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Environmental, Social and Governance (ESG) risks are now acknowledged as the most prominent long-term risks to investment outcomes and, as such, need to be appropriately assessed and managed.

For that reason, we have created our own proprietary ESG risk assessment tool – the Prescient ESG Scorecard – to manage risks and take advantage of opportunities as and when they arise. In addition, we have used the scorecard to screen for ESG opportunities within our investment universe and include these in an ESG-enhanced Equity Index that we have constructed. 

In creating the scorecard, our vision is to enhance our overall quantitative process by having the tools to conduct evidence-based due diligence of ESG risks and opportunities. In line with the goals of sustainable finance, we come up with a derived score for each counter based on Environmental, Social and Governance (ESG) factors. In line with our investment philosophy, the scorecard is predominantly quantitative. 

Our ESG investment process also enables us to translate qualitative data into quantitative scores, ensuring that we have a view on a given counter’s ESG initiatives at a point in time and can also assess changes through time. We believe that a robust system considers multiple factors rather than a single factor and thus tracks over 60 metrics covering various broader themes. Each of these broader themes is assigned a weight that reflects its significance. 

We track the key thematic drivers of each of the ESG pillars. For instance, the Environmental pillar follows five themes, including emissions, energy consumption, water usage, waste management and policy disclosures, each comprising various metrics. We consider GHG Scope 1,2 and 3, Direct CO2 and Indirect CO2, under the emissions theme. 

Larger companies inevitably produce higher emissions than their smaller-sized peers. To ensure we do not unfairly penalize larger counters, we strip out market size biases by adjusting the reported metric’s performance based on the market capitalization of the given counter.

From a Social pillar perspective, the themes covered include Employee Diversity and Investment, Safety, and Policies. In addition, the metrics covered include the percentage of minorities in mid-management. In line with the fundamentals that were/are prevalent in different geographies, the definition of ‘minority’ needs to reflect the fundamentals of that given geography. With that being said, we adopt the South African definition for all metrics that may otherwise be interpreted differently globally. 

Lastly, the Governance pillar tracks six themes, including Board Structure, Board Responsiveness, Audit Committee, Nomination Committee, Compensation Committee and Diversity.

Ultimately, the derived scores enable us to achieve a multi-tiered granularity of ESG risks and opportunities. We can track industry-wide trends and conduct peer analysis within each sector to identify sector leaders and laggards. We also conduct an in-depth analysis of the key drivers of each company’s scores. 

Given the intricacies at play in the various sectors, it is critical to treat each sector on a standalone basis and to assess the prevalent fundamentals accordingly.  In line with this, we conduct a materiality assessment to gauge which factors are the key drivers of sustainability in that given sector. For instance, counters in the Basic Materials sector materially affect the environment. Therefore we give the derived Environmental pillar score a higher weighting (40%) than the Social and Governance pillars, each assigned a weight of 30%. However, when it comes to Banks, which are notably far removed from the environment, the Environmental pillar has a lower weight (20%). In comparison, the weights of the Social and Governance scores are 35% and 45%, respectively.

Not only does the Prescient ESG Scorecard enable us to continuously and effectively identify and manage ESG risks, but it also allows us to identify ESG opportunities. One of the opportunities that Prescient has identified for classic passive investors is the need for an index cognizant of ESG factors. 

Taking advantage of ESG opportunities through the Prescient ESG-Enhanced Equity Index

Over the past few years, the number of ESG-focused investment products has grown rapidly, making it easier than ever for investors to allocate their capital responsibly. However, few of these products focus on taking advantage of South African ESG opportunities, with many asset managers preferring to track global ESG indices.

With that in mind, we recently embarked on a research process to create a product that would offer investors exposure to the South African equity market while maximizing the ESG quality of the overall portfolio. In addition, we sought to deliver a return profile similar to that of the FTSE/JSE Africa Top 40 Index. The culmination of our efforts is the Prescient ESG-Enhanced Equity Index. 

One of the common misconceptions surrounding ESG investing is that an investor would have to forgo some of the return that they would have earned from a standard index tracking fund to bring about positive change. Given this concern, we’ve designed the Prescient ESG-Enhanced Equity Index to achieve a higher ESG “score” than the JSE Top 40 index and match the return of the Index as closely as possible. 

In creating the Prescient ESG-Enhanced Equity Index, we utilize the ESG scores derived from the Prescient ESG Scorecard to calculate a baseline ESG assessment for the JSE Top 40 Index. Using a robust random sampling optimization approach, we evaluate one million potential portfolios, each representing a unique aspect of the Top 40 Index with unique ESG characteristics. The design of the Index was informed by Harry Markowitz’s highly regarded Modern Portfolio Theory. We plot each portfolio on the risk-return spectrum, defining risk as the tracking error, and return as the ESG score. We can infer an efficient frontier offering the highest ESG score per unit of expected tracking error based on these indicators. The result is an Index well suited to investors looking to invest locally and sustainably, contributing to the growth of our economy.

At the core of Prescient’s investment process is the goal to give our investors certainty of outcomes. Hence we have carried out extensive back-testing and analysis to ensure that this strategy meets both the ESG and return targets. Looking back over six years, the Index achieved an average improvement in ESG score of 5.15% relative to the Top 40 index, and at its peak, it improved well over 11%. This means investors in the Index will be making a material contribution to a sustainable future while promoting better business practices. From a return perspective, the Index outperformed the benchmark, generating an annualized gross return of 8.2% between March 2015 to July 2021 compared to the benchmark’s return of 7.7%. The portfolio did fluctuate around the benchmark at times, but the annualized tracking error was a relatively low 2.58%. 

Given Prescient’s long track record of delivering consistent outperformance due to its systematic, data-driven investment process, we are confident that this product is suitable for ESG-cognisant investors who aim to achieve index-like returns at an index-like cost. 

As a fiduciary asset manager, we take environmental, social and governance (ESG) issues seriously and thus continuously strive to provide our clients with solutions that matter. Developing the Prescient ESG-Enhanced Equity Index based on our proprietary, quantitatively derived ESG Scorecard is just the beginning.  DM/BM

Author: Sajjaad Ahmed – Credit Analyst, Prescient Investment Management


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