Can ESG data help generate Alpha?

S Can ESG data help generate Alpha?

ESG alone may not necessarily be a way to generate Alpha, but certain metrics that are based on ESG criteria may be useful in identifying outperformers.

By Gerald Cartigny

When discussing the subject of Environmental, Social and Governance factors, the conversation often turns to a widely held belief: that one has to give up returns to have a positive impact. We believe this is no longer the case. In fact, data shows us the opposite, namely that ESG considerations play an important role in identifying attractive investments and even in generating Alpha.

ESG in Quant Goldman Sachs Asset Management’s Quantitative Investment Strategies (QIS) team manages equity portfolios using data-driven investment models that aim to objectively evaluate public companies globally through fundamentally based and economically motivated investment themes. At its core, the investment philosophy is grounded in identifying highquality businesses with attractive valuations that are exposed to positive sentiment in the market and are beneficiaries of global economic trends. The QIS stock selection model, referred to as the Alpha Model, seeks to evaluate companies on the aforementioned investment themes and identifies those that, in our view, have the highest relative return potential. The investment horizon for our Alpha Model is approximately six to twelve months and balances risk/return forecasts in addition to moderating tracking error in its stock selection decisions. Several hundred unique signals are employed across four investment themes to form holistic views on stocks and make balanced investment decisions. In terms of ESG considerations, they found that certain signals rooted in sustainable investment ideas and data sets have attractive medium-term return profiles and are therefore incorporated within the four investment pillars of the Alpha Model.

Historically, most of the ESG-related signals in our Alpha Model, as well as most other criteria in our models, utilized large sets of traditional company-specific data like publicly available financial statements and stock price information. For example, as part of our High-Quality Business Models investment theme, we have long used accounting information to quantify the extent to which we believe a company is well governed. We assess this by looking at the actions of company management (such as their financing decisions, capital treatment etcetera) or by looking at the impact of those decisions on the health of a company’s balance sheet. Over time, our approach evolved to incorporate more nuanced and sometimes alternative data to help us gain an informational advantage and make more informed decisions. For example, we analyse the extent to which a company’s top management owns sha-

FIGURE 1: THE ALPHA MODEL

High-Quality Business Models Fundamental Mispricings

Themes and Trends Sentiment Analysis

Short to medium-term investment horizon

res in their company as well as their share buying and selling behaviour, where we favour companies with more aligned management and shareholder incentives. Additionally, we analyse the tenure of c-suite executives to evaluate the stability of a company’s management as part of our stock selection process.

The QIS Team has also seen heightened client interest in investment portfolio resilience to social pressures and concerns arising from COVID-19. Recent data on the importance of social factors revealed higher employee satisfaction—as measured by Glassdoor ratings from Thinknum Alternative Data—can result in better equity returns. These findings are consistent over time.

We also believe that the transition to a low-carbon economy at some point in the future may have a material impact on companies’ financial performance. As a result, the QIS Equity Alpha Team has incorporated climate transition risk through a Strategic ClimateAware Tilt in the management of its active equity portfolios.

We are reducing each portfolio’s exposure to two climate risk metrics – Blended Emissions Intensity, a measure of current emissions, and Embedded Emissions Intensity, a measure of future emissions – by at least 25 percent relative to its benchmark. This Strategic Climate-Aware Tilt is designed to deliver positive excess returns over the long term and thereby complement the team’s short to medium-term Alpha Model.

One environmental consideration incorporated within the Alpha Model is the extent to which a company ‘damages’ the environment. Environmental damage is broadly defined as direct damage from the company’s core activities (such as greenhouse gas emissions, waste, natural resource extraction and water use). Our research

FIGURE 2: STRATEGIC CLIMATE-AWARE TILT

At least 25 percent reduction in

Blended Emissions Fossil Fuel Reserves

Scope 1

Scope 2

Scope 3 Oil

Gas

Coal

relative to the benchmark, across all portfolios

Long-term investment horizon shows that companies exhibiting lower environmental damage per unit of revenue have been associated with outperformance relative to their peers, as less environmental damage may help companies command a lower cost of capital. As a result of this finding, we introduced an environmental impact factor to our Alpha Model in 2016 that favours companies with less damage relative to industry peers.

Conclusion We found certain ESG related metrics have assisted our models in generating new and relatively uncorrelated sources of alpha. We recognize that these ESG considerations can affect investment performance as well as expose potential investment risks. As a result, we incorporate ESG criteria in our Equity Alpha investment process, both as short to medium-term alpha drivers in our Alpha Model, as well as a longer-term alpha view through the lens of our Strategic Climate-Aware Tilt.

Are ESG considerations linked to future outperformance? We believe that the answer is: yes, they can be. But it is important to identify why. ESG for its own sake may not necessarily be a way to deliver outperformance. But certain metrics that are based on ESG criteria which are reflected in our four investment themes and longterm Strategic Climate-Aware Tilt may be useful in identifying outperformers. Finally, as has been the case for years, ESG alpha signals continue to be a focus for our QIS Team, and we are engaged in multiple research projects to evaluate ESG data as potential alpha drivers as well as a source of long-term capital appreciation.

Gerald Cartigny

Managing Director, Goldman Sachs Asset Management

SUMMARY

In our quantitative investing strategy, we found that certain signals rooted in sustainable investment ideas and data sets have attractive medium-term return profiles and therefore are incorporated within the four investment pillars of our Alpha Model.

Our research also shows that companies exhibiting lower environmental damage per unit of revenue have been associated with outperformance relative to their peers.

Hence why we adopted a Strategic Climate-Aware Tilt in the management of our active equity portfolios.