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ESG Data Coverage Gap Offers Opportunities For Active Managers

The U.S. equity market has become much more efficient in the past decade or so, the consequences of which include a higher level of difficulty for stock-pickers when it comes to delivering alpha returns.

In parallel with this trend has been the remarkable growth in interest in ESG-compliant investment products by institutional investors. Investment managers of all strategies have rushed to launch new products to tap into this demand, in turn giving rise to a plethora of companies offering ESG data designed to help these investment managers with security selection based on ESG-compliant criteria.

According to Ross Klein, Founder and Chief Investment Officer of Boston-based Changebridge Capital, which runs an actively managed long/short equity strategy and an actively managed long only sustainable equity strategy - both in an ETF wrapper - there is a gap which offers an opportunity for stock pickers like Changebridge to outperform; a glaring one, indeed, which savvy investors can take advantage of.

“The crux of the data gap in ESG coverage is size,” said Klein. “If you look at the data provided by some of these ESG data providers, they cover the top 500 or so companies by market cap very well. But below that, coverage really falls off a cliff. There’s a tremendous opportunity for bottom-up stock pickers who look at small and mid-cap stocks through an ESG lens.”

ESG data has its fair share of non-believers; the critics say that the data is, at best, inconsistent, with one provider rating a company highly and another rating them poorly for different reasons. Klein says that a more traditional approach is necessary to uncover the alpha generators.

“The datasets for ESG in small and mid-caps are not comprehensive and for that reason, can’t be solely relied upon. When a company has made it past our quant screen – which is not narrowly ESG-related – we then take a deep dive to analyse the ESG impact of the company, which factors into our portfolio construction.”

Vince Lorusso, Partner and Portfolio Manager at Changebridge, says that Klein and he look for inefficiencies where their assessment of a company’s ESG attributes are misaligned with the company’s ESG metrics.

“Inefficiencies are one of the main things that stock-pickers focus on, and there are plenty of them in small and mid-cap U.S. stocks when it comes to ESG. You can’t easily quantify a company’s sustainability because the rules are still very much being set, so digging into the company is the only real way to identify opportunities in the space we invest,” he said.

Long/short equity investing strategies are thought of primarily as being within the purview of the hedge fund industry, but Changebridge’s products are offered to investors as an ETF; U.S. regulator the Securities and Exchange Commission’s Rule 6c-11, adopted in December last year, enabled smaller managers to more easily launch ETFs. Reasons abound for the decision to go the ETF route, but Lorusso says that Changebridge operates invests similarly to a discretionary hedge fund manager in a preferable structure.

“Something like 96 or 97% of ETF assets are in passive products, but the new ETF rule means that it’s easier for smaller and newer managers to launch their investment strategy in an ETF. Also, it offers investors much more transparency – you can go to our website and see the stocks we are invested in. We bring active management to the ETF structure. We analyse balance sheets, we analyse industries, we meet with company management when we’re doing our due diligence, just like the other active managers. We ask them about diversity, their impact on the environment, and the other things we look for when screening companies. It’s still active management; it’s just offered to investors in a different structure that we think provides benefits over investing in a private fund,” he said.

It’s likely only a matter of time until data providers figure out how to provide more comprehensive ESG data on small and mid-cap stocks to match what they provide on large caps; conventional wisdom says that any ESG-related alpha will eventually be eaten away as this area of the market becomes more efficient and trades more crowded. For Klein, however, generating returns from sustainable investing is sustainable in of itself.

“Vince and I would both pound the table and say that doing right by shareholders and the wider community will never go out of style, so ESG-related investing is a multi-decade opportunity,” he said. “Within that, stock pickers like us are currently identifying companies poised to outperform over that long term. And there will still be opportunities to do this in 10 or 20 years because you can’t purely judge how a company will perform by looking at a dataset. ESG is an emerging opportunity in bottom-up, fundamental investing, a potential source of alpha for investors.”

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