Startup Hedge Fund Turns to Quantamental Analysis for ESG Products

A newly established investment firm, Changebridge Capital, is applying a “quantamental” approach, combining quantitative screening and fundamental analysis, to find ESG-related investment opportunities in misunderstood and inefficiently priced areas of the stock market.

Ross Klein and Vince Lorusso founded Boston-based Changebridge earlier this year, following a Securities and Exchange Commission rule change that allowed funds to bring exchange-traded funds to market quicker. Klein and Lorusso, who previously managed funds at Boston Partners and Clough Capital Partners, respectively, saw a gap in the market for ESG-focused products.

“In launching Changebridge, one of the areas that we thought was lacking in this space was integrating sustainability concepts into a fundamental research process. There are lots of ESG-centric funds out there, but they tend to look and act and feel similarly. They look a lot like the S&P 500 minus energy, with some focus on growth. There isn’t a lot of data coverage of the small- and mid-cap space, where Vince [Lorusso] and I had spent most of our careers finding investment ideas,” Klein says.

Data coverage of smaller firms is lacking because corporate ESG disclosures are not standardized and are of uneven quality all over the world, even in the European Union, where regulatory attempts to standardize them are further along than in the US. As a result, asset managers struggle to get an accurate idea of how well or poorly individual companies—and even entire industrial sectors—are meeting ESG benchmarks.

But for Klein and Lorusso, this spottiness in reporting was an opportunity: among small- and mid-cap companies, where disclosure tends to be even thinner and less reliable than among the Fortune 500, there could be investment opportunities in companies that other firms, even large systematic hedge funds, have failed to find.

“If you look at the large quant managers, they have really rigorous quantitative backbones, often with a fundamental overlay,” Klein says. “But most of those quantamental funds are holding portfolios of 300-plus names, and they are looking for certain characteristics and factors that they can apply to a product portfolio. Over time, they believe that those characteristics will add value. That is a very reasonable thesis, but you have hundreds of PhDs at these shops, all fighting through the same factors and looking at a lot of the same things, applying them in similar ways.

“We are focused on the tail ends of the inefficiency spectrum, where securities may be over- or under-valued, but the real insight is they exhibit some type of pricing inefficiency. These are places where we can dig in and say “something unusual is going on,” and when we apply fundamental research, we might be able to identify an investment opportunity.”

Changebridge announced last month that it has launched two funds: CBLS, a long/short equity fund with a focus on small- and mid-cap stocks and on ESG integration; and CBSE, a sustainability-focused equity ETF that utilizes a long-only approach and aims to select securities misunderstood by the market to generate risk-adjusted alpha, the company said.

Our portfolio has minimal overlap with the broad indices, and is a complement to passive strategies

Ross Klein, Changebridge

CBLS and CBSE aim to achieve a very different “feel” from the S&P 500, Klein says, because no active manager can add value anymore by providing access to something that looks a lot like one of the broad-based indices.

“In today’s investment landscape, the S&P 500 is so accessible that it is essentially free for investors to get passive equity exposure. … Our portfolio has minimal overlap with the broad indices, and is a complement to passive strategies.”

In selecting securities for these products, Klein and Lorusso take an approach that combines quantitative screening with fundamental analysis. The process begins with the quantitative analysis, using screening tools and a system based on multivariate factor analysis, a statistical method that measures data that arise from multiple underlying variables that cannot be directly measured. This system is designed to identify securities that are inefficiently priced—in other words, assets whose true value is misunderstood, either because they are undervalued or overvalued.

“These tools are proprietary. We built them using widely available financial data. The Changebridge approach to harnessing quantitative capabilities lies in our ability to use those tools to highlight areas of inefficiency. Quantitative factors never dictate portfolio decisions (buy/sell/hold), but they do help direct the fundamental effort towards areas of inefficiency. By focusing primarily on these areas, we are able to narrow down the universe to a targeted group of securities,” Klein says.

The quantitative research filters out most securities, Klein says, using ESG-related data from vendors such as Sustainalytics and Refinitiv to find a much smaller group that could present interesting opportunities. The data that is helpful in this part of the process can be almost anything, Klein says; it could be data on the number of independent trustees on a board, or the number of female executives at a company. 

Quantitative factors never dictate portfolio decisions (buy/sell/hold), but they do help direct the fundamental effort towards areas of inefficiency

Ross Klein, Changebridge

“If you picture the universe of 4,000 names in the US that are investable, our quantitative screens will identify the 300 or 400 that look really interesting, and often misunderstood. The fundamental research forces us to be very selective, to gain a deeper understanding of the business, and to construct a portfolio of only the highest conviction ideas. That is the nature of our quantitative process,” Klein says.

These proprietary quant tools free up the portfolio managers to focus on the next part of the process, the fundamental research, which is where they can add the most value, drawing on their prior experience of these companies. They use alternative data such as Google Trends, as well as ESG data from vendors like Sustainalytics, and Goldman Sachs’ sustainability research platform Sustain to “more intimately understand the efforts certain companies are making from an ESG perspective,” Klein says.

They also sift through financial statements and earnings call transcripts, talk to analysts, and consider whether these companies do demonstrate a commitment to activities that are considered ESG-friendly. This process gets those few hundred companies down to about 40.

“Vince and I have a background in understanding a lot of these businesses; years of diligence, building repositories of knowledge, spending the time it takes to understand some of these small- and mid-cap companies. We are boots on the ground talking to management, talking to customers, competitors, suppliers. We are doing sustainability analysis on all those levels on those companies,” Klein says.  

“We have the opportunity to say “disclosure or no disclosure,” we are determined to understand if these companies are doing the right things, are applying the rigor that we expect in our investment portfolio.”

The quantitative process narrows the search down and finds those companies that might present something unusual; the fundamental process is more revealing and useful in the end, Lorusso says.

“Quantitatively, it’s true: small and mid-cap companies just don’t have as much disclosure, and even where that disclosure exists, it doesn’t tell the complete story in terms of sustainability. That is why we also apply that qualitative perspective, which is often more revealing and more useful in our process,” he says.