Quantitative managers’ reliance on historical data to predict future returns makes investing with environmental, social and governance goals a tall order — after all, ESG investing wasn’t a thing in previous investment cycles.
But Andrew Dyson, CEO of QMA, the $122 billion quantitative asset manager that is part of PGIM, is prepared to take on the skeptics. Dyson argues that quant is a good fit for investing through an ESG lens, in part because investors can analyze the data and evidence behind the approaches. That is a big differentiator from fundamental asset managers peddling similar strategies, he said.
“Without transparency it feeds the perception that asset managers are just jumping on a trend,” said Dyson in an interview with Institutional Investor. He added that investors can see side-by-side how QMA’s ESG and non-ESG strategies differ, including at the individual stock level or on measures such as the aggregate level of CO2 emissions.
QMA has spent two years developing its ESG approach, including creating proprietary scores for all global stocks. The firm’s ESG and non-ESG portfolios offer the same overall exposures to market factors, the same pricing and incentive fees, and similar performance expectations.
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Dyson said its ESG approach is tailored to QMA’s philosophy, which relies on holding a large numbers of small positions. In its ESG portfolios, QMA swaps out companies with bad ESG scores for holdings that are similar but rank higher on environmental or other measures.
“At the aggregate level, the portfolios are identical,” he said. “That’s because no one stock is so unique that it can’t be replaced by another.”
According to recent research, QMA found that “companies with better ESG scores have similar returns to those with poor ESG scores, suggesting it should be possible to systematically tilt a portfolio toward better-scoring companies without detracting from performance.”
The authors of the study added, “As quantitative investment processes are likely the most efficient at incorporating sparse ESG data, our study provides an innovative and potentially powerful approach for quant investors to do well through doing good.”
Dyson said the biggest challenges that the firm tackled were minimizing the costs of ESG constraints and figuring out what to do about companies that don’t disclose sufficient ESG information — and the potential danger they pose. “It’s reasonable to assume that if a company doesn’t publish data there’s a reason,” he said.
Investors also need to determine whether ESG is a regime change — and this judgement needs to be made whether they agree with the validity of the concepts or not, Dyson argues.
“If you look back during most of the history of investing, nobody cared about CO2 emissions. No one. But now we’re in a different place,” said Dyson. “An indicator of potential regime change is when you can find tangible behavioral changes.”
What’s more, fiduciaries can’t sidestep making a judgement on the question. “They can’t just back one horse. You have a responsibility to your participants. You can’t just conduct yourself on your personal beliefs,” said Dyson.
If ESG is a secular change, QMA argues that it’s sensible to say it’s a new risk factor that may not have been reflected in historical return patterns.
“We’re quants,” he said. “We can’t wave our hands and say ‘It’s all going to be fine’.”