Quality and low volatility - the X Factors for sustainable investing?

  • 01 June 2023 (5 min read)

Key points: 

  • A truly sustainable investment approach should consider a trinity of financials, environmental impact and cost
  • Targeting quality and low volatility factors via an actively managed, systematic approach may provide potential outperformance for investors with lower risk appetites
  • What should investors expect into the second half of 2023?

What do we mean by a ‘sustainable’ equity strategy?

Sustainability is a broad term, but for investors typically means an investment strategy that integrates environmental, social and governance, or ESG, considerations into the selection, or exclusion, of individual securities. But we believe it can and should mean more. We believe that a sustainable investment is one that investors can hold over the long run and rests on three pillars.

First, financials. Our Sustainable Equity QI strategy seeks to invest in high-quality companies with low share price volatility, as we believe these may deliver sustainable long-term growth. We consider historic profitability and then use balance sheet and earnings revisions data, among other insights, to understand if that may change. In other words, we seek to understand how sustainable earnings may be in the future. We capture elements of ESG information here by also including board diversity data, as this is a useful indicator of whether companies with economic moats can defend those moats in the future.

The second pillar is the environmental footprint of the strategy. We integrate AXA IM’s rigorous ESG polices across all our mutual funds, but when constructing portfolios, where possible we seek to achieve a better-than-benchmark ESG score and lower carbon and water intensity than a fund’s benchmark. Our goal here is to invest in companies that are contributing positively to ESG issues and avoiding bad actors, as we believe these come with long-term risks from fines, regulatory intervention and more.

Finally, Sustainable Equity QI is an active strategy, and we believe the effect of fees should not offset the returns we generate for clients. Accordingly, we’ve designed the strategy to be low cost to implement and managed with low share turnover to reduce ongoing transaction costs. We think this makes the Sustainable Equity QI strategy competitive when compared with either passive or active alternatives.

Taken together, we believe that the trinity of sustainable earnings, integrated ESG and cost effectiveness make a sustainable investment that can be held for the long term.

Seeking steady, modest growth throughout market uncertainties

Much research has been published about the merits of using factors in an investment strategy, as they help identify common characteristics of companies that have a persistent historic risk premia attached to them. Investing using factors, therefore, may offer the potential to outperform the market. But that can come with a range of risk outcomes, or volatility. For the Sustainable Equity QI strategy, we explicitly blend two factor insights - quality and low volatility - as we believe this offers the potential to outperform the market but with less risk. We believe that this makes the strategy well-suited for investors seeking a core defensive global equity allocation.

Informing our approach is research that shows the adage of higher risk equating to higher return simply does not hold true. The highest volatility stocks can experience swings in return that are wealth destroying – sharp price rises are empirically often followed by sharp falls. We therefore seek to avoid companies with volatile share prices and focus on parts of the market that tend not to experience these extreme swings in investor sentiment. Historically this has helped the strategy to reduce participation in falling markets. Exposure to high quality companies complements this in two ways. First, by offering defensiveness through the persistency or sustainability of their earnings, as investors generally prefer stable earnings in times of market stress. Second, our view of quality incorporates a forward-looking element that captures changes to earnings growth, which provides an explicit link to the long-term positive returns from equities and allows the strategy to also benefit from rising markets also.

While we don’t use a valuation model to inform our view of attractive stocks in this strategy, we aim to control tail risks around valuation and volatility. We employ filters to remove stocks with extreme valuations, as we’ve found that these tend to mean revert sharply. We also remove stocks with a higher probability of future volatility, using proprietary machine learned models to assess non-linear distress indicators such as low levels of dividend cover, a high level of debt, and high probability of dividend cut, for example. We call these tail-risk filters, and they help us avoid stocks with higher levels of uncertainty surrounding them and ultimately reduce volatility in the strategy.

What this means for investors is that the strategy tends to have a systematic bias to sectors such as consumer staples – perhaps unsurprising if you think about companies that make our food and laundry products, day in and day out. We also tend to find industrials attractive – freight firms, business services and so on. Interestingly, portfolios in the strategy tend to be overweight financials, but driven largely by insurance companies and diversified financials rather than banks. Over time the strategy tends to underweight technology and communication services companies. The beauty of this strategy, however, is that we can invest wherever we see the opportunity. It is global in nature and has the latitude to take meaningful positions in sectors if stocks within them demonstrate the qualities we are looking for.

All hands on deck - navigating volatility in 2023

We believe that earnings growth is key to supporting 2023 returns for equity investors. A slower macroeconomic backdrop and stubborn core inflation increase the risk of negative earnings surprises and argues in favour of a focus on high-quality companies with strong profit moats; quality tends to outperform when macro momentum is weak or slowing. Indeed, slowing macro momentum is the key metric that continues to argue in favour of the defensive attributes of low volatility stocks as well, and ongoing uncertainty could mean that that we may see experience similar periodic bouts of volatility as views on global growth, inflation and interest rates evolve over the year. As such we think our blend of high quality and low volatility stocks means that the strategy could be well positioned to navigate uncertain markets in the year ahead.  

The strategy is actively managed with deviation expected in term of constitution and performance compared to benchmark that is likely to be significant.


Risks

  • Risk Profile - Risk of capital loss.
  • Risk Factors - The strategy is subject to the risks described in “General Risks”, as well as to the following specific risks (described in “Specific Risks”): Global investments, ESG, Method and model
  • Sustainability Risks - Given the strategy’s Investment Strategy and risk profile, the likely impact of the Sustainability Risks on the strategy’s returns is expected, according to the Management Company, to be low.
  • Method for Calculating Global Exposure - Commitment approach.

No assurance can be given that our equity strategies will be successful. Investors can lose some or all of their capital invested. Our strategies are subject to risks including, but not limited to: equity; emerging markets; global investments; investments in small and micro capitalisation universe; investments in specific sectors or asset classes specific risks, liquidity risk, credit risk, counterparty risk, legal risk, valuation risk, operational risk and risks related to the underlying assets.

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