Financial quality metrics and ESG factor interactions can impact equity markets

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As investors seek to integrate ESG data into their investment processes, they can mistakenly conflate ESG scores in practice with the more familiar financial quality metrics.

But this conflation stems from insufficient research that has yielded inconclusive results note Yijia Chen, ESG Quantitative Research Analyst and Alexander Deleon, Quantitative Research Analyst at Calvert Research and Management, an affiliate of Eaton Vance

“Given the knowledge gap, we seek to evaluate over recent history the following questions:

  1. What is the relationship between quality and ESG data over time?
  2. What is the relationship between specific quality and ESG factors?
  3. Is there an opportunity to improve portfolio performance through understanding the dynamics between ESG and Quality?”

In their joint new research titled ‘Financial quality metrics and ESG factor interactions in equity markets’ they aim to explore the relationship between quality factors and ESG factors, as well as the potential financial materiality of different multifactor combinations of quality and ESG factors across six-year backtests (June 28, 2013 to April 30, 2019) on the Russell 1000 Index, Russell 2000 Index4 and MSCI EAFE Index.

“Definitions of quality factors vary across the industry. For simplicity and clarity, we define quality in general terms of profitability. We use reported return on assets (ROA), return on equity (ROE) and return on invested capital (ROIC) as proxies for quality metrics.

“To represent the ESG factor, we use monthly MSCI Intangible Value Assessment (i.e., MSCI IVA6) weighted-average scores. We used Global Industry Classification Standard (GICS)7 sector classifications as the control variable for domestic universes, and used the combination of GICS sector and MSCI country classification as the control variables for international universes. Return data is calculated on a monthly basis.

“Our research shows that in large cap universes better ESG companies or higher quality companies have the potential to generate superior return performance over the sample period. This is largely consistent with other research findings.

“Interestingly, the data correlations between ESG and financial quality are uncorrelated while their factors returns are positively correlated suggesting that better ESG companies are not always higher quality companies but that both types of companies can outperform peer companies.

“When we create composite indictors using ESG and quality factors, we find that these factors can be combined to exhibit more positive return characteristics than do either factor alone. This suggests that ESG and quality factors have the potential to generate superior performance when combined, despite seeming to capture different kinds of companies when view through the singular lens of either ESG or quality,” they conclude.

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