Integrated Alpha: The Future of ESG Investing

George D. Mussalli is Chief Investment Officer and Head of Research (Equity), and Mike Chen is Portfolio Manager at PanAgora Asset Management. This post is based on a PanAgora publication by Mr. Mussalli and Mr. Chen.

When making investment choices, a company’s adherence to ESG principles is one that we believe is becoming increasingly relevant in today’s climate. Our research shows that companies which exhibit these principles not only historically outperform ones that do not incorporate them into the company’s DNA, but may experience less downside risk also.

Investors are looking more and more at adopting strategies which combine these new ESG tenets with existing methods of identifying attractive investment opportunities. Being a still evolving field, there is no well-defined process to best construct ESG portfolios which optimally combine profit-maximizing characteristics with ESG ones, all the while being mindful of client-specific requirements. At PanAgora, we believe an optimal approach to building ESG portfolios exists. An ESG portfolio can be constructed in a systematic way, with both traditional and ESG factors integrated in a manner that seeks to maximize performance based on objective measures. This may result in a portfolio which delivers alpha with ESG benefits that may accomplish both the return objectives and the values of the asset owner.

Current ESG Investment Landscape

A wide spectrum of ESG investment solutions exists as a result of various approaches being taken to address a growing desire for ESG portfolios. The current ESG offerings can be grouped as follows:

  • Restriction-list-based approach.
  • Integration Investing.
  • Impact Investing.

When it comes to ESG portfolios, we believe investment managers do not optimally integrate their traditional and ESG factors in such a way as to maximize joint ESG and alpha performance according to reasonable metrics. The reason for this is because in the traditional sense, the manager’s job is to maximize alpha per unit of risk. However, for ESG investing the goal could be to optimize along two distinctive dimensions, ESG and alpha.

ESG: Does it Drive or Detract from Alpha?

One of the most common challenges for asset owners seeking to integrate ESG portfolios into their asset allocation is understanding whether ESG might dampen portfolio returns. Historically, this would have been the case with an SRI-based approach as a smaller universe limits investment opportunities when compared to the unconstrained portfolio. With the newer Integration and Impact approaches, the investment community is beginning to realize that ESG and alpha generation are not mutually exclusive. Our research, in fact, shows that in many cases including ESG conscious firms in a portfolio can be additive as well as providing downside protection. Firms that rank high on ESG metrics have shown an ability to deliver above-market returns.

Another potential benefit of considering ESG alpha sources is that high ESG-rated companies tend to have lower exposures to systematic and company-specific risk factors, which leads to a lower cost of capital and higher longer term valuation under the DCF framework. Many other channels of linkages between ESG and alpha are being discovered, and the list of industry and academic studies documenting such connections is growing rapidly. See for example (Kotsantonis, Pinney, and Serafeim, 2016) and (Dhaliwal, Li, Tsang, and Yang, 2011) .

ESG Factor Materiality Categorization

Materiality of ESG factors varies across companies. Environmental issues are important to industrial companies, and not as important to professional service companies, while employee satisfaction is important to professional service companies and not as important to companies whose assets are mostly physical-capital-based. The common approach to identifying materiality is to segment companies by industry. However, we believe this is not the most ideal method to measure materiality.

PanAgora utilizes Contextual Modeling, as documented in (Qian, Hua, Sorensen, 2007), which identifies the power of factors such as value, quality, and momentum has different efficacy across various risk contexts. In recent years, PanAgora has applied a similar approach across its suite of ESG alpha factors, not along risk dimensions as in (Qian, Hua, Sorensen, 2007) but rather depending on salient firm characteristics, to evaluate materiality of ESG alpha factors and determine which ESG alpha factors are most relevant to each company. This process cuts through industry group and can identify differences across companies within an industry. For example Netflix and Yum! Brands are both in the consumer discretionary sector however we believe relevant ESG alpha (and standard alpha) factors are different for the two companies.

PanAgora ESG Portfolio Construction

We believe investors generally focus on maximizing alpha generation while minimizing downside risk. ESG-minded investors face additional decisions we believe may be equally important:

  • How important is ESG exposure versus alpha?
  • Which ESG metrics matter?

The answer will differ between asset owners and even when this is known the challenge still remains in constructing an ESG portfolio with the objective of maximizing along two dimensions: ESG and Alpha. PanAgora has an Integrated ESG Modeling Framework that addresses the above concerns of asset owners by constructing a bespoke portfolio which holistically integrates standard and ESG alpha factors, in a manner that seeks to satisfy the dual objectives of maximizing alpha and ESG performance. The Integrated ESG Modeling Framework has the following characteristics:

  • Flexibility: The Framework has the ability to adjust standard and ESG alpha levers based on asset owner preferences or investment policy requirements. The framework is agnostic to the relative importance an asset owner assigns between ESG and alpha performance.
  • Relevance: The Framework takes in any ESG metric the asset owner cares about. Since it is agnostic to the ESG measure selected, each asset owner may select the particular ESG metric that matters to her.
  • Dynamic: As alpha and ESG performance of the various standard and ESG alpha factors ebb and flow, the model dynamically adjusts factor weights in an effort to optimize alpha generation and ESG performance.

N.B. Mathematical details are in the paper.

PanAgora ESG Portfolio Measurement and Reporting

We believe measurement and reporting are critical components to assessing the impact of ESG measures within portfolios. For ESG performance measurement we use metrics from independent, third party ESG providers as we believe this approach offers unbiased results.

The entire paper can be download here.

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One Comment

  1. Larry Degaetano
    Posted Saturday, August 18, 2018 at 11:48 am | Permalink

    See The CPA Journal (July 2018) article entitled Using ESG Ratings to Build a Sustainability Investing Strategy which reviews ESG metrics from Bloomberg, RobecoSAM and Sustainalytics. It can be read at: The statistical results which accompany the article can be viewed at