By Institutional Asset Manager
Arabesque Partners’ Omar Selim makes the case for a quantitative approach to delivering outperformance through sustainable ESG investment.
London-based Arabesque Partners was established by founder and CEO, Omar Selim in June 2013. It is one of the first asset managers to bring a robust, quantitative approach to sustainable investing to deliver market outperformance to investors.
The Arabesque Systematic Fund and Arabesque Prime Fund launched in August 2014. To date, both have outperformed the MSCI AC World Index by 5.05 per cent and 2.88 per cent respectively. This places Arabesque within the current top 10 percent of best performing European funds, according to Morningstar analysis.
At the heart of the investment philosophy is the ability to use comprehensive ESG research in tandem with active portfolio management and as Selim is keen to stress:
“We are not using ESG data merely to please ethical investors at the expense of performance. We use ESG information to generate outperformance. We are suitable for all global investors, not just ESG investors.”
There is substantial academic expertise behind Arabesque, whose advisory board is made up of CEOs and leading academics in quantitative finance and ESG research. Not that this happened overnight.
The genesis of Arabesque dates back to 2011 when Selim was working as the Head of Global Markets for Institutional Clients (EMEA and Eastern Europe) at Barclays.
“One of our SWF clients approached us and said, ‘I want you to research how asset management in the future is going to look. Go out there and think about how five to 10 years from now the industry will have likely changed’,” says Selim. “A team of academics and research staff was put together from the universities of Oxford, Cambridge, Stanford, Maastricht and the German Fraunhofer Society for the advancement of applied research.”
The project was split into three themes: the first was asset allocation. Looking ahead, the concept of fixed income products – which make up 60 per cent of portfolios – delivering a steady 7 per cent per annum is unrealistic. The problem with fixed income is that there is a theoretical maximum price; once you hit rates of zero per cent, there’s nowhere else to go.
“If you look at five-year German bunds, you have to pay money to hold them (yielding -0.06 per cent). It’s one of the most underestimated issues facing investors. The point is, things will change. Institutions are going to have to find a new home to invest and global equity is the next best thing. The idea we had was to construct something as solid as possible to capture that fixed income money,” says Selim, and in effect, try to deliver smooth, low-volatility returns akin to fixed income.
The second theme was non-financial information.
There is plenty of public information available on socially responsible investing. This has led some asset managers to build simplistic funds that remove defence stocks, tobacco stocks etc., but as Selim points out, “when you take optionality away the quality of the portfolio falls and performance is impacted”.
“We don’t want to use ESG information to negatively impact performance. On the contrary, what our clients want us to do is use that information specifically to drive performance and reduce risk. In collaboration with the University of Oxford, we published a meta-study on all the available research on ESG and published that study in September 2014 – From the Stockholder to the Stakeholder: How Sustainability Can Drive Financial Outperformance.
“Our research was to try to understand the impact of sustainable investing on the portfolio – is it positive, is it neutral, or is it negative? We tried to analyse companies’ behaviour on a range of environmental topics – water consumption, production process, wastewater management and so on. We analysed the governance structure of the company, we analysed the social aspect; how they treat their employees. We found a correlation between those parameters and outperformance of the stock price,” explains Selim.
This research took two years to complete.
The third theme was instrument selection. Futures and derivatives were immediately ruled out.
To get the full benefits of an ESG portfolio using non-financial information requires true stock ownership. But this is not about individual stock picking and building overweight positions in the top 10 most favoured companies; rather, it is about developing themes that provide access to a broad, optimal range of stocks.
Come June 2013, Selim left Barclays and in a management buy-out established Arabesque Partners.
The two Arabesque funds are based on rigorous systematic models, the Arabesque team maintaining its research links with the leading academic institutions Selim worked with whilst at Barclays. Professors from Cambridge University did the validation of the financial models, for example.
To highlight the quality of the team, Anja Mikus is the CIO, having previously worked as CIO for Union Investment, Germany’s largest pension fund (USD250bn) for 14 years.
There are three levels to the Arabesque Process.
Level one is the pre-selection process. This involves systematic stock selection across a universe of 77,000 stocks using 200 ESG indicators and over 100 market criteria to create an index of over 1,000blue chip stocks. This is known as the “Arabesque Prime League”, the index on which both funds are based.
Level two is fundamental analysis, which has its roots in New York. The fundamental stock selection process was originally developed in 1999 by Professor John B Lightstone and was employed to manage more than USD1bn for Morgan Stanley; this company – 5 Star rated by Morningstar – was acquired by Arabesque in 2014, with Professor Lightstone now a member of Arabesque’s Advisory Board. The objective here is to identify the 300 best companies from the index, the components of which go into the Arabesque Prime Fund.
Various quantitative equity screening filters are used in the model. These include: liquidity, forensic accounting, United Nations Global Compact (UNGC) compliance, ESG, balance sheet, and business-activity.
Level three is momentum recognition. This is essentially behavioural finance, where the model works on the principals of what people think companies should be worth rather than what they are actually worth. This approach, in conjunction with Arabesque’s proprietary Adaptive Risk Technology – which dynamically adjusts the exposure to equities between 0 per cent and 100 per cent depending on market concerns – brings further refinement and selects 100 stocks with the objective of minimizing the portfolio’s risk.
This additional third level is used in the Arabesque Systematic Fund. Whilst the Arabesque Prime Fund is rebalanced quarterly, the ART methodology means that cash and equities are managed on a daily basis in the Arabesque Systematic Fund.
“We use a conditional VaR model to manage risk in the portfolio and we have no concentration risk. The maximum allocation of any one name is 1 per cent. We use no leverage and we do not short. We never bet against a company. Also, we use no FX overlay.
“At the end of the day what we give you is a model that allocates between whether you own the stocks or not; the system allocates money according to the overall best exposure. It’s about finding the best combination of stocks to deliver the best overall risk-adjusted returns,” explains Selim.
The filter process that screens the universe of 1,000 stocks to find the best combination resembles that of an Arabesque geometric motif; this, says Selim, was the inspiration for the name of the firm.
This is heavy duty research-driven, systematic investing to deliver outperformance in the most attractive, well-governed stocks. What makes Arabesque’s approach unique is that when using ESG data, companies are not merely singled out on the basis of one aspect of ESG. Rather, the systematic model tries to find the best ESG combination in stocks, says Selim: “Companies like BP, for example, have excellent governance but are less good on safety. We have hundreds of questions that we go through, and the system then assigns each stock a number. The higher that number is the higher up the matrix it moves.”
Selim says that Arabesque currently has accumulated investor interest of more than USD1bn, “which we hope to close within 12 months”.
“The days of risk-free 7 per cent fixed income returns are gone. What we are trying to do at Arabesque Partners is build equity in a way that can capture a part of fixed income by reducing risk. This is a new way of investing, for all investors, not just those who are looking for ESG investments,” says Selim in conclusion.
Both funds offer daily liquidity. As well as being UN Global Compact-compliant they are also compliant with UN Principals for Responsible Investment (PRI). Management fees for the Arabesque Systematic Fund are 0.82 per cent and 0.32 per cent for the Arabesque Prime Fund.