ESG at Velox - Alpha opportunities
In January this year I wrote about the beginnings of our team's ESG integration initiatives (ESG at Velox - The responsibility to be better), including our achievements and plans as a firm (see our CSR manager, Isobel’s, further insights from June this year, entitled Corporate Social Responsibility during the global pandemic) and our 2020 plans for implementing ESG integration into the Velox investment strategy. At a little past the half way mark of 2020, now felt like the right time to provide an update on our progress and how we intend to grow further.
We have seen a successful integration of ESG into the investment process which, for the first phase, was focussed on assessing the ESG risks associated with companies. Prior to 2020, we looked at companies through 4 lenses; Fundamental, Technical, Sentiment and Catalyst. The process has now been enhanced with a 5th lens, ESG. Through having this additional lens, we have found that the portfolio is now positioned with almost 90% invested in stocks which are in the top 2 quartiles on average across their industry specific material issues (excluding indices and stocks not covered by our ESG data provider. Average rating equally weights all industry specific material issues). Since mid-March, approximately 70% of stock returns in the portfolio have come from high ESG scoring stocks.
As we became comfortable with the first phase of integration, the team began work on phase 2 – ESG alpha opportunities. Through 2019, as ESG popularity grew, almost all investment teams and allocators with an interest in ESG were asking whether there was any alpha to be had in ESG stocks and themes. Analysis, such as that discussed by our ESG Officer, Saarthak, in his post ESG stocks thriving during COVID-19 Crisis, indicates that both best-in-class stocks, and strategies using a form of ESG scoring, do indeed deliver alpha. In addition, these same stocks offer relatively lower maximum drawdowns over their respective benchmarks. The key question now is, how does one extract ESG alpha effectively?
The Velox team are working on a number of exciting initiatives, some widely known, others perhaps not, that I am happy to share (to some degree) via this post. Those that perhaps will not surprise anyone are Thematic, Engagement and ESG Factor trades. Alongside these, we also continue to develop alpha opportunities with Thematic Baskets, Controversy Signals and enhancements to capturing momentum in Third-Party Score changes.
Thematic trades involve holding positions in stocks where we feel the company will be a leader in the theme, and therefore should outperform. An example would be EDP, an integrated utility with a 2/3 of its valuation in clean energy (wind, hydro) and 1/4 in regulated networks with very high earnings visibility. Having met with top management regularly, we were confident of their focus to crystallise value of their wind portfolio in the private market at valuations much higher than is implied in the stock price. These asset ‘farm-downs’, along with organic growth in wind led by a greater demand for clean energy, was a good catalyst to drive the stock’s re-rating.
Engagement trades encompass companies that we feel have been incorrectly rated. This could be due to lack of, or dated, engagement with ESG data providers. Corbion, a chemical company focused on bio production and bio degradable materials, is a company that currently fits into this category. We are particularly interested in its PLA JV with Total, where they plan to establish and grow the market of BioPlastics. The company recently released its H1 statements and we believe that it was more than evident that this is a key growth area, which leads to green Alpha for the strategy – but it is still somewhat an undiscovered gem. Through engaging with the company on its S&G practices and communication, we hope to help broaden its exposure to ESG investors.
ESG factor trades are custom baskets where we add an ESG overlay to the underlying factor trade. Numerous research has shown that ESG has low correlation to other factors. By combining ESG with dynamic factor rotation, we enhance the signal’s risk adjusted return. ESG acts as a second catalyst to companies in the basket and as such should provide reduced volatility.
Thematic baskets allow us to align the portfolio to ESG thematics that we feel will do well. Categories that we have traded to date are EU Green Deal beneficiaries, Hydrogen, Renewable Energy, Green Technology and Sustainable Fishing.
Controversy signals alert the team when news about an evolving controversy is released, and similarly when the controversy ends or proves to have had a bigger price reaction than we believe it warranted. Sentiment in these stocks can get progressively worse, and we continue to expand and develop how we analyse and monitor this sentiment.
Third-party score changes - specifically, enhancements to this previously utilised initiative. Why enhancements? Pre COVID-19 alpha opportunities around third-party score changes worked well, but we have seen alpha dissipate due to inconsistency in scoring between data providers. We believe that with further development, we can once again identify alpha opportunities with this approach.
Whilst making money is by no means the objective of the ESG movement (and our firm and strategy initiatives demonstrate our alignment with ESG’s core intentions), invariably the investment industry is going to ask how money can be made from a theme sweeping through markets with such force and causing valuation disruptions. Hopefully, this should always be as an enhancement to integration of the fundamental objectives. We believe that it is this, together with our process and initiatives, which stand us apart from our peers. In a world that is increasingly dominated by machines and commoditised data, ESG related information is still in its infancy. The ability to source, organise, combine and be creative with this information - alongside utilising enhanced information to question management teams - gives us an additional edge to combine with alpha generation in our underlying strategies.
We continue to be excited by the advancements we are making within the team and the Velox strategy.