect between ESG, or any ethically-driven restrictions, and financial value. In other words, doing good didn’t necessarily translate into doing well – and doing well (or more specifically the fear of doing badly) frequently trumped doing good.

One reason was the way in which corporations made money and were valued, and the historical view of a corporation’s objective, which was to increase profits for itself and its shareholders. Social responsibility did not play a role.

The idea that a corporation has a social obligation as well as a profit objective, has only become much more widely accepted over the past 30 years and at the same time, the economic landscape has changed dramatically.

As the disastrous effect of depleting natural resources and global warming has become apparent, using natural resource as if they were limitless and free is not sustainable – and this has affected the profits and sustainability of ‘old-world’ businesses, like oil, gas and the automotive industry. Additionally, over time this will prove to be transformational for the food, apparels, transportation, real estate, banking, insurance, as well as many other segments of the economy.

If we add in the effects of the rise of digital technology, and how it has changed the way we live, shop and do business, it’s clear that old world businesses face an entirely new set of challenges from newer businesses with very different value drivers. These are the businesses which create and sell intangible assets, like brand value, intellectual property or even active users of new technologies. Intangibles are outpacing tangible assets, and the kinds of businesses which are most profitable are changing.

ESG and quant investing

ESG considerations are increasingly seen as important, not only because of the dire state of our planet, but also as performance drivers. This is because ESG factors capture some of the risk and return drivers not captured in traditional financial metrics, but which are highly relevant to valuation today, in a way they weren’t in the past.

For quant investors, historically there have been challenges in addition to those which discretionary managers faced, when looking at incorporating ESG factors into investment making decisions.

Today however, the situation is very different, and quants are now armed with new ways to systematically extract topical information from multiple sources. This means we can now compete with discretionary managers on selecting assets and building portfolios with sustainability tilts.

This change is primarily due to advances in technology, machine learning and artificial intelligence (AI) which are increasingly allowing quants to analyse alternative data sources and and to make use of this data within investment strategies.

Alternative data sources now form the basis of many of our insights and strategies and are growing in size and importance exponentially. Information collected from individuals on social media, imagery from drones and satellites, even the kind of language CEOs use when issuing an earnings update is all data which has existed for a long time.

What hasn’t been possible, until recently, has been our ability to store and interpret this data, particularly given how much of this data is unstructured and dirty.

Making sense of this type of data and using it to inform investment strategies requires advanced statistical techniques such as neural networks – areas where quant investors have a serious advantage over discretionary managers.

An added advantage is that AI allows us to listen in on billions of conversations going on not only in the financial ecosystem, but also outside the financial ecosystem. This is important because some of the themes which fundamentally shape our future do not necessarily happen in financial circles.

The first conversations about hydrogen powered cars, for example, weren’t had by investment managers, they were had by academics and NGOs – but listening in to these conversations gives real insight into the ESG themes likely to shape the future.

What companies does CFM believe best represent the opportunity in ESG?

Unlike discretionary managers in this space, we don’t make high conviction trades in only a handful of stocks, but rather we are extremely diversified taking both long and short positions across many stocks according to our algorithms. We invest systematically, using signals or indicators based in part on direct and indirect emissions but also related to physical and various transition risks companies will face as they move to a more sustainable economy. 

We also use a network approach and natural language processing as we seek to monitor and quantify the propagation of this greening wave across the entire market. 

This helps us identify companies that we believe will do relatively well during the carbon transition, because they are either greener already, or in the right eco-system, or more able to green themselves, or able to help others getting greener, compared with those who will stay behind, procrastinate and or struggle.

Conclusion

Regardless of investment strategy, active investment managers are all engaged in a hunt for alpha – or a return in excess of the market – which they hope to consistently deliver to investors.

The proliferation and democratisation of data has seen it become a highly-valuable commodity in its own right, but to extrapolate meaningful value from it requires both technical know-how and technological capacity.

Put simply, data isn’t worth much if you don’t know how to use it – and that’s where experience comes into the equation.

In closing, financial markets evolve constantly, but history shows us that they do have a degree of predictability. Furthermore, as companies continue to ‘green’ as part of a transition to a low-carbon economy, we believe analysing and acting upon alternative data sets in a systematic way, has never been more relevant to identifying and investing in the winners of the low-carbon revolution.

Footnotes

(1) CNBC, ESG investments surged in Asia-Pacific in 2020 as sustainable investing takes off, MSCI survey finds

(2) Financial Times, ESG demand prompts more than 250 European funds to change track

(3) MarketWatch, ESG investing now accounts for one-third of total U.S assets under management