The rise of smart beta investing coincides with the rise in environmental, social and governance (ESG) investing, yet there are only a few products on the market that combine the two.
Last summer, for example, Axa Investment Managers launched the Axa World Funds Global Smart Beta Equity ESG fund. Societe Generale also has a product that focuses on corporate governance.
The underdevelopment of ESG in smart beta in many ways reflects the sluggish acceptance of ESG into mainstream circles. Regardless of the numerous conversations and headlines, it is still only a minority that employs ESG into fundamental securities analysis alongside key financial and non-financial criteria, such as cash flows, P/E ratios, competitive position and strength of management team, to name just a few.
This is borne out by a comprehensive study conducted in late 2015 by Deutsche Asset Management and the University of Hamburg, called ‘ESG and financial performance’. The study aggregated evidence from more than 2,000 empirical studies and found that while close to $60 trillion in assets under management – or 50% of the total global institutional asset base – was managed by the United Nations Principles for Responsible Investment (PRI) signatories, traditional investors were still lagging behind in their own sustainable investment practices.
The meta study showed that less than a quarter of investment professionals considered extra-financial information frequently in their investment decisions and only around 10% of global professionals received formal training on how to consider ESG criteria in their analysis. This is despite the fact that 62% of studies examined revealed a positive correlation between looking at ESG factors and financial performance, while only 10% displayed a negative ESG-corporate financial performance relationship.
Data quality
One of the biggest challenges for both the market-cap and smart beta ESG spheres is the lack of quality data. This is partly due to the way the information is collated. Instead of focusing on products and services, taxes and any penalties, the ESG scores tend to look more at the operational and organisational structures. This may help explain why energy group Shell, despite the greenhouse gas emissions from its core product, typically ranks highly on the scorecard while electric car group Tesla, which does not have a formal code of ethics or state-of-the -art governance policy, often has poor ratings.
The other drawback is that much of the data is limited to US large caps so does not present a comprehensive picture, according to Bas Peeters, head of quantitative research and strategy at NN Investment Partners. “This is why you see such mixed results with some concluding that incorporating ESG detracts from performance while others show the exact opposite. There needs to a more robust data set and definitions.”
“I think ESG will be part of smart beta but at the moment, it does not have the track record or level of detail needed to make investors comfortable with the strategy,” says James Price, senior investment consultant at Willis Tower Watson. “Many investors like to see at least 20 years of history and one of the ways smart beta products have been sold is that some, such as value, can produce favourable back tests that go back 40 years.”
Manuela Sperandeo, regional head of smart beta at iShares, adds: “The data on ESG typically dates back to around ten years ago, which is why investors do not feel confident about categorising ESG as a rewarded investment factor. So in many ways, we are in the same place that factor-based investing was five years ago. While the conversations have traditionally been mainly around exclusions such as weapons, tobacco and fossil fuels, investors are now shifting their focus towards broader management practices linked to ESG issues.”
She adds that “on the back of this, all index providers have ramped up their efforts and there is much more activity in trying to accurately measure companies according to ESG criteria, and this improved availability of data will definitely help progress the conversation”.
MSCI, for example, has more than 150 analysts looking at the combination of ESG and factor strategies. One of the index provider’s recently published papers – ‘Factor-based investing and ESG integration’ – found that over the past ten years, investors were able to significantly increase the ESG rating of their factor strategies with a relatively modest impact on target factor exposure and returns.
However, as Hitendra Varsani, executive director of factor strategies at MSCI points out, not all strategies were affected to the same extent. For example, minimum volatility strategies, which aim to lower the risk of the parent index experienced only a 7% reduction in target factor exposure for a 30% enhancement in their ESG rating, while value strategies, which are more sensitive to an ESG overlay, incurred a 22% reduction in target factor exposure for a similar 30% improvement in their ESG characteristics.
Lower risk, higher return
Research by Axa Investment Managers conducted three years ago also shows that combining ESG and smart beta strategies can offer investors a lower total risk and higher return than index investing, along with improved diversification and strong ESG performance. It compared the returns of its Axa IM SmartBeta Equity portfolio with the same portfolio overlaid with an ESG filter, as well as the MSCI World Index, over the period February 2007 and December 2012.
Both the vanilla and ESG versions of the smart beta portfolio yielded an annual 3.22% over the period, which was well ahead of the MSCI index’s annualised return of 0.84%. Moreover, while the ESG portfolio outperformed the standard smart beta portfolio in terms of overall ESG risk, it had higher annualised volatility (17.47%) than the vanilla portfolio (16.08%). The MSCI had the highest of the three at 19.56%.
Last summer, the fund manager launched the Axa World Funds Global Smart Beta Equity ESG fund which aims to deliver 1%-2% annualised excess return with around 80% of market volatility over a full cycle, as well as achieving a higher ESG score and a lower carbon footprint. It will avoid investments in companies with controversies and low ESG scores while increasing exposures to companies with high ESG scores using a ‘best in class’ approach.
“We believe that investors are best served by combining proven risk premia strategies with thoughtful ESG integration,” says Kathryn MacDonald, head of sustainable investment at Axa IM Rosenberg Equities. “For example, those interested in capturing equity upside while also seeking some downside risk mitigation would be well served by a blended risk premia strategy emphasising low risk equities and high-earnings quality names. Adding ESG to the mix – that is, omitting names that score poorly along ESG dimensions and up-weighting the stocks for which the opposite is true – further increases the ability to avoid tail risk exposure and opens the door to long-run return opportunities.”
Peeters also believes excluding companies with controversial behaviour from the investment universe can help improve performance. The definition of a company behaving controversially, according to a study published last year by NN Investment Partners along with the European Centre for Corporate Engagement (ECCE) at Maastricht University, is if they, for example, are involved in activities such as environmental pollution, bribery and corruption and human rights issues.
The study divided them into three categories based on the severity and frequency of a specific issue. Overall, it noted that during the period studied – from January 2010 through September 2014 – returns improved not only when avoiding “severe” and “high” controversies but also those they considered “significant” controversies.
The view is that if investors had, for example, focused more intently on these issues, then they may have seen the warning signs in companies such as Volkswagen. This is because the number and seriousness of the controversies had already risen before the problems with the cheating emissions tests came to light.
Corporate governance is another area where there has been product development. Societe General has been one of the forerunners with its CEO Value strategy, which ranks pan-European companies on their governance credentials and financial strength. It uses the CEO Model, a bottom-up approach chasing historically underperforming companies with solid performance recovery potential thanks to sound corporate governance principles. It assesses the period during which the CEO has been in charge and the historical relative share performance versus competitors.
“The nice thing about the CEO Value is that it is an investable index and has a long track record as it was launched in 2006,” says Isabelle Millat, head of sustainable investment solutions. “Since its inception, it has outperformed the Euro Stoxx 600 by 68%. I think looking ahead it will take time for ESG and smart beta to evolve and indices are created where investors can overweight and underweight companies with good and bad ESG scores.”
MacDonald also notes that there is a growing number of investors who have adopted a ‘double bottom line’ approach to investing, which encompasses not only a requirement for superior risk-adjusted returns, but additionally investments that support a sustainable future. “ESG-integrated smart beta is indeed a next-generation product as it speaks directly to the next generation investor,” she adds.
©2017 funds europe
