Finding value in the hard work of quantitative ESG investing

 At PanAgora Asset Management, hard work is expected to yield competitive advantage. This is no blustery maxim that assigns moral value to time spent working. It’s a strategy.

George Mussalli, chief investment officer and head of research at the Boston firm, believes investments happen in the real world, not just in analytical and statistical models. This is still quantitative investing. But it’s also a type of whole-picture investing. The picture will change, and it can be seen from many viewpoints. “Finance,” Mussalli believes, “is a social science.”

Finding those viewpoints and incorporating them into a model: that’s the hard work. To Mussalli, MBA ’00, a good idea is one that comes with a barrier to entry. The work required to overcome that barrier strengthens the idea.

The strategy is a good fit for environmental, social, and governance-based investing, which will require more and newer sources of data, hidden where only a dogged, creative team will find them. We talked with Mussalli about his philosophy of asset management and what it means for ESG investing today.

What inspires you?

Knowing our work — finding trading strategies to improve portfolio returns — will help our clients meet their needs of retirement and health care costs. And our work helps cities, states, and countries provide for a better life for their citizens. We know our clients well and work hard to help them meet their goals.

I take inspiration from successful businesses and look at what characteristics make them great. I take an introspective view and think about the companies that make my life easier and more enjoyable.

Who inspires you? 

For the last 21 years I have been working with Eric Sorensen, the CEO of PanAgora. He has been a pioneer in developing the first quantitative equity model, led groundbreaking work on municipal bond pricing, and built the first macroeconomic equity risk model. Having him as a sounding board and a guide through turbulent, ever-changing markets is invaluable.

There are always market environments that prove a challenge to even the best built quantitative models — such as last year’s COVID-19 recession. Having Eric’s five decades of experience in financial markets helps us navigate these treacherous waters much more smoothly.

Where do you get ideas?

I believe systematic investors are far too often boxed up in an academic, statistical world, devoid of real-life applications. I want my investors out in the field, talking to companies, testing products to understand what’s driving corporate and customer preferences at the cutting edge. The best place to get ideas is from the world around you. The market is a living, breathing entity that is constantly changing. The only way you can identify the most actionable, pertinent company qualities is to be constantly aware of the changing world around you. 

Finance is a social science, and elements such as culture and tradition make market participants’ reactions different around the world. Having a diverse set of backgrounds within our team helps us understand markets with much more depth. Diversity is one of the tenets of our hiring culture at PanAgora.

How are new ideas discovered and developed in your organization?

The overarching theme of our research within the equity department for the last 15 years has been the “rise of intangibles.” Along with the technological revolution, companies have been transforming from manufacturing and industrial companies with major assets, including plant property and equipment, to companies whose most important traits are their intellectual property, brand strength, and other such intangible qualities. We have been on the hunt to find ways to quantify these ethereal ephemeral qualities of companies. It’s not an easy task, but we have created a mindset among the team to train them to identify these properties. This requires a large amount of understanding into how industries work and how companies break away from the pack.

Once we recognize a new trait of a great company that we don’t currently model, we need to go out and find the data to model that. This is a painstaking task. We may find the data on a website, as text in a large document, or on a physical piece of paper. It is the investment team’s job to bring that data to life in a usable format. This could take long hours of coding and manual work. But it's worth it. The more obscure the data, the more valuable it is to us.

How do you keep track of new ideas?

Keeping detailed documentation of our research is crucial to the efficiency of our research platform. We do not want to replicate work across team members or across time. We use the online tool, Confluence, to store detailed descriptions and statistical methods used in each test, and this is accessible to the entire team.  

How do you test ideas? 

We have been continually developing and improving a proprietary testing platform over the past 20 years that all researchers use. Very quickly, an analyst can determine if their new signal will add value to our current process. It is important to compare each trading strategy along similar dimensions. Any behavioral biases could creep in, spoiling the research, if this is not the case.

How do you know an idea is a good one?

The definition of a good idea for us is one that makes fundamental sense and has a high barrier of entry for other market participants to imitate. At PanAgora, our goal is to quantify our fundamental insights. This is done by interviewing fundamental analysts, investors, industry experts, and management on the best ways to identify how companies work and what sets apart the winners. The harder it was for us to collect the data and the more obscure the data source is, the greater the barrier to entry for others to imitate our process and the longer this strategy will help clients in meeting their financial goals.

What's the biggest idea you are working on right now?

The biggest idea we are working on right now is pioneering the field of quantitative ESG. We believe sustainable investing is one of the biggest market disruptions and opportunities, which is revolutionizing investing today, and curiously not much work so far has been done in quantitative ESG investing. As such, we intend to lead the quant ESG revolution.

As we see it, quantitative ESG investing is composed of three major components. The first component is ESG/alpha factors. As discussed, the overarching theme of our research for the past 15 years has been quantifying the intangible. Much of this research, such as quality of management, employee sentiment, and efficiency of a corporation’s production process, has naturally led into ESG alpha factors. Asset owners do not need to impair their returns by implementing ESG. We can provide attractive returns as well as exposure to strong ESG companies.

However, quantitative ESG investing is much more than just factor research. ESG asset owners want to achieve above benchmark returns in addition to having their portfolio reflect their sustainable values. So, the second component of quantitative ESG investing is how to construct portfolios that optimally blend alpha and sustainable value together. Towards that end, we have written papers and patented our approach.

Finally, the issue of greenwashing is a huge one in sustainable investing and so the ability to measure sustainability alignment is important. This is the third component of quantitative ESG investing. We have done quite a bit of research in this area, including a recent paper on using natural language processing to measure U.N. Sustainable Development Goals alignment. 

Despite the amount of work we’ve done in pioneering quantitative ESG, there is much more work ahead. This is truly one of the few greenfield areas in finance, no pun intended.

At MIT Sloan, we talk about ideas made to matter — ideas that are carefully developed and have meaningful impact in the world. In that context — what is your idea made to matter?

We believe the work we’ve done and continue to do in pioneering quantitative ESG falls into this category. If done properly, not only does sustainable investing hold the promise of contributing to the solution of some of the most urgent issues of our time — such as climate change and various forms of inequality — through the powerful invisible hand that is the global capital market, we know from firsthand experience that this type of investing can also generate a superior and uncorrelated return stream. Finally, quantitative ESG investing makes a positive impact on finance theory by building on the long and rich history of academic finance theory and extending it.

Quantitative ESG investing can make a positive impact on our society and the environment. By investing in companies with positive E, S, and G characteristics, we send a strong signal to the corporations that some practices and behaviors are desired, and others will not be tolerated. Although this is a softer form of persuasion then regulations, for example, money and economics are powerful forces that can cause wide and lasting change.

When done correctly, quantitative ESG investing can generate positive return. We’ve seen it firsthand in our investment portfolios over the last 10-plus years. Our hope is that by pioneering the field of quantitative ESG investing, we can raise the game for all sustainable investors both fundamental and quantitative, and raise the alpha and sustainability returns for all asset owners. That’s why we believe this is an idea that matters.