The New Frontier in Sustainable Investing

12 Dec 2017

The New Frontier in Sustainable Investing

Omar Selim founded Arabesque Asset Management to invest sustainably. He needed better data, so he built the most comprehensive database to date. And he’s using it to beat the market—with the help of Big Data and artificial intelligence.

Arabesque Asset Management is a relative newcomer to sustainable investing, but the young firm has made a big splash. Steered by Omar Selim, 54, who led the European firm’s 2013 buyout from Barclays (where he was a top banker), Arabesque manages $150 million, including two European quantitative funds that have outperformed their benchmarks. The board is a who’s who of the sustainable universe, including chairman Georg Kell, the founder of the United Nations Global Compact, the world’s largest corporate sustainability initiative, and Barbara Krumsiek, the former CEO of socially responsible powerhouse Calvert Investments, as well as academics with specialties including finance, neuroscience, and computing.

Arabesque’s products include a tool called S-Ray, an intelligent database that monitors the sustainability of 7,000 companies around the world, combining some 200 environmental, social, and governance (ESG) metrics, with news from more than 50,000 sources. (Arabesque charges clients for the product, but makes it free on its website with a three-month delay on the data.)

Arabesque also has a tiny new fund in the U.S. that Morningstar categorizes as a “tactical allocation” fund; fans say the high-quality holdings offer a margin of safety. Jeff Gitterman, CEO of Gitterman Wealth Management, who helped seed the fund, says: “With ESG you have better companies. This will drive the need for companies with low scores to start to improve them.”

Every penny of Selim’s personal account is in Arabesque funds, he said in a conversation with Barron’s last week. He shared his views on disrupting finance, what’s wrong with the ESG universe, the charms of computer programs, and why stocks will keep rising.

Barron’s:What is Arabesque? A money manager? A data provider? Something else?

Selim: We are a tech company. We are also an asset-management firm that’s focused on quantitative, sustainable investing. We have a screen of 3,000 sustainable equities, from which we use fundamental analysis to identify companies that demonstrate continued growth and increasing earnings, strong balance sheets and cash flow, and are incorporating the behavioral patterns of sell-side research analysts. Our strategy uses artificial intelligence. In the U.S., we have a Securities and Exchange Commission-registered fund called Arabesque Systematic USA (ticker: ASUIX) and separately managed accounts. We also have Arabesque S-Ray, which collects data on sustainability.

How did you approach starting your firm?

I’ve been in banking for 20 years. In 2010, I began to think finance and business would be significantly disrupted, partly because of the zero interest-rate environment. Of the five asset classes—equities, rates, real estate, commodities, foreign exchange—60% is in rates and credit, and we’ve had falling rates for over 25 years. In Germany, the unprecedented negative interest rates will affect pension savings, insurance policies, everything. Equities are the new fixed income.

Really? Stocks are the new bonds?

Real estate is regional and local, commodities are a function of geopolitics, foreign exchange is dictated by the central banks. The only asset class that’s liquid, transparent, and can be used globally for asset allocation is equity. That’s why we see all-time highs around the globe and will probably see them for quite a while—with some corrections. If you don’t want to sell bonds, you are sitting on a pretty nasty position once rates start to rise.

How does this fit in with sustainability?

Investing in fixed income is risk-transfer, in equities it’s risk-sharing. Once invested in equities, you start thinking differently about the company, which paves the way to sustainable investing.

And that’s one of the big “disruptions” the financial world is experiencing today. What else?

Another disruptor is something I call the “lifestyle feeling of finance.” Finance is opaque; the language is difficult to understand. That will change with millennials, the people whom Georg Kell calls Generation S, who want sustainability, don’t want to contribute to climate change, and so forth. Another is the availability of Big Data and the ability to put it through machine learning and artificial intelligence. Pushed by the regulatory environment, companies now have to provide more information. You know, 90% of the world’s data is only a couple of years old.

So the zero-rate environment, equities being the new fixed income, Big Data, and the lifestyle of finance will all change how finance will work. In 10 years, the biggest banks will be called Google, Apple, and Facebook.

What do you think of the stock market today?

My gut feeling is it will go higher, we’ll have a sharp correction, and then it will continue up. Nobody knows where the market is going. I intend to be free of that. I want to let the system choose what makes sense. When you buy a car, you go on the website, pick your color and the leather and the engine. You don’t look at how the valves open and close. I want people to see what their money is doing and enjoy it, rather than seeing whether the P/E is too high or too low—which has nothing to do with investing, really.

What’s holding sustainable investing back?

In the past, impact investing gave up returns for some greater good. We are doing our best to make sustainability competitive. Here’s an analogy: We had years of ugly electric cars that didn’t go fast and weren’t cool. Then Tesla (TSLA) came along and made electric cars go like a rocket and made them cool. Tesla was the first electric car built by people who love cars. Arabesque is a firm built by finance people who love sustainability and want to use our expertise to generate performance and make alpha. Sustainability is still a luxury good. Our mission is to take it mainstream. Because we use machine learning, I can do that in a way that is performance- and cost-efficient.

Why did you build S-Ray?

When we decided to build Arabesque, we needed to know how sustainable companies are, because we wanted to be a sustainable asset manager. We thought we would take the service available from current data providers, but we weren’t too happy: The data were biased, delayed, inconsistent. The big providers had a correlation of 0.2—it was all over the place. So we built a vacuum cleaner that sucked in everything we could find, including providers like Transparency International, which supplies data on global corruption, or regional specialists like Thaipat Institute in Thailand and GoldenBee CSR in China. We built a machine-learning algorithm to cross-reference all this information and come up with a score. That’s S-Ray. People started to ask us about it, so we made it available. It’s become a big success. We cover 640 Japanese companies, and a Japan pension fund asked us to increase it to 2,000. Now, State Street, Deutsche Bank, and S&P Dow Jones Indices are using it.

Other data providers base their data on human analytical work. Sustainalytics and MSCI built the pot we’re using now. I have the utmost respect for them; they are making the transition. I don’t have a single ESG researcher, just data scientists and programmers. We are like Airbnb, which doesn’t have a single hotel room, but is still the biggest provider of hotel accommodations in the world. Machine learning thrives on Big Data. We are the only service that refreshes daily; has 10 years of history; and because it’s quantifiable, I can see what contributes to alpha. We can switch every filter on and off and calculate the impact.

How do you define sustainability?

S-Ray scores companies based on their compliance with the U.N. Global Compact principles on human rights, labor rights, the environment, and anticorruption. It then scores companies on [more specific] ESG factors. Lastly, it filters information based on specific client preferences. We exclude companies that violate UNGC principles and those with ESG rankings in the bottom 25% of their industry, although we readmit them if they show an improvement over two quarters. We also exclude companies significantly involved in producing weapons, tobacco, or gambling.
How do you narrow ESG down to what’s material to stock price performance?

Companies that are better in terms of sustainability generally have better risk-adjusted returns. The most important component, the one that helps us generate alpha, is governance. S-Ray prevented us from investing in companies such as Toshiba (6502.Japan), Volkswagen (VLKAY), and Kobe Steel (5406.Japan), which had low ratings primarily because of governance issues. I believe ESG is the fourth dimension of investing, giving investors more information about the DNA of a company—for example, how risk-embracing or risk-averse management is. We are at the start of the journey; ESG data is only about 10% of what it will become in the next few years.

What are the limitations?

Data quality is better in developed countries and for larger companies. We also need enough companies for a good statistical sample. Give me two companies to choose from, and I might get it wrong. Give me 100 companies, and I will get it right more often than I get it wrong.

Tell us about the mutual fund.

Our flagship European fund, Arabesque Systematic, has used machine learning and has a three-year track record that outperformed its benchmark by two percentage points every year, with a quarter less volatility. It invests in 100 stocks, and the computer allocates among them. The Arabesque Systematic USA fund is similar, with a system that assesses market risk daily and, in times of crisis, will reduce equity exposure and increase cash. At the moment, the fund is mid-cap growth, but that could change: It looks for companies with positive price momentum.

Next year, we’re bringing out in the U.S. a pure artificial intelligence product that uses 32,000 investment models to generate its own investment process. If we’re cooking, S-Ray defines the ingredients and what’s allowed to be part of your meal. Our Systematic strategy is a recipe we’ve developed over the years with a good track record. But the AI piece is literally building the kitchen, designing its own recipes. That is the future of asset management.

Thanks, Omar.

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