Calls for environmental, social and governance criteria to be injected into smart beta portfolios have prompted a growing number of ESG factor-based indices. Lynn Strongin Dodds looks at their construction and hears how they generate enhanced returns and lower risk.
Sustainable investing is increasingly becoming an embedded feature of the investment decision-making process, so it is no surprise that there has been a spate of environmental, social and governance multi-factor funds coming on to the market. However, definitions and methodologies differ significantly and many view ESG as a complement rather than as a factor in its own right.
“There is massive diversity on the ESG landscape in terms of what investors are looking for and how it is defined,” says Vincent Denoiseux, managing director, head of portfolio solutions at DWS Group (formerly Deutsche Asset Management).
“The market is not mature and investors have to be clear about the convictions they want to take as well as tracking error from the benchmark. I would not say it is mainstream yet but there is definitely growing interest.”
To date, fund managers such as State Street, Vanguard, Candriam Investors Group, Oppenheimer and Columbia Threadneedle have brought different offerings to the market, while large Dutch and Nordic pension funds have led the way. AP2, one of five buffer funds within the Swedish pension system, is one of the most recent examples.
It announced that 29% of its overall portfolio will be managed to multi-factor indices where a basket of ESG themes, including climate, diversity, corporate governance and transparency, will be the most important criteria for the weighting in the benchmarks.
The trend is evidenced in the latest FTSE Russell 2018 survey, which shows that nearly 40% of respondents anticipate applying ESG considerations to a smart beta index-based investment strategy in the next 18 months.
The drivers have shifted, with 63% now motivated by societal good compared to the 54% who listed avoiding long-term risk as their main reason. Performance has also become an important factor for 44% of asset owners, up 13% since last year when ESG smart beta awareness and usage was first measured.
The results reflect a wider trend, with a report from JP Morgan revealing that the total sustainable investment market is worth almost $23 trillion, with around half of all assets managed in Europe and more than a third in the US.
The growth of ESG assets stateside has soared over 200% from the past decade and the popularity of ESG-themed exchange-traded funds (ETFs) has surged since 2016, with $11 billion (€9.5 billion) in assets under management (AuM) across 120 funds around the world.
However, there have been challenges. A paper published last year from MSCI – ‘Foundations of ESG Investing: How ESG Affects Equity Valuation, Risk and Performance’ – notes that across the thousands of research reports investigating the relationship between ESG characteristics and financial performance, analysis methodologies show little consistency. Overall, results have been inconclusive, though the majority found a positive correlation.
The paper adds that even those finding such a correlation have failed to provide evidence that positive ESG performance is the cause, rather than the effect, of positive financial performance.
One of the biggest issues, particularly in regard to categorising ESG as a factor, is the lack of historical evidence to prove that it offers a reliable long-term premium. Typically, companies have not been required to disclose ESG information as they do for financial measures. Moreover, when they do, the definitions employed are not consistent. For example, there is no book-to-price equivalent of ESG that can be applied universally, plus the information is updated much less often than most data – once a year is the standard – and the track record is very short.
Vernacular
Andrew Howard, head of sustainable research at Schroders, also believes there needs to be a new vernacular. “We have to think differently about ESG criteria than you would when looking at a company’s balance sheet,” he says.
“Something like common equity is fairly well understood, but ESG topics cover a wide range of areas and vary by investor. For example, the impact of emitting CO2, avoiding taxes, selling alcohol and tobacco can all matter in different situations and for different investors. We need to be very clear about what ESG analysis means in each situation rather than relying on shorthand”
Terminology is not the only problem. The links made between ESG and factors should also be carefully examined.
Connections do exist between ESG and quality, size and low volatility, but, for example, some industry participants point out that larger companies may have higher ESG scores because they have the resources to provide more information and transparency. This may not be the case with their smaller or medium-sized counterparts.
“There is also a residual correlation between quality and ESG, but the problem is that while there is over 20 years of statistical evidence about how quality behaves, there is only around five years for ESG,” says Yazann Romahi, chief investment officer for quantitative beta strategies (QBS) at JP Morgan Asset Management.
“I think that is why to date, if ESG is used in a multi-factor fund, it is viewed more as an exclusion or part of the metrics that are used to measure the quality of a company.”
This typically entails applying a filter for ESG factors before adding the traditional factor tilts such as momentum or value. Although screens vary, the most common approach is both to exclude stocks based on measures of controversy such as tobacco or arms, and to comprise a positive selection of stocks with good ESG ratings, such as green energy.
Many multi as well as single-factor fund managers also look at ESG through a prism of risk. The study by MSCI did find robust evidence that companies with strong ESG profiles were better managed and were at a much lower risk of suffering from incidents like the Volkswagen ‘dieselgate’ case or BP’s Deepwater Horizon disaster in 2010.
Ana Harris, global head of equity portfolio strategists, indexing, at State Street Global Advisors echoes these sentiments. She adds, “We need long-term evidence to see whether it is a long-term driver of risk and return.
“However, you can look at ESG as a non-financial metric that can be incorporated into multi- factor portfolios, which can provide access to opportunities not accounted for and help minimise risks that may be in the future.”
Take climate change, which has become a key item on the ESG agenda. Investors can mitigate this risk by reducing the carbon footprint of their portfolios, although there is no guarantee whether the move will translate into better returns.
“There is a debate as to whether ESG is a rewarded or unrewarded risk,” says Bruno Taillardat, global head of smart beta and factor investing at Amundi.
“We do not see it as a factor today because of the lack of analysis and backtesting, but you can integrate ESG criteria into a risk mitigation objective at no extra cost and it will be better-equipped to withstand any risks if they materialise in the future. You have to make sure, though, that it does not change the behaviour of the factors.”
Bull market
Invesco’s senior portfolio manager for quantitative strategies, Georg Elsäesser, also believes incorporating ESG will translate into a stronger risk-managed and more optimised portfolio.
“Think about a bull market – a lot of the stocks could be exposed to several factors at once and they won’t offer factor diversification. We believe it is better to take a holistic view and consider the exposures to, say, momentum, quality and value from each security.”
Wilma de Groot, head of core quant equities at Robeco, also notes that portfolios can offer both outperformance and a green profile with careful stock selection. All of Robeco’s quantitative equity strategies integrate ESG scores, based on RobecoSAM’s annual Corporate Sustainability Assessments.
“The weights depend on the clients’ preferences but if a stock is appealing from a quant and not an ESG perspective, it has a lower chance of ending up in portfolio. But we ensure that for all portfolios, the scores are at least higher than the index’s own score,” she adds.
However, she does not see ESG as a factor in its own right and believes that more evidence is needed to demonstrate the relationship between ESG and returns. “ESG is a slow-moving factor and does not change from day to day, such as momentum. We will have to be patient and wait for more data to come through.”
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