A recipe for alpha?

Adam Gustafsson, Research Analyst – Global Equities, and Katerina Papamihail, SI Quants, argue that while they are one of many inputs into our investment process, our research suggests they do add to financial returns.

Universe

We start with the MSCI All Country World Index (ACWI) constituents.¹ With 2,532 companies on average during the last 10 years, the index covers approximately 85% of the global investable equity opportunity set across both developed and emerging markets. Within this universe, stocks covered by analysts in our GEVS are selected narrowing down the universe to 1,295 stocks.² Analysts use GEVS to estimate present value of a company’s future free cash flow and compare it to the firm’s current market price to calculate a predicted potential alpha. We have recorded analysts’ GEVS estimates, based on a multi-period discounted cash flow, for decades in our system which facilitates comparisons over time.

Figure 1: Backtest Company Universe

Since mid-2020, we have generated the UBS ESG Consensus Score through our proprietary ESG Risk Dashboard, which quantifies the most financially important environmental-, social- and governance-related risks and opportunities for companies. To allow us to consider a longer time horizon, prior to mid-2020, we have adopted the MSCI ESG rating³ to backfill prior periods. MSCI assesses thousands of data points across 35 ESG key issues, focusing on the intersection between a company’s core business and the industry issues that can create significant risks and/or opportunities for a company. This gives us close to complete ESG score coverage for the GEVS-covered universe.

Backtest methodology

Our investment decisions are complex and account for multiple considerations and constraints. Still, our backtest highlights two of the essential components for typically identifying a security for sustainability-focused strategies: high intrinsic value and high ESG scores.

Figure 2: High Intrinsic Value and High ESG Scores

Note: Intrinsic value and ESG represented as a two-dimensional matrix. Sustainability focused strategies have an overrepresentation of stocks in the upper right quadrant.

To evaluate the historical contribution of ESG scores within our investment process, we created four equally sized, sector neutral, long-only portfolios with stocks selected on the intersection of two criteria: Intrinsic value; and ESG score. First, the universe is split 50/50 based on high/low intrinsic value. Then, each of these two groups is split 50/50 based on high/low ESG scores. This results in four equally sized portfolios with around 300 stocks in each. We ran the hypothetical backtest for the 10-year period 2013-2023 with annual rebalancing using monthly datapoints recorded point in time.

Figure 3: Portfolio construction

Results

Our results show that the portfolio with high analyst estimated intrinsic values outperforms the one with low. Interestingly, ESG scores adds incremental returns to both the high and low intrinsic value portfolio. The portfolio that performs the best is the one with both high intrinsic values and high ESG scores.

Across all active equity strategies, we invest in the stocks our analysts estimate have high intrinsic value. Therefore, the most important question for us is does the integration of ESG add value?

Indeed, in the backtest of these hypothetical portfolios, we do find this to be the case, with the top ESG portfolio outperforming the bottom by 30% over the 10-year period, translating to a 1.6% annualised additional return (see Figure 4 and Table 1). While these results are theoretical, they give us confidence that considering ESG scores contributes to incremental financial returns.

Figure 4: Portfolio performance and excess return

Note:
Top chart: PnL curves for the four long only, sector neutral portfolios. High intrinsic value PnLs are shown in red line, while low intrinsic value PnLs are shown in gray line (solid for high ESG & dashed for low ESG). Even though in both cases top vs bottom ESG demonstrates excess returns, the uplift is stronger among high intrinsic value stocks.

Excess Returns are calculated as the difference between the High intr. Value, High ESG and High Intr. Value, low ESG hypothetical portfolios.

The bottom chart: shows excess returns generating up to 30% during the last 10 years (1.6% annualized)

Source: MSCI, Factset, UBS Asset Management. As of February 2023.

Table 1

Performance analysis

Source: MSCI, Factset, UBS Asset Management. As of February 2023.

Table 1: Performance analysis of top/bottom 50% ESG portfolios among high intrinsic value stocks. Even though both portfolios exhibit the same volatility, the improved returns of the top vs. bottom lead to better Sharpe ratio. Accounting for just downside risk, Sortino ratio is still featuring a higher value in the case of top vs. bottom ESG portfolios.

Shows the annualized returns, hit ratio, volatility, Sharpe ratio and Sortino ratio for the portfolios

What remains unexplained by traditional factors

It has become a stylized fact within the investment industry that stocks with high ESG scores tend to score higher on quality, be less volatile, and larger in size. While we see no meaningful contribution to size, our result indicates that exposure to quality and volatility explained part of the ESG-related performance. Also, momentum stands out with high positive contribution within our backtest.

Breaking down the 1.6% annualized excess returns of the top ESG portfolio with respect to the bottom, we find that 2.7% is attributed to local and -1.0% to currency element. Drilling further into the 2.7% local excess, 1.8% is attributed to common factors (risk, industry, country) while 0.9% is strategy specific – and thus while not definite, could be attributed to ESG (see Table 2)

This would further reinforce the conclusion that ESG integration enhances stock selection, after taking into account other influences, such as traditional and regional factors. Our investment process has always stressed that ESG cannot and should not be thought of as separate from traditional factors, but rather they are intertwined and stock selection should therefore focus on a holistic understanding of both dimensions.

Table 2

Attribution

Source: MSCI, Factset, UBS Asset Management. As of February 2023.

Note: Returns attribution of the top ESG portfolio with respect to the bottom among high intrinsic value stocks using GEMLTL risk model. Annualized excess returns of 1.62% are attributed to local and currency factors. Local factors are further split into style, country, industry and specific factors. GEMLT’s 16 style factors are classified into five categories: value, volatility, quality, size and momentum risk factors. Specifically, top vs. bottom excess returns manifest strong positive exposure to quality and momentum while weak exposure to value and size.

Acknowledgments
The authors would like to acknowledge Grzegorz Ledwon, Portfolio Manager on UBS-AM's Private Client International Equity team for his contribution in the returns attribution analysis.

Shows the breakdown of the contributors to the excess return for the high intrinsic value/high ESG score portfolio vs. the high intrinsic value/low ESG score portfolio

Adding value

Sustainability efforts go well beyond ESG integration. While our focus has shifted to a more holistic concept of sustainability, ESG scores remain a fundamental step of our investment process. Still, we believe it is important for us to continually test how ESG scores interact with our analysts’ estimates for intrinsic value, and how the combination of the two can drive financial performance.

On top of high intrinsic values, the inclusion of ESG in the backtest of four hypothetical portfolios built in line with our investment process added an additional 1.6% annualized return. Almost 0.9% of this performance remains unexplained by traditional factors, and we believe may be attributed to the inclusion of companies with higher ESG scores. While this is, of course, an indicative test of a purely hypothetical portfolios, it suggests to us that including ESG scores in the core analytics of an investment process just makes sense.

1. In the MSCI index DM countries include: Australia, Austria, Belgium, Canada, Denmark, Finland, France, Germany, Hong Kong, Ireland, Israel, Italy, Japan, Netherlands, New Zealand, Norway, Portugal, Singapore, Spain, Sweden, Switzerland, the UK and the US. EM countries include: Brazil, Chile, China, Colombia, Czech Republic, Egypt, Greece, Hungary, India, Indonesia, Korea, Kuwait, Malaysia, Mexico, Peru, Philippines, Poland, Qatar, Saudi Arabia, South Africa, Taiwan, Thailand, Turkey and United Arab Emirates.
2. Note that the analyst coverage is not random. We tend to have coverage of stocks with meaningful market capitalization and/or appears attractive as investments focusing on our bottom-up fundamental research approach.  
3. Note that we used MSCI ESG instead of UBS ESG's score for our backtesting to ensure greater coverage and consistency of data over the period 2012-mid 2020.
4. Excess return factor attribution (annualized) and exposure (average over the period) (Table 2)