- Asset class focus: Listed equity
- Signatory type: Investment manager
- HQ Country: United States of America
Why this approach?
ClearBridge’s approach to investing involves analysts and portfolio managers integrating industry- and company-specific ESG factors into its fundamental research process. All companies in its coverage universe earn a proprietary ESG rating, updated at least annually. For every stock recommendation, each analyst presents the investment thesis, risk/reward profile, valuation, target price and internal ESG rating. These proprietary ratings – initiated and maintained in-house by analysts with extensive experience implementing ESG research across all Global Industry Classification Standard (GICS) sectors – are differentiated from those available from third-party firms.
In 2020 and 2021, ClearBridge undertook two studies of its ESG-rated stocks to determine 1) whether higher ESG-rated stocks outperformed lower ESG-rated stocks and 2) whether higher ESG-rated companies exhibited better traditional fundamental characteristics than lower ESG-rated companies. ClearBridge also wanted to explore whether its ESG ratings simply reflected common factor exposures and fundamental characteristics, or whether they captured company-specific idiosyncratic drivers of risk and return above and beyond the factor exposures and fundamental characteristics.
To evaluate the performance of its ESG-rated stocks, ClearBridge performed a stepwise regression of weekly returns of equal-weighted portfolios constructed against a basket of common quant factors, including market beta, size, value, momentum and quality. It used stepwise regression because this model starts by regressing all factors, then drops the least significant one(s) until only significant factors remain. This approach minimises the issue of covariance/correlation between independent factors in the regression model. ClearBridge performed this analysis on data spanning from 2015 to mid-2020.
The second study examined the relationship between ClearBridge’s proprietary ESG rating of a security and its fundamental characteristics. It considered 27 financial metrics divided into three categories: growth, profitability and balance sheet strength. For each rated security, ClearBridge compared its ESG rating to its standardised, fundamental composite score based on that security’s relative position within its peer group (by GICS sector and market cap). Fundamental financial metrics tend to be of different magnitudes and display strong sector/market-cap biases, which makes them unsuitable for direct comparison. To address these challenges, ClearBridge divided the full sample of securities into 33 peer groups by GICS sector and by market cap, and then compared each security’s financial metrics to its peer group by using a standardised z-score for each metric. The transformation of fundamental financial metrics into z-scores enabled the creation of composite z-scores for the growth, profitability and balance sheet strength categories, as well as an overall fundamental composite z-score. This study was conducted using data as of February 2021.
What were the outcomes, benefits and challenges? And what are the next steps?
These studies quantify the relationships between ClearBridge’s ESG-rated stocks, factor exposures and fundamental characteristics and show that ESG integration, expressed in ClearBridge’s proprietary rating system, appears to contribute to performance and has an added benefit beyond that which could be explained by common quantitative factors and fundamental financial metrics.
The key findings from the two studies are that:
- Higher ESG-rated stocks outperformed the market more frequently than lower ESG-rated stocks.
- Higher ESG-rated securities generated higher risk-adjusted returns (Sharpe ratios) than lower ESG-rated securities. AAA and AA securities generated higher risk-adjusted returns than the S&P 500 Equal-Weighted Index (Chart 1).
Chart 1: Annualised Sharpe ratio by ClearBridge ESG ratings
Data from 2015 to mid-2020. Sources: S&P , Russell Indexes, FactSet Research Services, ClearBridge Investments.
-
Higher ESG-rated securities generated higher alpha than lower ESG-rated securities after accounting for common factor exposures including market beta, size, value, momentum and quality (Chart 2). Coefficients from the stepwise regression show that higher ESG ratings are associated with higher exposures to growth (lower values for the value factor in Chart 2), quality and modestly smaller size. Meanwhile, value and quality factor exposures are most pronounced for B-rated stocks, which explains the outperformance of B-rated stocks during the 2016 value cycle.
Chart 2: Stepwise regression result using common quant factors
| AAA | AA | A | B | |
|---|---|---|---|---|
|
Alpha (annualized) |
1.63% |
0.76% |
0.53% |
0.71% |
|
Beta |
1.04 |
1.04 |
1.08 |
1.03 |
|
Size |
0.15 |
0.17 |
0.35 |
NS |
|
Value |
0.04 |
0.10 |
0.18 |
0.51 |
|
Momentum |
NS |
NS |
NS |
NS |
|
Quality |
0.10 |
-0.07 |
-0.17 |
-0.51 |
Data from 2015 to mid-2020. “NS” indicate data that was not statistically significant. Sources: AQR Research, S&P , Russell Indexes, FactSet Research Services, ClearBridge Investments.
-
ESG ratings display modestly positive correlation with the overall fundamental scores (Chart 3). This is due to positive relationships between fundamentals and ESG ratings for profitability (Chart 4) and balance sheet strength (Chart 5), while there is no significant relation between ESG ratings and growth scores (Chart 6; this study analyses a point in time – February 2021 – and differs from the multiyear regression analysis above in terms of period of observation as well as definitions of growth, with the regression analysis showing a positive relationship between ESG ratings and the growth factor over a specific time frame). In all cases there is greater discriminative power for the highest and lowest ESG ratings.
Chart 3: ClearBridge ESG ratings vs. standardised overall fundamental scores
Data as of February 2021. Sources: S&P Capital IQ, Credit Suisse HOLT, ClearBridge Investments. Bubble size reflects number of securities in each cohort.
Chart 4: ClearBridge ESG ratings vs. standardised profitability scores
Data as of February 2021. Sources: S&P Capital IQ, Credit Suisse HOLT, ClearBridge Investments. Bubble size reflects number of securities in each cohort.
Chart 5: ClearBridge ESG ratings vs. standardised balance sheet strength scores
Data as of February 2021. Sources: S&P Capital IQ, Credit Suisse HOLT, ClearBridge Investments. Bubble size reflects number of securities in each cohort.
Chart 6: ClearBridge ESG ratings vs. standardised growth scores
Data as of February 2021. Sources: S&P Capital IQ, Credit Suisse HOLT, ClearBridge Investments. Bubble size reflects number of securities in each cohort.
-
While ESG ratings and fundamental scores are positively correlated at the cohort level, at the security level the relationship is much less clear, suggesting that the ESG ratings capture company-specific, idiosyncratic information that is not reflected in the standard financial data.
One important limitation of the performance studies is that the markets have been in some combination of pro-growth, pro-quality and pro-momentum regimes for most of the past 10 years. This limitation does not invalidate ClearBridge’s findings, but it is important to be mindful of this bias.
ClearBridge interprets these studies to confirm the value of ESG research and its integration into fundamental investment analysis. Over time, ClearBridge will extend these studies and incorporate additional market regimes to continue testing its ESG ratings.
