PGIM Quantitative Solutions seeks to help solve complex investment problems with custom systematic solutions across the risk/return spectrum.
See right through our ESG approach
There is growing interest by investors to “do the right thing” by using their influence to pressure companies to improve their approach to environmental, social and governance (ESG) issues. But a major challenge is how to minimize the potential costs imposed by ESG constraints on portfolios and overcome the persistent sparsity of ESG data resulting from companies’ non-reporting. In this study, we propose a quantitative approach to integrating ESG into portfolios that is expected to deliver comparable performance to non-ESG portfolios and is capable of classifying companies based on ESG even when they do not disclose sufficient data. The approach is particularly suitable for quantitative portfolios with large numbers of positions and many small exposures. In such portfolios, one can generally identify companies with bad ESG metrics and swap them out for companies with similar expected future returns and better ESG scores. This allows the manager to efficiently tilt the entire portfolio towards better ESG companies without the need to employ detailed ESG analysis of individual firms.
Key Findings
- Classification of companies should be performed using ESG items material to their specific industry.
- Our innovative Good Minus Bad (GMB) ESG factor can be used to extend ESG classification to non-reporting companies, expanding the universe by over 200%. This approach helps to overcome one of the most challenging obstacles to ESG portfolio construction: the lack of available ESG data.
- With our quantitative approach, which combines the material ESG items and ESG expansion, the companies with better ESG metrics have higher valuations than lower-scoring companies but comparable future returns. We find that financial analysts misprice the returns of good ESG companies by expecting their higher valuations to continue, in much the same way that good-quality companies often enjoy both current higher valuations and potentially higher future returns.
Find more at qma.com/esg
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