PRI Awards 2019 case study: Systematic Investing Multi-Factor Opportunities strategy

Overview of the firm’s approach to ESG incorporation

The Systematic Investing Multi-Factor Opportunities (SIMON) strategy is a quantitative-based strategy that takes into consideration factor categories such as profitability, errors and biases, value and anchoring (momentum) and resilience. It was established as part of a broader internalisation strategy by First State Super (FSS) to reduce agency risk, drive down costs and provide strong returns to the fund’s members. It was developed, researched and tested by FSS’s internal portfolio management team.

A key part of the design process for SIMON was the development of FSS’s own proprietary long-term value creation or ‘LVC’ score. This score was developed in collaboration with the ESG team and continues to be used for all ASX200 stocks.

The theory behind the LVC score is that too many investors discount the return dividend to strong governance and leadership, attach greater weight to near-term earnings, or even encourage management to frontload earnings or cut strategic research and development, at the expense of longer-term profits.

As a result, the market tends to under-price the ability of companies with a strong or improving LVC to deliver higher and more sustainable returns over the medium to longer term. A key benefit of the LVC score is that it is a longer-duration indicator, relative to other factors, and therefore requires less portfolio turnover.

The LVC score combines a range of characteristics relating to a company’s social licence to operate, the alignment behind its leaders’ long-term vision (including through well-designed long-term incentives), and its focus on enterprise risk management, including with respect to climate change and stranded asset risk, among other things.

It is part of a broader factor grouping referred to as ‘resilience’, which aims to deliver stronger outperformance during periods of market stress. In this sense, it not only seeks to add value over time but also provide some degree of downside-risk mitigation to equities.

The LVC concept was developed following research by FSS’s responsible investment team. Part of the research involved putting together a series of case studies with selected Australian companies, which included interviews with senior executives to examine links between key ESG factors and long-term corporate performance. These discussions incorporated the companies’ approach to managing major existential risks such as technological disruption, climate change and regulatory change.

Why this approach stands out in the market

FSS’s approach is different because it uses proprietary research and data from its own responsible investment team to assess companies. The team actively engages with companies in order to establish their credentials along categories that include:

• purpose (and social license);
• vision (and room to grow);
• culture and remuneration;
• competitive advantage;
• management quality and discipline;
• and organisational resilience.

It also attempts to incorporate more forward-looking metrics into its assessments. This is because most of the ESG data/scores available from other research providers are based on present or past company information.

Practical examples of how the approach was applied, and challenges overcome

Here are a few examples of how the LVC score has affected portfolio positioning:

• SIMON was generally underweight in Australian banks over the past 18 months due to, among other things, a low LVC score associated with poor social licence, a lack of long-term vision and internal alignment and poor management of key risks - including around brand and technological disruption – which was subsequently brought into sharp relief by the Banking Royal Commissions.
• The LVC has contributed to low-to-nil holdings in a range of companies that have suffered a significant loss of value due to increased ESG or stranded-asset risk. For example, Aurizon, AMP, Dominos and (earlier) Telstra.
• A positive shift in the LVC score pre-empted a positive re-rating of the market of several stocks, most notably AGL, Xero and TradeMe.

The investment team found two key challenges in implementing the LVC Score. These were:

• The fact there was no definitive literature or philosophy on measuring long-term value creation, and so the initial work was largely covering new ground.
• The limited historical data for what is a proprietary factor.

As a result, the LVC score’s inclusion as part of SIMON required conviction from the team, rather than compelling historical back-tests. In this sense, FSS has shown strong faith in the role of ESG in supporting higher risk-adjusted returns over time, and in its ESG team’s research to identify key insights and risks.

Measurements for success and lessons learned

The LVC research project was achieved on time, within budget, signed off by the investment committee and the scores then fed into the live SIMON process. In conceiving of and successfully executing the LVC project, FSS concluded that a focus on long-term value creation in Australian listed companies is important because:

• They are a disproportionately large part of the FSS portfolio.
• Markets tend to over-price stocks enjoying recent good performance and do not price long-term value creation.
• An undue focus on short-term performance may lead to perverse management behaviour.
• More constructive engagement with larger, long-term asset owners can help them to better manage key stock-specific risks and support higher returns to equities over the longer term.

SIMON was a strategy developed by FSS’s internal portfolio management team and had very defined objectives and outcomes. Investment recommendation papers, extensive testing and due diligence was undertaken for SIMON and the fund’s investment committee approved the concept. This approval was subject to continuous reporting and the achievement of ‘stage gates’ along the way. The strategy is now live and being reported as part of FSS’s equities portfolio.

FSS measures success through the returns to SIMON above its benchmark over rolling fiveyear periods, and associated attribution of performance to underlying factors. SIMON has only been live for 18 months (as of the submission of this award entry) and so it is too early at this stage to be conclusive about the contribution from the LVC Score. However, FSS continues to monitor this. It will also be using this approach in a separate internal screened ESG portfolio to deliver strong returns to its members and save on fees by internalising mandates.