In a previous post, I showed how ESG screening substantially improved a strategy focused on profitability (long-short ROE) that was both sector-neutral and style-neutral. The main point was to reveal the true impact of ESG on equity performance by removing unintended influence. I didn't discuss a separate point: The lesson for 2024 on how risk control was used to remove the unintended influence of the COVID market crisis.
The small, inset chart in the larger chart shown here is from the previous post. The green line is the cumulative return of a long-short portfolio of S&P500 stocks, long stocks that are top ROE and top ESG in each sector of the S&P500, while short stocks that are bottom ROE and bottom ESG. ESG filtering used consensus ESG scores (OWL ESG, Inc.) The portfolio for the green line was both sector-neutral and style-neutral. The black line in the inset chart is the ESG-filtered long-short ROE performance that is sector-neutral but not style-neutral.
The divergence between the green and the black lines that began during the COVID-19 market crisis in March 2020 highlights the importance of style neutrality. The arrows on both the large and inset charts point to the March 2020 market. While March 2020 witnessed a meltdown for the market, both the style-neutral (green line) and non-style-neutral (black line) returns jumped (as did the unfiltered ROE long-short return in the red line). The style-neutral version (green line) continued climbing after March 2020, but the non-style-neutral version (black line) trended down for over a year.
Style neutrality for the green line was achieved using the style-risk model on the Finsera platform. The model considers seven exposures (growth, value, momentum, size, volatility, liquidity, and credit). Exposure to these risks was effectively zero for the green line. The risk from credit exposure was especially relevant for the black line, as seen in the chart. The black line in the larger chart is the same as in the inset chart, depicting the non-style-neutral ESG-filtered return. The blue dotted line depicts the strategy's credit exposure. This exposure was relevant to the collapse of the non-style-neutral strategy and subsequent rebound in 2021. For two years after March 2020, the ESG-filtered return was in the grip of credit exposure (defined by a blend of liabilities to assets with debt and preferred stock to market cap.). That connection was partially re-established in 2023.
Even now, almost four years after the March 2020 market turmoil, it is surprising to see how significant credit exposure was for controlling risk. The lesson is that it seems safe to assume that the risk exposures that will matter in the event of a crisis in 2024 are unpredictable. However, a good risk management approach can help preserve performance.
