ESG Trading Strategies (Backtest)

Last Updated on October 10, 2022 by Oddmund Groette

ESG has really gone mainstream, as the framework is becoming an increasingly important consideration in the investment community. With ESG data becoming more prevalent, investors now have ESG trading strategies. But what are ESG trading strategies?

ESG is an abbreviation for Environmental, Social, and Governance, which are a framework for understanding and measuring how sustainably an organization is operating with reference to environmental, social, and governance factors. Those criteria help stakeholders understand how an organization is managing risks and opportunities related to environmental, social, and governance criteria

In this post, we take a look at how to apply ESG criteria in investing, and we end the article by looking at the performance of ESG trading and investing (backtests).

What is ESG?

ESG is an abbreviation for Environmental, Social, and Governance, which are a framework for understanding and measuring how sustainably an organization is operating with reference to environmental, social, and governance factors. It helps stakeholders understand how an organization is managing risks and opportunities related to environmental, social, and governance criteria.

  • Environmental criteria: These are used to assess how a company safeguards the environment, including its corporate policies and risk management practices. Factors here include a company’s policy regarding climate change, flooding, and fires; its direct and indirect greenhouse gas emissions; and its stewardship over natural resources.
  • Social criteria: These consider how a company manages relationships with employees, suppliers, customers, and the communities where it operates. Some factors that a firm may be measured against under this category include Human Capital Management metrics (such as fair wages and employee engagement metrics), as well as the company’s impact on the communities where it operates (especially those in developing countries where environmental and labor standards may be less robust).
  • Governance criteria: These criteria are concerned with a company’s leadership, executive pay, audits, internal controls, and shareholder rights. Factors to consider here include how leadership’s incentives are aligned to stakeholder expectations, how shareholder rights are viewed, and what types of internal controls exist to promote transparency and accountability by leadership.

Apart from socially conscious investors who use ESG criteria to screen potential investments, other stakeholders who might be interested in how sustainable an organization’s operations are, include customers, suppliers, and employees.

Why ESG investing?

It has become necessary to evaluate how companies operate and partake in safeguarding our common existence, and the capital markets are increasingly becoming a powerful tool to create that change. With investors demonstrating interest to uphold their values through investing, companies and their management teams may be incentivized to improve performance across the environment, social, or governance measures. ESG investing is also known by other names, such as sustainable investing, responsible investing, impact investing, or socially responsible investing (SRI).

Interestingly, investors have now shown interest in putting their money where their values are. With investors becoming more interested in companies’ ESG practices, there are a growing number of ESG rating agencies and reporting frameworks that help to ensure the transparency and consistency of the ESG information that firms are reporting publicly. To assess a company based on ESG criteria, investors look at a broad range of behaviors and policies.

How investors apply ESG criteria

In recent years, investors have shown interest in putting their money where their values are. They now consider ESG criteria when choosing stocks to invest in. To assess a company based on ESG criteria, investors look at a broad range of behaviors and policies.

Given this trend, brokerage firms and mutual fund companies have started offering exchange-traded funds (ETFs) and other financial products that follow ESG criteria. Robo-advisors including Betterment and Wealthfront have promoted these ESG-themed offerings to younger investors.

Moreover, large institutional investors, such as public pension funds and hedge funds, now consider ESG criteria when making investment decisions. In fact, according to the most recent report from US SIF Foundation, investors held $17.1 trillion in assets chosen according to ESG criteria at the end of 2019, up from $12 trillion just two years earlier.

What are the three principal ESG strategies?

The three principal ESG strategies are as follows:

  • Inclusionary screening
  • Exclusion strategy
  • ESG integration

Inclusionary screening

This means the inclusion of companies with higher ESG scores in your investment universe. It involves the use of specific ESG filters to rule in or out companies for potential investments based on your preferences and values.

For example, you may have the Best ESG performers category, which would include companies outperforming in ESG measures. You can also have an ESG momentum category, which would include companies whose ESG measures are improving faster than peers.

Exclusion strategy

With this approach, you exclude companies, sectors, and countries whose behaviors do not align with ESG principles. So, you may choose to exclude weapon manufacturers, tobacco producers, gambling firms, or sanctioned countries.

Even if you want to invest in funds, you can use the same principle of exclusion to arrive at the fund that suits your values.

ESG integration

With this method, you want to incorporate ESG data into your financial analysis and stock selection process. So, instead of simply using an inclusion or exclusion screening method based on ESG information, you consider the financially material ESG information of all the stocks you are analyzing. Financially material ESG information here refer to those ESG data that are highly likely to affect corporate and investment performance

For example, quantitative traders that use the ESG integration method can create models that integrate ESG factors alongside other factors, such as value, size, momentum, growth, and volatility. By integrating ESG data in their investment process, they can adjust the weights of relevant securities upwards or downwards. They do this by either adjusting the weight of securities ranked poorly on ESG to zero based on research that links ESG factors to investment risk and/ or risk-adjusted returns or by adjusting the weight of each security in the investment universe, according to the statistical relationship between an ESG dataset and other factors.

How retail investors can get into ESG investing

Here are how retail investors can apply ESG principles to their investing process:

Build an ESG portfolio

Retail investors who want to build their own stock portfolio can start by determining what’s important to them in terms of ESG. The thing is to find out what aspect of ESG they are mainly concerned about — environment (climate change and water quality), social (how the company pays and treats its employees, its customers, suppliers, and members of the community), or governance (issues like diversity and executive compensations compared to average worker pay).

They may also want to avoid companies with certain practices or those who produce certain types of products, such as tobacco. So, when looking to choose individual stocks, they should take what they have identified as important to them and start researching candidates. With that, they can use the relevant criteria in each category to screen in or screen out stocks that fit into their values. They could do research independently or sector by sector. Out of their stock universe, they can use their financial analysis methods to choose the ones to invest in.

Invest in ESG-focused funds

For investors who don’t want to go through the hurdle of creating an ESG portfolio, they may want to invest in an ESG-focused investment fund, such as mutual funds and exchange-traded funds. Some robo-advising services also offer ESG portfolios. However, they will have to pay fees to fund managers or robo-advisors, which could be well worth the cost to many investors.

Invest in any security and then support charity

Another option is to not bother about ESG when investing and simply invest in an index fund. Then, they can use their profits to support their favorite charities and organizations that help to protect the environment and promote equity and justice. This makes sense, as most who pick stocks and most active mutual fund managers often underperform the markets, which leaves the investor with lower returns and less money to do good.

ESG trading strategies

Backtests of ESG trading strategies coming soon.

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