Ross Klein, CFA and Vince Lorusso – Changebridge Capital 

For ETF-issuer Changebridge Capital, staunch supporters of a “quantamental” investment process that applies quantitative tools alongside fundamental tools in security analysis, ESG mandates provide the perfect terrain for active managers to add value.

Where Passive ESG Strategies are Precise, Can Active ESG Strategies be Accurate?

Evidence of socially responsible investing dates back thousands of years, primarily entrenched in moral considerations.  This long history has now been supplemented by a growing body of evidence that investors can pursue progress and profits simultaneously.  This realization alongside a convergence of other societal factors has accelerated a massive movement towards ESG investing.  With these trends in place, is it time to consider whether the tools we are using to organize and direct our ESG efforts are both precise and accurate?

Accuracy and precision both offer insights into how close a measurement is to an actual value, but on a more granular level accuracy reflects how close a measurement is to a known value, while precision reflects how reproducible measurements are, even if they are far from the accepted value.

“If all you have is a hammer, everything looks like a nail.” — Abraham Maslow

The ESG Ratings Conundrum

The basic proposition of ESG rating agencies is to assign metrics to the virtues of environmental stewardship, social responsibility, and governance.  Many investors cite these ESG ratings as one of their primary data sources when evaluating companies or funds.  This may not be surprising, given our cognitive preference for using statistics and seeking simplicity in the things we wish to understand.  It is convenient (if not idealistic) to apply metrics into the process, but challenges inevitably arise when we attempt to translate the nuances of ESG into numbers.  Different requirements and disclosures across industries, geographies, and rating agencies create systematic failings and inconsistencies.  The process is inherently more subjective than the color-coded output of the rating agencies would imply.

“And the portions are too small…”

If data validity is the first challenge, data coverage may be the second.  The rating entities offer broad coverage of mega and large-cap companies, but there is a precipitous drop-off in coverage when we look at small and mid-cap companies.  Since market capitalization is at least one proxy for investor interest, the rating agencies focus their data collection efforts on the larger institutions.

Adding to the coverage gap, significant resources (time and money) are required for any business to monitor and report formattable ESG data.  Some firms may be reticent to embark on an ESG self-assessment, others may welcome the process but prefer to allocate scarce resources towards a different set of initiatives.  In the most noble light, perhaps some companies are choosing to invest in their employees, customers, or product safety – instead of allocating resources to demonstrate their ESG worthiness to unaffiliated entities.  Should they be left out of the ESG discussion?

Investors who rely upon ESG ratings to guide them may be applying false precision to the task, and they aren’t being served with the entire landscape of available investments.

Actively Investing in ESG

The broad adoption of ESG ratings parallels the popularity of passive ESG investments.  Strategies that can apply objective factors like exclusionary lists, disclosure scores and ESG rankings have garnered billions of dollars in assets.  To be sure, many of these funds provide a real value to investors who seek broad equity exposure, or thematic exposure with an ESG consideration.  But when we consider the issues of data validity and data coverage, should this work be more active in nature?  Fundamental analysis is a method of studying all the factors that affect value – it forages beyond datasets and rankings. 

For ETF-issuer Changebridge Capital, staunch supporters of a “quantamental” investment process that applies quantitative tools alongside fundamental tools in security analysis, ESG mandates provide the perfect terrain for active managers to add value.  Both of Changebridge’s actively managed strategies, a long-only Sustainable Equity ETF (CBSE) and a Long/Short Equity ETF (CBLS) integrate sustainability into the investment process.

The Changebridge team acknowledges, datasets provide a helpful starting point in the process – highlighting areas of interest – but the work only begins with these metrics.  The true depth of ESG analysis is revealed by actually engaging with management teams, reading transcripts, evaluating financial statements, and seeking qualitative feedback about sustainability initiatives.

When a portfolio manager at Changebridge asks the employee of a company to discuss their firm’s sustainability initiatives, the responses are often enlightening, but rarely quantifiable.  Many times, there is a sense of pride and enthusiasm that emanates from the conversation, even if it is dampened by the recognition that these initiatives aren’t getting the credit they deserve in the world of ESG investing.

When the illustrations of sustainability become tangible; diversity initiatives, investments in product safety, heightened environmental efforts, the value of fundamental analysis becomes more profound.  The goal for any active manager is to discover under-appreciated opportunities; areas where value is observed, but not yet recognized in the market.

If rating agencies & passive strategies can use their blunt instruments to advance environmental stewardship, societal demands, and stronger governance, then progress will be evident to a wide range of stakeholders.  But if their methods and tools are also neglecting important information and creating pricing inefficiencies, then modern active managers like Changebridge Capital will be applying tools that precisely highlight ESG opportunities, with greater accuracy.

-Changebridge Capital

About the authors:

Ross Klein, CFA is the founder and Chief Investment Officer of Changebridge Capital, LLC. Previously, he served as a Long/Short Generalist and Portfolio Manager at Boston Partners for 10 years. His coverage encompasses the entirety of the US Universe, giving him a broad perspective on the domestic equity market. In those 10 years, he focused on discovering short positions, and his cumulative coverage list exceeds 700 individual companies. Ross co-Managed the Boston Partners Select Equity Fund from August 2019 to February 2020, before founding Changebridge Capital. Ross received the CFA designation in 2014 and a BS in Business Administration from Babson College.

Vince Lorusso is a Co-Founder and Portfolio Manager at Changebridge Capital, LLC. He has 22 years of industry experience, previously serving as Partner and Portfolio Manager at Clough Capital Partners, LP where he worked for 16 years. Prior to that, Vince was a Senior Investment Consultant with Natixis Asset Management. With a global perspective, Vince has analyzed and invested in a broad range of equity securities over the course of his career. Vince holds an M.S. in Finance and a B.S. in Finance & English, both from Boston College.

Investors should consider the investment objectives, risks, charges and expenses of the funds carefully before investing. This and other information are contained in the Fund’s prospectus, which may be obtained by visiting www.changebridgefunds. com or by calling 617-717-2912. Please read the prospectus carefully before you invest.

Investing involves risk. Principal loss is possible. As an ETF, the fund may trade at a premium or discount to NAV. Shares of any ETF are bought and sold at market price (not NAV) and are not individually redeemed from the Fund. The equity securities held in the Fund’s portfolio may experience sudden, unpredictable drops in value or long periods of decline in value. This may occur because of factors that affect securities markets generally or factors affecting specific issuers, industries, or sectors in which the Fund invests. The Fund is considered to be non-diversified, which means that it may invest more of its assets in the securities of a single issuer or a smaller number of issuers than if it were a diversified fund. As a result, the Fund may be more exposed to the risks associated with and developments affecting an individual issuer or a smaller number of issuers than a fund that invests more widely. This may increase the Fund’s volatility and cause the performance of a relatively smaller number of issuers to have a greater impact on the Fund’s performance. Applying ESG criteria to the investment process may exclude securities of certain issuers for non-investment reasons and therefore the Fund may forgo some market opportunities available to funds that do not use ESG criteria, The Fund is new with a limited operating history.

The Changebridge ETFs are Distributed by Foreside Fund Services, LLC.