Why we believe quantitative investing is the perfect partner for ESG

Invesco Quantitative Strategies understands the importance of managing environmental, social and governance risk to get the best results from portfolios. Here we explain why our quant management team’s ESG approach makes the difference. 

Invesco Quantitative Strategies (IQS) is a systematic investor with 20 years of experience in implementing and executing environmental, social and governance (ESG) into portfolios. As a critical and ever-changing part of investment today and in the future, we are constantly evolving our approach.

The right fit

When traversing the ESG investment landscape, it helps to understand how a quantitative approach can be its perfect partner and why we believe these considerations are part of the permanent fabric of investment.

Quantitative investing is about finding the common ground separating attractive investments from unattractive ones. This means identifying “factors” that explain performance and risk and recognising stock characteristics proven to add value over the long term.

We look for QVM:

1.       Quality - good balance sheets

2.       Value - attractive valuations

3.       Momentum - earnings and price

This systematic assessment of assets used in our quant investing can be extended easily to ESG.

As societies, regulators and capital market participants are all demonstrating a rapid increase in awareness of the importance of ESG considerations, it is no surprise that these risks and opportunities will continue to impact asset valuations. However, it is worth noting that they are not yet reflected in historic data and covariances.

IQS strongly believes that a company’s carbon footprint and its exposure to ESG risks will be monitored by investors with increasing scrutiny.

An in-depth systematic analysis and portfolio construction approach can help investors actively control their exposure to behaviours that have a material financial impact on an investment, while aiming to optimise their risk and return profile.

For example, in a world moving towards a low carbon economy, a company with high emissions across products and processes faces increased transition challenges and a higher risk of stranded assets. The consequence of such pressures is a negative impact on asset valuations.

For some managers it is difficult to anticipate these risks but at IQS we eliminate them from the portfolio – let us explain how.

Exclusion

At IQS we set an extremely high bar for ESG and this is seen across our Sustainable Structured Equity Strategies.

The strategies exclude companies with controversial business areas – those with significant revenues from coal, fossil fuel, nuclear power, weapons and tobacco – from the investable universe.

Carbon Control

As part of our portfolio construction, we systematically control ESG exposure by excluding stocks with negative ESG momentum and reducing carbon intensity relative to the benchmark. We also tightly constrain investments in companies with severe controversies, such as those relating to issues on biodiversity, pollution, or community involvement.

All these measures support the management of risks whose timing and impact are challenging to forecast and that most certainly will lead to a negative impact on future performance.

Best in class

ESG is not only about exclusions. In conjunction with excluding ‘ESG laggards’, IQS applies a best-in-class approach to our Sustainable Structured Strategies. This is based on a scoring system to assess a company’s energy transition measures and we only consider those that actively commit to making a positive impact on climate change. We also include our ‘quality’ factors, which have a direct link with governance and help identify companies with the potential to outperform their peers.

All these aspects lead to a reduction of the investable universe of around 40-50%, which shows the high bar we set ourselves.

Understandably, investors may be concerned about the implication for risk and return when half of an investment universe is excluded. Yet, as quant managers, we know a portfolio’s return potential is driven by its factor exposures, not single stocks, which means there is no impact.

For example, in a recent client portfolio, we excluded tobacco stocks and replaced these holdings that had attractive quality and value characteristics by a mix of assets with similar factor exposures from the auto, telecom, and consumer goods sectors. This shows there is no long-term performance impact from adding ESG to a multi-factor portfolio, so long as the investable universe remains broad enough.

Stewardship

ESG promotion goes hand in hand with active ownership, and investment managers have privileged access to companies and their management teams. With this comes a fiduciary duty to address corporate behaviour, and IQS exercises all its proxy voting power on every holding. In addition to Invesco-wide initiatives, the team takes specific voting decisions on many key ESG topics, such as gender pay gap proposals; political contribution disclosure; privacy and internet issues; reports on climate change; and gender diversity on public boards.

IQS sets the same high bar for company engagement as is applied to our investment process. We regularly enter dialogue with target companies, engaging on topics related to priority ESG themes, including climate change, human rights, supply chain management, water, and bribery/corruption.

A high bar

It should not be a surprise that a quant manager integrates ESG in numerous ways. However, we think that IQS’s systematic approach is perfectly partnered with ESG and our key differentiator is the extremely high bar to exclusion, engagement, best in class and, of course, the benefits from our factors such as Quality, Value and Momentum.

We believe there is no doubt that ESG will remain prominent across the investing landscape and as awareness grows, at IQS we will continue to evolve our approach as we have done over the last 20 years.