Measuring ESG Effects in Systematic Investing

A unique perspective on the implications of incorporating ESG considerations in systematic investing

In Measuring ESG in Systematic Investing, a team of authors from Barclays’ top-ranked Quantitative Portfolio Strategy group (ranked #1 by Institutional Investor in its 2022 Global Fixed Income Research Survey in both the US and Europe) delivers an insightful and practical discussion of how to reflect ESG considerations in systematic investing. The authors offer a cross-asset class perspective—incorporating both credit and equity markets in the United States, Europe, and China—a unique coverage scope amongst books on this subject. They discuss the interaction between ESG ratings and various other security characteristics, suggest a methodology for isolating the ESG-specific risk premia, analyse the impact of an ESG tilt on systematic strategies and risk factors, and identify several ESG-based signals that are predictive of future performance.

You’ll also discover:

• Analysis of companies in the process of improving their ESG ranking (“ESG improvers”) vs. firms with best-in-class ESG ratings
• A study using natural language processing (NLP) to predict changes in corporate ESG rankings from company job postings for sustainability-related positions
• In-depth explorations of ESG equity fund performance and flows and the information content of ESG ratings dispersion across several providers

Perfect for portfolio managers including non-quantitative, fundamental investors, risk managers, and research analysts at financial institutions such as asset managers, pension funds, banks, sovereign wealth funds, hedge funds, and insurance companies, Measuring ESG in Systematic Investing is also a must-read resource for academics with a research interest in the performance and risk implications of ESG investing.

Foreword xiii
C.S. Venkatakrishnan, Group Chief Executive Officer, Barclays

Preface xv
Jeff Meli, Global Head of Research, Barclays

Acknowledgements xvii

Introduction xix
Lev Dynkin, Global Head of Quantitative Portfolio Strategy, Barclays Research

Part One: Effect of ESG Constraints on Portfolio Performance and Valuation

Introduction to Part I 1

Chapter 1 How Do ESG Criteria Relate to Other Portfolio Attributes? 5

Chapter 2 Measuring the ESG Risk Premium: Credit Markets 19

Chapter 3 Measuring the ESG Risk Premium: Equity Markets 43

Chapter 4 Performance Impact of an ESG Tilt in Sovereign Bond Markets 77

Chapter 5 Effect of SRI-Motivated Exclusion on Performance of Credit Portfolios 115

Part Two: Systematic Strategies and Factors Subject to ESG Constraints

Introduction to Part II 133

Chapter 6 Effect of ESG Constraints on Credit Active Returns 137

Chapter 7 Incorporating ESG Considerations in Equity Factor Construction 169

Part Three: Performance Implications of Companies’ ESG Policies

Introduction to Part III 203

Chapter 8 ESG Rating Improvement and Subsequent Portfolio Performance 205

Chapter 9 Predicting Companies’ ESG Rating Changes Using Job-posting Data 237

Chapter 10 The Relationship Between Corporate Governance and Profitability 271

Part Four: the Lack of Uniformity in ESG Definitions—Investment Implications

Introduction to Part IV 283

Chapter 11 ESG Equity Funds: Looking Beyond the Label 285

Chapter 12 Combining Scores from Multiple ESG Ratings Providers 321

Chapter 13 The Informational Content of Dispersion in Firms’ ESG Ratings across Providers 337

Index 373

LEV DYNKIN, PHD is the founder and Global Head of the Quantitative Portfolio Strategy (QPS) Group at Barclays Research. Lev and QPS joined Barclays in 2008 from Lehman Brothers, where they had been a part of Global Research since 1987 and helped launch the Lehman fixed income indices. QPS was ranked #1 in its category in the US and Europe in the 2023 Institutional Investor Global Fixed Income Research survey and was top-ranked for the past 15 years. Lev and QPS co-authored 4 books: Systematic Investing in Credit, Wiley, 2021; A Decade of Duration Times Spread (DTS), Barclays, 2015; Quantitative Credit Portfolio Management, Wiley, 2011; Quantitative Management of Bond Portfolios, Princeton Univ. Press, 2007.

ARIK BEN DOR, PHD is a Managing Director and a QPS member since 2004. In addition to originating innovative fixed income research for over two decades, he initiated and oversaw QPS extension into equity markets, and the development of cross-market signals between equity and credit markets. Arik co-authored 3 QPS books on quantitative investing, 30 articles in leading industry journals, and is a member of the Journal of Portfolio Management and Journal of Fixed Income editorial boards. He holds a PhD in Finance from the Kellogg Business School at Northwestern University, and worked at Lehman Brothers and Morgan Stanley prior to Barclays.

ALBERT DESCLÉE is a Managing Director in Barclays QPS based in London, and is responsible for its European activities. He advises investors on all aspects of portfolio construction. He was ranked 1st in Institutional Investor European Fixed Income Research Survey in the Quantitative Analysis Category from 2019 to 2023. He joined Barclays in 2008 from Lehman Brothers. He graduated from the Catholic University of Louvain (Belgium) and obtained an MBA from INSEAD.

JINGLING GUAN, PHD is a Director in Barclays QPS. She works on research related to systematic investing in both equities and credit, including signal development (especially cross-asset-class signals), portfolio construction, and risk hedging. She joined Barclays in 2015. Jingling holds a PhD in Finance from Kellogg School of Management, Northwestern University.

JAY HYMAN, PHD is a Managing Director in Barclays QPS. He advises investors and publishes research on all aspects of portfolio structuring and risk management, across multiple asset classes. He has co-authored four books with QPS colleagues. Jay joined Barclays in 2008 from Lehman Brothers, where he worked on quantitative portfolio strategies since 1991. Jay holds a PhD in Electrical Engineering from Columbia University.

SIMON POLBENNIKOV, PHD is a Managing Director in Barclays QPS. He is responsible for empirical research of all quantitative aspects of the investment process including systematic strategies and investment styles in fixed income, benchmark customization, tactical allocation, and hedging. Simon joined Barclays in 2008 from Lehman Brothers. Simon holds a PhD in Empirical Finance from Tilburg University, Netherlands.

Authored by members of the Quantitative Portfolio Strategy Group at Barclays Research—a recognized authority in the field—Measuring ESG Effects in Systematic Investing is entirely based on their original research. The authors take no views on the merits of Environmental, Social and Governance (ESG) based investing, but rather take a purely quantitative approach to measuring its impact on the performance and valuation of bond and equity portfolios by applying consistent methodologies across the two markets.

The book is written in an intuitive yet quantitatively rigorous style. Its four parts address distinct aspects of ESG investing.

First, the authors address the seemingly simple question of how to measure ESG-related returns, and show that a direct comparison of sustainability indices to standard indices can give misleading results. They introduce a methodology for isolating the performance effect of ESG while matching all other risk dimensions of the underlying market and document the behavior of this premium in equities and bonds over time. The performance of this “best in class” ESG investing is contrasted with the exclusionary negative screening approach.

Next, the authors use the context of a systematic credit strategy based on proprietary signals for value, momentum and sentiment to test the effect of ESG constraints on portfolio alpha. They also examine how ESG constraints affect equity style factors: to what extent does the return profile of a constrained factor preserve the behavior of its original version?

In addition to evaluating ESG choices faced by investors, the book explores the implications of ESG-related activity by issuers. Do companies that hire for ESG-related positions more aggressively than their peers receive higher ESG ratings in subsequent years? Are corporations with improving ESG scores rewarded by increased valuations of their debt and equity? Does improved corporate governance lead to higher company profitability?

Finally, the authors address one of the key issues in the field: the lack of consensus on how ESG rankings should be formed. Given the dispersion in ESG scores across providers, how can investors form a consensus score? Does this disagreement among score providers have implications for future ESG returns? How does ESG labeling influence the mutual fund performance, fund flows and AUM?

Perfect for institutional investors, portfolio managers and hedge fund professionals, Measuring ESG Effects in Systematic Investing belongs on the bookshelves of all practitioners and academics involved in ESG strategies.

PRAISE FOR MEASURING ESG EFFECTS IN SYSTEMATIC INVESTING

“Over the years Lev Dynkin and team have shown a remarkable talent to address complex and topical themes in a practical fashion. This book is yet another example. ESG has been around for quite some time, but most proof points remained a narrative. In line with previous work by Dynkin and team, this book introduces quantitative approaches to get a better grip and gain more insights in the financial reality of ESG factors. This book is a must for every investor who wants to fully integrate ESG factors in their investment process.”
— Eduard van Gelderen, Senior Vice President and Chief Investment Officer, PSP Investments, Canada

“ESG is a generational investment theme of critical importance to many institutional investors. In this insightful and unique book, the Quantitative Portfolio Strategy Group at Barclays Research, builds on their prior successful research to provide valuable ESG insights to practitioners. Readers will achieve a strong base knowledge of current state of research, while laying the scientific foundations for new insights. A must-have book for fixed income and equity investors with an ESG lens.”
—Alex Khein, Chief Executive, BlueCove Limited, United Kingdom

“ESG is among the most active research areas in the industry. This book explores various aspects of ESG investing from both a top down and a bottom-up perspective, over time and across asset classes. It addresses the delicate relationship between ESG characteristics and performance and raises the question of whether ESG is a real risk factor. This opus provides a sound methodological framework for identifying bias and controlling for systematic risk exposures, helping practitioners to see beyond the distorted view stemming from simple comparison of sustainability indices with standard ones. A must-read if you’re looking for a comprehensive yet detailed overview of ESG investing, based on figures while bearing in mind the constantly evolving regulatory landscape.”
— Ibrahima Kobar, Global CIO Fixed Income, Research & Structuring, Ostrum Asset Management, France

“This book is a true gem for anyone with a passion for ESG and impact investing. It is groundbreaking in quantifying the risk/return impact of ESG factors and provides practical solutions for improving portfolio construction and the application of ESG data. It does so in a highly objective and very precise manner, with reliable methodologies. All these features are an absolute prerequisite to scale ESG investing with integrity.”
—Eloy Lindeijer, (Interim Chair of) Board of Directors, Global Impact Investing Network, the Netherlands

“Measuring ESG Effects in Systematic Investing is a comprehensive exploration of how ESG criteria impact investment portfolios. This book offers invaluable insights, backed by data and analysis, that will help both seasoned and novice investors to navigate the ESG landscape, integrate ESG considerations in their investment process and correctly measure its implications for performance in credit and equity markets.”
—George Mussali, CIO of Equity, PanAgora Asset Management, USA

“The authors take an agnostic, bias-free approach, and develop methodologies and tools to assist portfolio managers in optimizing fixed-income and equity portfolios given different ESG measures. The book assesses the impact of ESG-consciousness on various aspects of the active investment industry, from portfolio and factor construction to fund flow and performance. It also finds the time series and cross-sectional variation in ESG scores to be informative. The book makes an excellent contribution and can serve as a leading guide to any quantitative institutional investor seeking to incorporate ESG scores into their investment models.”
—Ronnie Sadka, Haub Family Professor of Finance, Carroll School of Management, Boston College, USA

“Lev Dynkin and the QPS team are the pioneers in the research field of ESG and its impact on financial markets. Over the years they have examined the different ESG methodologies, they have derived ideas on measuring the ESG risk premiums and most importantly they made great suggestions to consider for portfolio implementation. Now this extraordinary research is all bundled into this great book, another must-read for modern investment professionals.”
—Herman Slooijer, CIO Capital Markets, APG Asset Management, the Netherlands