Sustainable alpha over the long term, with rigorous risk management
Among the different regional developed country equity markets the US equity market is by far the largest, the most ‘efficient’ and most liquid market. As a result it constitutes a challenging environment for the generation of incremental returns over the long term. For this reason over the last decade investors have increasingly chosen to make passive, rather than actively-managed allocations to the US market.
Within the quantitative equity team at BNP Paribas Asset Management we have developed a sustainable multi-factor strategy that has the potential to deliver excess returns on a regular basis. The strategy offers a well-diversified and liquid exposure to US large-cap stocks. Our strategy is fully systematic with minimal discretionary intervention. It combines four factors; low volatility, value, quality and momentum. These are the factors that have proven to be key drivers of equity returns over the long term.
➢ Low volatility – overweighting stocks with the lowest volatility
➢ Value – overweighting the cheapest stocks
➢ Quality – overweighting the stocks of the most profitable companies
➢ Momentum – overweighting stocks with the strongest upward price trend
The strategy’s investment objectives are threefold:
➢ Generation of sustainable alpha over the long term
➢ Rigorous control of the investment risk
➢ Integration of ESG and climate change objectives
Since inception the strategy has delivered a return of 11.3% versus 9.2% for the S&P 500 Index, i.e. an excess return of 2.1%. Exhibit 1 shows the cumulative excess returns since inception.
Over the period, the tracking error was limited to 3.5% and the equity beta was equal to 1. The strategy invests only in stocks included in the index; there are no off-benchmark holdings. The strategy delivers a pure alpha, exclusively derived from the equity factors listed above.
Exhibit 1: Sustainable outperformance over the S&P 500 index, with a limited Tracking Error of 3.5%
Table 1: Performance of the Multi-Factor Equity USA strategy since inception (June 2015)
ESG integration at each stage of the investment process
Sustainable investment objectives – and in particular ESG standards – are fully integrated into each stage of the investment process: they are inherent to our investment philosophy, portfolio construction and reporting. Sustainable investing is now a core strategic component. Integrating sustainability objectives has become crucial in meeting investors’ expectations and needs. That is why BNP Paribas Asset Management’s quantitative equity investment team manages two ESG integration objectives in addition to the exclusions already in place:
- An increase by 20% of the portfolio ESG score versus the benchmark ESG score
- A reduction by 50% of the portfolio’s carbon footprint versus the benchmark carbon footprint
Source: BNP Paribas Asset Management- As of April 2019
In the case of multi-factor investing, this means going beyond exclusions to focus on ESG integration at the portfolio construction level. Sustainability is an explicit objective of the investment strategy. In light of this, our strategy recently received the French Finance Ministry’s socially responsible investment (SRI) label certification. This was put in place to improve SRI visibility for investors in France and Europe. This certification enables professional and non-professional investors to easily identify investment products that incorporate ESG criteria into their investment policy.
In Table 2 and Exhibit 2, we illustrate the significant improvement in the portfolio’s ESG score. Indeed, the proprietary ESG decile, created by BNP Paribas Asset Management’s Sustainability Centre, is 3.78 versus 5.08 as of 31 May 2019. The ESG decile is on a scale from 1 to 10: 1 being the best, 10 being the worst. In this case, the improvement in terms of ESG is 24.5% versus the ESG score of the S&P 500 index.
Table 2: Comparison of the ESG decile of multi-factor US equity strategy versus S&P 500 Index
In addition to the ESG score improvement, the strategy also excludes the biggest polluter, ranked in ESG decile 10. In Exhibit 2, we illustrate the US equity breakdown of the strategy’s portfolio relative to its index. The portfolio clearly overweights stocks in the best ESG deciles (1 to 4) and underweights those in the worst ESG deciles (8 to 10).
Exhibit 2: Equity weighting by ESG decile of Multi-Factor US equity strategy versus S&P 500 Index
Combining performance and sustainability is feasible in the US equity market
Our Multi-Factor equity USA strategy is an active approach fulfilling several investment objectives: excess returns over the S&P 500 Index, control of the investment risks (Tracking Error, Beta, etc.) while integrating sustainability objectives.