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  • Rishi Midha

Money Does Grow on Trees

Rishi Midha, Senior Research Analyst

Is sustainable finance a quixotic principle, or the way of the future? The answer was hiding in plain sight all along. As it turns out, there’s a reason “money is green”.

There was a time when environmental, social and governance (ESG) issues were nothing but a niche concern for a select group of ethical or socially responsible investors. That time is now long gone. The value-driven notion of negative screening, a pillar of ethical and impact investment, has transitioned from faith-based ideologies to socially responsible investments putting ESG in the spotlight.

What was once an exclusion tool used by investors to minimize risk, ESG investing has now cemented its place not just as a crucial investment mandate but also a strategy that produces sound financial returns. Traditional investment techniques focus on financial fundamentals based on the belief that “money makes money”. ESG investing has shown that it pays to be good. The benefits of ESG investing are two-fold; you reward inherently good companies, and, at the same time, starve companies with poor ethical standards.

However, the question remains; can traditional financial techniques be altered to cater to the demands of this new norm? In our attempt to answer this question, we look at one of the most ground-breaking theories in portfolio management, Markowitz’s modern portfolio theory, and try to take it apart and piece it together “sustainably”.

The modern portfolio theory, or mean variance analysis, aims to achieve maximum levels of financial returns for a given amount of risk. We overhaul this process and look at it from a purely ESG perspective: i.e., maximum level of ESG return for given amount of ESG risk. Achieving this was only possible because of Orenda’s unique dataset, which has time and again proven that fundamentals are not the sole driver of price performance.

This model looks at a pool of 1500 securities from a period of January 1st, 2017 to June 30th, 2021. The methodology uses Orenda’s Risk Factor to filter out the top 10% ESG performers on a per sector basis, rebalanced quarterly. Subsequently, Orenda’s ESG scores are used for optimization and producing asset weights. As a test for alpha, the Fama French five factor model along with an additional momentum factor was used. Both strategies generated alpha, or in simpler terms, “beat the market”.

The benchmark, iShares MSCI World ETF(URTH), provided all the desirable features of a suitable benchmark – it is unambiguous, measurable, investable, appropriate, and it was specified prior to developing and testing the model.

The chart clearly indicates the superior absolute performance of Orenda’s sector weighted optimized portfolios against the benchmark. In the given period, Orenda’s optimally risky and minimum volatility strategies would yield a 112% and 139% holding period return as opposed to the benchmark’s 94%, meaning a hypothetical $10,000 investment would yield $21,236 and $21,392 when Orenda’s strategies are used and $19,352 for the benchmark respectively.

Orenda surpasses the benchmark significantly in terms of risk adjusted performance as well. The Sharpe ratio, a measurement of the portfolio’s outperformance per unit of the portfolio’s volatility, demonstrates that Orenda’s portfolios are a safer and more profitable investment.

As the market continues to experience abrupt volatility, Orenda will continue to collect, quantify, and analyze community conversations on companies and the initiatives they have taken during this erratic stock performance period.

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