ESG without “R” is incomplete | ARTS Asset Management

@ ARTS Asset Management

By Leo Willert, Founder and Head of Trading, ARTS Asset Management

The consideration of ecological, social and governance-related criteria is gaining in importance in the asset management industry. New ESG providers emerge on a regular basis and praise their sustainable funds.

The comparability of the different strategies is, however, often difficult, and investors can only understand to a limited extent how sustainably or socially responsibly their capital is actually invested.

Even if investments match the ESG-compliant ideas of the investor, there is no guarantee that they yield higher returns or are protected from market risks. Consequently, a sustainably oriented strategy does not yield a return on its own. So far, there is no scientific evidence for a higher performance of sustainably positioned portfolios.

With a view to risk hedging, an ESG-based approach likewise does not mean that the portfolio is protected from losses. The ESG component of a fund is rather comparable to a filter through which only companies fit which meet certain predefined criteria.

The application of exclusions and the best-in-class approach means, for instance, that companies from controversial industries like the tobacco or gambling industry are not taken into account, and for non-critical industries only those issuers are added to the portfolio which perform best in terms of ESG. Based on this restricted ESG investment universe, an investment strategy is then to be applied which has already proven its worth in the past and consistently limits the risks.

In quest of trendy, sustainable equities

The momentum strategy is an investment strategy which is based on a quantitative trading approach. This scientifically proven momentum effect means that sectors and regions which have created the relatively most stable uptrends compared to all other markets in the recent past, offer a higher probability of continuing to rank amongst the top performers.

This investment strategy, which is mostly implemented through an algorithm, can also be applied in practice in the field of sustainability. A quantitative trading system analyses millions of prices of sustainable equities around the clock and then selects the ones with the highest momentum. Securities which have lost in momentum are, by contrast, automatically sorted out.

Due to the broad database it is, therefore, possible to take securities into account which human fund managers frequently fail to see due to the large data volumes. At the same time, it is possible to keep emotional and biased decisions out of the investment process. Only the hard facts matter – there are no favoured securities.

Risk control often more important than performance

The hedging of the portfolio by a stringent risk management is at least as important as the achievement of a positive performance. Because although a sustainable stock portfolio without hedging gives investors a clear conscience, it gives them a sleepless night if the stock exchanges are strongly fluctuating and losses arise.

Products which take ESG criteria into account are, therefore, not better protected from general market risks than those who do not take them into account. Only because the product is invested in sustainable securities it is not less exposed to the market risk or even immune to setbacks in stock prices.

This applies, more particularly, to index funds which try to reflect a certain market as accurately as possible and must, therefore, also follow its downslide in prices without control. If one does not only want to invest in sustainable securities but also generate superior, risk-adjusted returns, there is a need for a careful selection of products.

ESG without “R” is incomplete

When investing in an ESG-compliant equities fund, investors should, therefore, ensure that a transparent, sustainable investment strategy is pursued which also includes a consistent risk management. Loss prevention can, for instance, be ensured by reducing the equities share in stressful market phases.

In the event of stock exchange crashes, as we experienced last year, this can even go down to 0%. However, even then it is not necessary to do without sustainability. In this case, a shifting to safer bonds and money market instruments which likewise meet ESG criteria takes place. Another hedging mechanism are stop loss limits. If the stock prices remain below a predefined value, the sell button is pressed automatically.

A quantitative momentum strategy can meet both criteria through its automated management which acts according to purely mathematical criteria. Losses are limited and profits are allowed to run. In this way, sustainable values are identified which perform best in terms of sustainability, performance and risk.

All opinions expressed are those of the author. is an independent and neutral platform dedicated to generating debate around ESG investing topics.