December 08, 2020
PGIM Quantitative Solutions seeks to help solve complex investment problems with custom systematic solutions across the risk/return spectrum.
Take a Consistent Approach to Custom ESG Investing
QMA integrates custom ESG exposures into equity portfolios across the risk-return spectrum for more of what you want with no extra fees.
AUTHOR
Gavin Smith, PhD
Head of Equity Research
ABOUT QMA
QMA began managing multi-asset
portfolios for institutional investors
in 1975. Today, we manage both
systematic quantitative equity and global
multi-asset strategies as part of PGIM,
the global investment management
businesses of Prudential Financial,
Inc. (PFI).
1
Our investment processes,
based on academic, economic and
behavioral foundations, serve a global
client base with $106.1 billion in assets
under management as of 6/30/2020.
1
PFI of the United States is not affiliated in any manner with Prudential plc, incorporated
in the United Kingdom or with
Prudential Assurance Company, a subsidiary of M&G plc, incorporated in the United Kingdom.
FOR MORE INFORMATION
To learn more about our ESG
offerings, please contact us by email at
contactus@qma.com
or by phone in the
US at +1 (866) 748-0643 or in the UK
at +44 (0) 20-7663-3400.
For Professional Investors only.
All investments involve risk, including the possible loss of capital.
A CONSISTENT APPROACH TO CUSTOM
ESG INVESTING
July 2020
INTRODUCTION
Sustainable investing is under increased scrutiny, as a series of proposed and upcoming
regulations start to take effect. The EU Action Plan: Financing Sustainable Growth
now requires investment firms doing business in the EU to implement mandated
Environmental, Social and Governance (ESG) reporting standards. In the US, the
Department of Labor (DOL) recently proposed a new ERISA rule, with guidance
specifically calling out ESG investing. If this proposed regulation were to become law,
sustainable strategies that “increase risk for the purpose of non-financial objectives” would
be prohibited.
Selecting a strategy that can effectively meet these new requirements, however, is only
one of many hurdles facing ESG investors. The sheer variety of ESG strategies can
be overwhelming. Many options are limited in their ability to provide a transparent,
cost-effective approach that takes individual circumstances into account. Several
challenges further complicate the selection process. Asset owners are confronted by
lack of consistency in ESG analysis and measurement, data disclosure and regulatory
requirements. There can be strong conflicts of interest between companies and their ESG
ratings providers, as well as in the construction of ESG indexes. Since neither firms nor
ratings providers/indices are held to uniform standards, it can be hard to decipher the
actual level of ESG vs. “greenwashing” that goes on. In addition, since ESG strategies can
dilute performance, they may be inadmissible for ERISA plan owners’ consideration.
It is easy to appreciate how these issues temper investor choice and confidence in ESG
strategies. How can investors be confident that an ESG strategy is aligned with their
sustainability objectives, when, in fact similarly named strategies offer vastly different ESG
exposures? How can asset owners seek to advance a sustainability objective if there is not
enough data to evaluate which companies are aligned with that goal? Regardless of the
proposed DOL regulation: why should investors pay more to invest sustainably?
At QMA, we applied 40+ years of quantitative investment experience to help solve these
problems. Our framework
Evaluates, Expands
and
Integrates ESG
exposures in a
process that (1) is transparent (2) does not compromise performance (alpha-neutral) (3) is
flexible enough to accommodate investor ESG preferences. Our customized approach offers
ESG exposure at the same price point as non-ESG offerings across the risk-return spectrum.
A Consistent Approach to Custom ESG Investing 2
THE PROBLEMS WITH SUSTAINABLE INVESTING
In the midst of nearly unprecedented market volatility, sustainable business practices are proving their mettle. Companies with strong
stakeholder relationships, a deep commitment to employees, smaller carbon footprints and a longer-term focus are weathering the
downturn significantly better than those without such standards. While no one would have chosen these particular testing grounds, the
results are clear: sustainability has real-world consequences.
At present, Europe is making particularly fast strides in ESG investing. The EU Action Plan for Financing Sustainable Growth now
includes mandated ESG reporting for both asset owners and asset managers. Such regulations will hopefully spearhead widespread
societal and environmental changes, but also run the risk of being so far-reaching that they are practically unenforceable. Companies are
scrambling to meet them, without a clear understanding of (a) what they need to deliver (b) what clients need from ESG.
Such issues are not specific to European asset owners, of course. Industry-wide, the approach to ESG investing is currently overly
generalized and inconsistent. Despite progress made toward recognizing the need for sustainability, the path to implementing an ESG
investment approach is still strewn with performance, cost and suitability hurdles. As a result, asset owners are hard-pressed to choose
sustainable investments that actually meet their ESG goals, as well as their fiduciary duties. Institutions with funding needs, pensions
to pay, and fiscal responsibilities to their clients have inflexible portfolio requirements. They simply cannot make cost or performance
sacrifices. Nor should they.
EVALUATING ESG
Quantitative managers are well-suited to overcome the existing flaws of ESG strategies and to deliver the solutions that ESG investors
need. Quants can provide transparency into ESG exposures and measurement techniques that may improve on the offerings from index
providers; offer solutions that neither detract from performance nor cost more; and design customizable client solutions that solve for
individual ESG challenges. The core strengths of quantitative investing lie in sourcing and cleaning data, carefully constructing factors,
balancing competing objectives and managing various exposures in portfolio construction. This produces portfolios that are controlled,
repeatable, and transparent. QMA begins this process by developing a rigorous, systematic method for measuring a company’s
ESG attributes.
Setting ESG Standards
The lack of consensus around a definition of ESG is confusing. The two dominant standard setters are Global Reporting Initiative (GRI)
and Sustainable Accounting Standards Board (SASB). GRI defines sustainability as “development that meets the needs of the present
without compromising the ability of future generations to meet their own needs.” Here, sustainability equates to the sustainability of
the planet and social systems. SASB, however, defines sustainability as “corporate activities that maintain or enhance the ability of the
company to create value over the long term.” Seemingly small, but significant differences.
Inconsistent methods of measuring ESG attributes also make it difficult for asset owners to enforce strict criteria. This is certainly true
in the carbon reduction space. A recent study of climate-aware funds by Morningstar
2
showed that only 40% of ex-fossil fuel funds are
actually fossil-fuel free. Furthermore, clean energy/tech funds were shown to carry some of the highest carbon risk.
This confusion around climate has prompted the EU Action Plan for Financing Sustainable Growth to develop standards for
harmonizing frameworks around carbon-oriented strategies. While this is encouraging, it only focuses on energy, a single dimension
of ESG. Definitions around the measurement of investments in the social and governance categories are still up in the air.
Transparency and Measurement
ESG ratings providers are generally not transparent about their methodologies. Most ESG ratings providers adopt what we call a hybrid
approach—combining objective data inputs with analyst insights. There is also an issue of conflicts of interest. ESG ratings agencies
provide consulting services to the same companies they rate. These concerns have been significant enough for Japan’s Government
Pension Investment Fund (GPIF)
3
to increase its due diligence of ESG ratings and index providers, and for the European Securities and
Markets Authority (ESMA)
4
to raise the idea that ESG ratings providers should be regulated and supervised as public sector authorities.
QMA doesn’t rely on ratings providers. We steer clear of bias, analyst insights and personal interpretation by using the ESG framework
developed by the Sustainability Accounting Standards Board (SASB), so our system of measurement is clear to clients. SASB’s goal is to
provide clearer guidance to companies on what ESG issues to disclose. QMA is also a member of SASB’s Investment Advisory Group,
through which we advocate to improve the quality, quantity and consistency of the ESG data disclosed within the investment industry.
2
Investing in Times of Climate Change—An Expanding Array of Choices for Climate-Aware Investors, Morningstar Manager Research, April 2020.
3
Breaking Down the Elements of Passive Management to Enhance Sophistication: GPIF
Initiatives, 4 February 2020.
4
Sustainable Financial Markets: Translating Changing Risks and Investor Preferences into Regulatory Action, European Financial Forum 2020, European Securities and
Markets Authority, 12 February 2020.
A Consistent Approach to Custom ESG Investing 3
Several features make SASB’s framework attractive. To begin with, SASB is an independent organization, limiting governance and
conflict-of-interest concerns. SASB’s framework is clean, focusing solely on material issues that are important within certain industries. It
is also highly transparent in terms of decision-making. The method SASB uses to determine the importance of each ESG issue is clearly
delineated, so asset owners know exactly what they are investing in. Lastly, it is globally relevant, providing intuitive exposures to investors
in all regions around the world. This framework does not reflect a predominance of views from policy-makers or standard-setters in any
one region.
While ratings providers use readily observable attributes to evaluate stock attractiveness from an ESG perspective, we believe that a
company’s stock price largely reflects the benefits of such attributes. Instead, following the SASB approach, QMA uses industry-specific,
financially-relevant attributes in the evaluation process to identify attributes that have more likely been undervalued by the market.
We also use a combination of effort and action-based metrics in our evaluation process to minimize exposure to ESG traps and the
performance drag that is associated with them. Consider a company that claims to encourage diversity and inclusion. This could simply
be achieved through the existence of a Diversity and Inclusion (D&I) policy. But do they “walk the talk?” In our process we also look
at action metrics, such as the percentage of the workforce that is female. The combination of these metrics helps us to avoid ESG
window dressing.
We first map each of SASB’s material items to raw, objective ESG data. The use of objective data helps maintain the transparency of
the final ESG score and removes any ambiguity in the evaluation of attributes. We do not introduce analyst views or opinions. The
combination of these metrics also helps us to avoid ESG greenwashing.
5
We are confident that these ESG scores are transparent, alpha neutral, and can facilitate customization into any equity investment solution.
6
EXPANDING ESG INSIGHTS
Frustratingly, ESG data is still voluntarily disclosed and incredibly sporadic. Some items, mainly about companies’ own practices and
performance (e.g., emissions, diversity), can be difficult or impossible to determine. The median firm in the S&P 500 Index discloses
only a dozen different ESG data items. In global markets, the picture worsens, and becomes practically non-existent in emerging markets,
with only a trivial number of ESG items disclosed.
QMA uses a proprietary data completion methodology to expand ESG insights. Stock-return similarity helps us identify additional firms
that are “good” or “bad” from an ESG perspective. Our research shows that the performance of firms we infer to have positive or negative
ESG characteristics is comparable— if not stronger— than it is for firms with actual ESG data. This technique can also be applied to make
inferences on individual ESG issues (e.g., carbon emissions), which helps us address varying ESG preferences investors may have.
We are actively researching approaches to supplement our data completion methods, such as Natural Language Processing (NLP)
techniques, which also allow us to extract insights from various forms of unstructured data. Our approach to using NLP is not
straightforward machine learning. It is built, rather, around the development of rules, which are used to guide the search process to
extract relevant information. We can create custom rules to search for insights relating to any ESG issue—another method of expanding
ESG insights for client customization.
ESG INTEGRATION
Exclusion is the most common form of integration among ESG funds, and yet, it can also be detrimental to asset owners, increasing risk
and tracking error when entire sectors/industries are removed from investment consideration.
Many ESG indexes exclude a large portion of the index they represent. For some investors this may be satisfactory. However, ESG
indexes have built in disadvantages. The goal of an ESG index is to deliver the return of the parent index. They do this frequently
through what we call smart beta techniques (such as reweighting stocks in proportion to the ESG score), or simple optimization
techniques (maximizing exposure to ESG for a given level of tracking error). These methodologies may limit both the investment strategy
and potential ESG exposure. They may also restrict the ability of investors to meet their individual risk-return needs.
5
In our initial research, we analyzed performance from December 2008 through Decemb
er 2015 for companies with ESG scores in the Russell 3000
®
and S&P 500 indices. The results
showed that companies with positive ESG metrics according to material items showed a strong tendency to outperform the “bad” companies, with an average excess return of 1.7%
(vs. -1.4% for companies with bad ESG metrics).
6
With our ESG evaluation methodology, we continue to look at ways to evolve. If all firms strive for better ESG, will there be any real variation in ESG standards? This can be thought of
as ESG compression. How does an evaluation methodology solve this problem? Related, we are also considering how to evaluate more than current ESG practices, with an eye toward
which firms will be good ESG companies in the future. It is one of the more challenging issues, but it can help better position portfolios toward stocks expected to achieve the biggest
improvements in sustainability outcomes. QMA’s ability to evolve thinking around ESG reflects the importance of an active approach.
A Consistent Approach to Custom ESG Investing 4
QMA uses a substitution method for ESG integration. We are effectively agnostic if two stocks are comparable from an alpha
perspective. Risk and alpha exposures in our ESG portfolios are the same as in non-ESG portfolios. They differ solely on ESG
attributes. If all risk and alpha exposures are identical, the original performance objectives of a strategy remains intact.
If the current proposal by the DOL becomes law, such alpha-neutrality becomes even more compelling. Our ESG approach does
not impact performance—either positively or negatively. Rather, we would maintain the same alpha and risk exposures as the original
portfolio, while improving the ESG profile.
We can also implement this substitution effect to target a specific level of ESG exposure, calibrated to suit investor preferences. That is
one of the most compelling arguments for our framework: our approach to ESG integration allows investors to add ESG at any level to
any investment strategy.
7
At QMA, we believe that there is no one-size-fits-all ESG solution. Our customized offerings reflect that belief
in a client-directed product lineup.
CONCLUSION
The majority of available ESG frameworks fall short of asset owners’ needs from ESG strategies and often require significant
compromise either in beliefs, costs, or both. Are there any ways to direct investments into specific areas of ESG, while maintaining
adherence to a mandated risk and return budget?
The answer is a resounding “yes.” QMA’s approach to ESG is rigorous and systematic. We provide transparency into both our
exposures and the methods we use to measure and report ESG metrics. We do not expect clients to accept a performance haircut in
order to invest sustainably. Nor do we expect clients to fit their specific ESG needs within predetermined guidelines. In our approach,
QMA’s investment professionals
Evaluate, Expand
and
Integrate
customized ESG exposures into equity portfolios across the risk-
return spectrum—all at the same price point as non-ESG offerings.
QMA’s ESG exposure can be systematically applied onto a wide range of strategies, from enhanced index and core strategies to higher
active-risk equity opportunity strategies, all the while aiming to maintain alpha neutrality. We can apply our methodology to global or
regional mandates, including emerging markets; our framework is globally consistent, data driven and scalable.
We look forward to outlining relevant case studies and research in future publications.
7
Similar to our research into evaluating ESG attractiveness, our work on ESG integration
is not finished. New demands bring placed on strategies stemming from the EU Sustainable
Action Plan and the criteria around Climate Transition Benchmarks and Paris Aligned Benchmarks. In response, we are examining how to integrate ESG in a manner so that our
portfolios continue to improve year-on-year exposures.
A Consistent Approach to Custom ESG Investing 5
Notes to Disclosure
For Professional Investors only. All investments involve risk, including the possible loss of capital. Past performance is not a guarantee or a reliable indicator of future
results. There is no guarantee these objectives will be achieved. Diversification does not assure a profit or protect against loss in declining markets.
These materials represent the views, opinions and recommendations of the author(s) regarding economic conditions, asset classes, and strategies. Distribution of this information
to any person other than the person to whom it was originally delivered is unauthorized, and any reproduction of these materials, in whole or in part, or the divulgence of any of
the contents hereof, without prior consent of QMA LLC (QMA) is prohibited. Certain information contained herein has been obtained from sources that QMA believes to be reliable
as of the date presented; however, QMA cannot guarantee the accuracy of such information, assure its completeness, or warrant that such information will not be changed. These
materials are not intended as an offer or solicitation with respect to the purchase or sale of any security or other financial instrument or any investment management services and
should not be used as the basis for any investment decision. No liability whatsoever is accepted for any loss (whether direct, indirect, or consequential) that may arise from any use
of the information contained in or derived from this report. QMA and its affiliates may make investment decisions that are inconsistent with the views expressed herein, including for
proprietary accounts of QMA or its affiliates.
These materials are for informational and educational purposes. In providing these materials, QMA is not acting as your fiduciary.
In Europe, certain regulated activities are carried out by representatives of PGIM Limited, which is authorized and regulated by the Financial Conduct Authority (Registration Number
193418), and duly passported in various jurisdictions in the European Economic Area. QMA LLC, which is an affiliate to PGIM Limited, is an SEC-registered investment adviser, and a
limited liability company. PGIM Limited’s Registered Office, Grand Buildings, 1-3 Strand, Trafalgar Square, London WC2N 5HR.
These materials are issued by PGIM Limited to persons who are professional clients or eligible counterparties as defined in Directive 2014/65/EU (MiFID II), investing for their own
account, for fund of funds, or discretionary clients. No liability whatsoever is accepted for any loss (whether direct, indirect or consequential) that may arise from any use of the
information contained in or derived from this report.
QMA is a wholly-owned subsidiary of PGIM, Inc., the principal asset management business of PFI of the United States of America. PFI of the United States is not affiliated in any
manner with Prudential plc, incorporated in the United Kingdom or with Prudential Assurance Company, a subsidiary of M&G plc, incorporated in the United Kingdom.
In Japan, investment management services are made available by PGIM Japan, Co. Ltd., (“PGIM Japan”), a registered Financial Instruments Business Operator with the Financial
Services Agency of Japan. In Hong Kong, information is provided by PGIM (Hong Kong) Limited, a regulated entity with the Securities & Futures Commission in Hong Kong to
professional investors as defined in Section 1 of Part 1 of Schedule 1 (paragraph (a) to (i) of the Securities and Futures Ordinance (Cap.571). In Singapore, information is issued by
PGIM (Singapore) Pte. Ltd. (“PGIM Singapore”), a Singapore investment manager that is licensed as a capital markets service license holder by the Monetary Authority of Singapore
and an exempt financial adviser. These materials are issued by PGIM Singapore for the general information of “institutional investors” pursuant to Section 304 of the Securities and
Futures Act, Chapter 289 of Singapore (the “SFA”) and “accredited investors” and other relevant persons in accordance with the conditions specified in Sections 305 of the SFA. In
South Korea, information is issued by QMA, which is licensed to provide discretionary investment management services directly to South Korean qualified institutional investors.
The opinions expressed herein do not take into account individual client circumstances, objectives, or needs and are therefore are not intended to serve as investment
recommendations. No determination has been made regarding the suitability of particular strategies to particular clients or prospects. The financial indices referenced herein is
provided for informational purposes only. Financial indices assume reinvestment of dividends but do not reflect the impact of fees, applicable taxes or trading costs which may also
reduce the returns shown. The statistical data regarding such indices has been obtained from sources believed to be reliable but has not been independently verified. You cannot
invest directly in an index.
Certain information contained herein may constitute “forward-looking statements,” (including observations about markets and industry and regulatory trends as of the original date
of this document). Due to various risks and uncertainties, actual events or results may differ materially from those reflected or contemplated in such forward-looking statements. As
a result, you should not rely on such forward forward-looking statements in making any decisions. No representation or warranty is made as to future performance or such forward-
looking statements.
PGIM, QMA, the QMA logo and the Rock design are service marks of PFI and its related entities, registered in many jurisdictions worldwide.
QMA-20200722-211
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