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ESG Portfolio Construction

‘I often say that when you can measure what you are speaking about, and express it in numbers, you know something about it; but when you cannot measure it, when you cannot express it in numbers, your knowledge is of a meagre and unsatisfactory kind’ – William T. Kelvin

This famous quote is attributed to the British physicist and mathematician William Thomson Kelvin, also known as Lord Kelvin, who, among many other things, is known in science for the creation of the Kelvin temperature scale in 1848.

I can't think of a better sentence to try to explain the current context of ESG investing. According to Lord Kelvin's analysis, the first step in tackling a problem is to define it. Once defined, we have the ability to measure it and use tools and information to help us size it up. This is how we will be able to find solutions.

Adrian Miranda Escudero
Portfolio Manager, ESG Equities, GMAS

But what happens if the information is insufficient or, even worse, if we do not make good use of it? Undoubtedly, we will continue to do things the same as always, and if we do the same, the situation degrades and eventually breaks down.

Let us take Lord Kelvin's logical-mathematical reasoning to the world of sustainability and ESG.

Today we know that companies face a variety of environmental, social and governance challenges and it is through the measurement of ESG metrics that these issues find a definition. The philosophy behind ESG criteria is to recognize the effect that companies have on the environment and society as a whole, as they seek their own resilience and profitability. But in order to measure these variables it is necessary to understand which indicators actually have an impact on financial performance and how this can vary depending on the sector or region. This is known as financial materiality. There is little point in using all this data and metrics if it is not possible to filter out what really reflects a pattern and involves an improvement in terms of asset selection.

The methodology developed in SAM aims to obtain an ESG valuation of each asset from a financial materiality point of view, through a detailed analysis of those ESG factors that impact a company's performance, both at industry and market level. This valuation and analysis model uses information and data from various sources and suppliers in order to obtain an optimal assessment of the performance and risk of each asset. From a portfolio construction standpoint, it is essential to find the best way to actively select those names that, in a given context, reflect the best risk/return as well as the greatest social, environmental and governance benefit.

Considering the above, we have developed at GMAS (Global Multi Asset Solutions) team in Santander Asset Management an investment process that incorporates a systematic approach in the construction of ESG portfolios.

Our process integrates, through portfolio optimization, the selection of assets and the percentage to be invested in those names with the best ESG performance. We combine a top-down approach, through the limitation of sectors and investment factors, with a bottom-up analysis, taking into account the fundamentals and the investment recommendations of our team of analysts. In addition, the different variables, both in terms of risk and bias allocation, are considered so that they match the team's investment views.

The use of a systematic model helps to define a set of rules and conditions that help prevent some of the most common mistakes in behavioral finance, while ESG information becomes a determining factor in generating alpha. In order to execute this systematic strategy with an ESG approach, it is important to pay attention to:

1. Data and information providers

The data and information providers used to calculate the different metrics are key to the process. All information used to calculate a score or KPI (Key Performance Indicator) must be quality controlled and presented in an efficient and regular manner.

In addition, the methodology for calculating the scores, the measurement approach, the way in which the suppliers collect the information and the periodicity with which they do so must be understood to ensure that it leads to a good decision making process.

2. Controlling risk and volatility

ESG can affect the valuation and performance of companies, both through their systematic risk profile (lower capital costs and higher valuations) and their idiosyncratic risk profile (higher profitability and lower exposure to tail risks). Several studies show that ESG investing significantly reduces the downside risk of a portfolio.

Therefore, it is important to analyze the aggregate level of volatility and risk of a portfolio to consider the use of ESG information and to identify those companies that show exceptional behavior, trying to generate returns not explained by common market risk factors.

3. Identify financial materiality

These are those factors that may affect the financial condition or operating performance of a company within a specific industry. It would be equivalent to a target with which to measure and compare problems within an industry that may reasonably affect the performance of a stock.

As an example, more environmentally conscious investors will pay more attention to the CO2 emissions of a company in the transportation industry. In this case, the emissions reported by the company may have a direct effect on financial results and share prices. On the other hand, more socially oriented investors may look for the commitment of a company in the food and beverage industry to pay a living wage and respect human rights conditions at all stages of its production chain.

The financial relevance of ESG factors varies within different sectors and industries. But today there are international bodies such as SASB (Sustainability Accounting Standards Board) that have developed sectoral financial materiality maps to guide investors and companies on the need to report metrics on those business issues with financial relevance related to sustainability.

4. Search ESG Momentum

ESG Momentum is a term used to describe how companies change their ESG characteristics over time. Those companies that exhibit positive momentum will be improving their practices and, therefore, may be more recognized by investors. Setting carbon reduction targets, improving governance by adding board diversity or improving supply chain transparency to ensure that suppliers comply with human rights standards are business development policies that are often rewarded by the market.

Any such improvements are usually reflected in a company's share price, mainly through improvements in its underlying financials, thus generating long-term benefits for investors.

In practice there can be a lag between the implementation of these changes and the impact on the price. This, in part, can be attributed to the fact that companies starting the journey to improve their ESG standards often face skepticism. Nevertheless, spotting names with ESG momentum presents an investment opportunity.

5. Avoid "Green Washing"

ESG is also a story to tell investors so that they move from being just shareholders to being participants in the company's growth. It is about people leading and executing a long-term vision by setting clear goals and using resources to move in the right direction. However, like any story, this one can be manipulated or used in favor of a few.

‘Green washing’ is making misleading marketing claims to falsely suggest an environmental benefit or promote a false image. In the case of ESG reporting, companies know how their various indicators are being calculated and therefore try to report on what is in their best interest to the market.  That is why doing ESG research together with financial research is key.

In conclusion, let us return to Lord Kelvin. The value of ESG lies in finding out how to measure and monitor aspects that until recently were undefined or unknown. It is only through information processing and correct measurement that we will be able to steer sustainable investment in the right direction and make the necessary changes.

As data availability, technology and sophisticated risk management techniques advance, it will become essential for investors to use ESG factors in order to align their investment portfolios according to their values and select those assets that present the best investment opportunities. This is where the expertise of an ESG team like Santander AM's can make a difference.