Quants Join Chase for ESG Trillions. No One Knows If It’ll Work

(Bloomberg) -- When Gideon Smith and his AXA Rosenberg colleagues set up their quant fund in 2013, they called it “Sustainable Equities” since the original goal was to deliver sustainable earnings.

But its penchant for the environmentally sustainable is what made things really take off.

With the pitch that it could deliver a clean conscience as well as returns, the fund’s assets have defied the pandemic-induced market turmoil to triple over the past year to $789 million.

Welcome to the ethical gold rush in quantland, where systematic managers are morphing into evangelists for environmental, social and governance investing. It’s woke. It’s popular. It’s earnest.

And no one can agree whether it works.

Smith will tell you it does. He retooled his value model to make it consider each stock’s carbon footprint, based on his thesis that capital markets will increasingly punish polluters. Even through the coronavirus crisis, his fund has dropped just 2% over the past year compared with a 5% decline for its benchmark.

“If I can build an equity fund that has ESG integrated into it and delivers the same investment outcomes, why would I not?” Smith said in an interview. “There is a sweet spot where you can maximize both.”

He’s in good company, as the biggest names from Dimensional Fund Advisors to PanAgora Asset Management tout ESG as the next frontier in a brand of quant trading known as equity factor investing.

This is a cohort that typically devises investment rules by crunching decades of data to find strategies with proven profitability. So there’s a fierce debate surrounding the outperformance -- or otherwise -- of this newfangled allocation style.

For one, ESG scores are notoriously inconsistent across providers, and most such indexes in the U.S. more or less performed in line with benchmarks through the recent bout of turbulence. QMA and Robeco -- quant shops integrating ESG in one form or another -- are among those conceding there’s little historic evidence of alpha.

At AQR Capital Management, founder Cliff Asness has argued that sacrificing performance is the whole point of it all. By screening out the bad, investors raise the cost of capital for these companies, he said at a London conference last year. That translates into higher returns for those willing to buy the stock.

That line of reasoning fits right into quant orthodoxy but sits awkwardly with the ESG boom.

“If a company is truly a good company, that’s probably already priced in,” said Stacie Mintz, a fund manager at QMA, which oversees $127 billion. “We don’t believe that tilting toward ESG is going to help your portfolio. Theoretically, it may hurt, which is why we think it’s important to pair it with” other processes, she said.

$20 Trillion

But for all these academic questions, quants can hardly afford to watch the green bandwagon hurtle past.

Bank of America Corp. estimates investors will pour an astonishing $20 trillion -- not much less than the value of the S&P 500 -- into ESG funds over the next 20 years. Inflows into such products notched new records in the U.S. and Europe last year, Morningstar data show.

“These things are important in changing the image of quants,” Etienne Vincent said as head of global quantitative management at BNP Paribas Asset Management, before joining Ossiam. “Quants are not just greedy black boxes.”

Increasingly, many are willing to part with conventional wisdom to bet on a future where historical data may offer little guidance. Guido Baltussen, co-head of quant allocation at Robeco, says while the 10 to 15 years of numbers it’s looked at shows there’s little added value from using ESG, there’s still a good case for it.

“Qualitatively, from a risk perspective, it helps because stocks that, for example, pollute the environment quite a bit or have high greenhouse gas emissions will most likely in the future face higher costs,” he said. “It’s purely a belief -- there’s not enough evidence for that yet.”

Diverse Approaches

Like Smith and his carbon footprints, some quants say they’ve found trading signals in pockets of ESG, even if it’s still far from what they would call a factor, or a stock characteristic like how cheap companies look that predicts long-term outperformance.

That means different firms can draw radically different interpretations. Some are developing proprietary ESG measures across the board and scraping news articles, social media and earnings reports for intel.

Others like AQR dabble in ESG more selectively only when the data flash reliable trading signals. Right now, it uses sustainability and governance signals to guide stock picking in its regular strategies but not environmental, the firm’s head of responsible investment Chris Palazzolo says.

The good news for those who want to make money from shifts in regulation and consumer spending friendly to ESG companies is that they actually might not need new strategies.

Researchers at BlackRock Inc. found that a multi-factor portfolio already has lower carbon emissions and a slightly higher ESG score than a market benchmark, partly because investing styles such as low volatility and quality are inherently skewed toward better-behaved firms.

Still they also found that a fund aimed at maximizing ESG scores would have skewed style exposures and trail a regular factor strategy. The upshot: ESG may offer returns in key areas but only up to a point.

Meanwhile the market meltdown this year spurred both by the oil collapse and the spreading virus is doing little to settle these existential questions.

While the largest ESG exchange-traded funds did hardly better than the S&P 500’s 13.5% drop this year, QMA’s sustainability strategy outperformed in part because of its defensive tilt and avoidance of carbon-intensive industries such as airlines and oil, according to fund manager Gavin Smith.

All that means recent performance is shining little light on key issues like whether the ESG hype offers long-term alpha or if it’s just been lucky of late.

“It may be the case that ESG has actually been successful this year but one year of course doesn’t tell you everything you need to know,” said Palazzolo at AQR. “It’s very difficult to say ESG has performed this or that because there are lots of different approaches.”

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