Elizabeth Pfeuti finds certain investment factors could be boosted if ESG criteria were added to them – but that limiting stock selection by mixing ESG in with smart beta could heighten risks.
In the decade or so since the financial crisis – and potentially fuelled by pre-existing ideas – two distinct emerging trends in fund management have been smart beta and environmental, social and governance (ESG) investing.
Smart beta channelled the stock-picking aspects of active management, but without the frequent sky-high fee; ESG attempted to seek out some of the practices and pitfalls that might hasten corporate collapses.
According to FTSE Russell’s annual smart beta survey, by the midpoint of 2018, some 48% of global institutional investors had some allocation to the strategy. This number rose to 91% when it included the investors who were actively considering it. Flows into ETFs in 2019 have also been dominated by smart beta, according to various industry measures.
On the other side of this equation, ESG growth among the world’s 500 largest asset managers had soared nearly 25% to reach more than $1.4 trillion (€1.3 trillion) at the end of 2018 – up from $1.19 trillion in 2017 – Willis Towers Watson’s Thinking Ahead Institute revealed in November.
The natural next step would be to put the two together – a match made in heaven, perhaps…
Bruno Taillardat, head of smart beta and factor investing at Amundi, sees it happening already. “There is a very strong appetite for ESG combined to smart beta in funds,” he says. “Smart beta funds rely on well-structured and disciplined investment processes.”
It is important to note that ESG does not use the factors defined within the smart beta process, rather a series of elements and filters that are often based on qualitative reports and experience. But with smart beta strategies relying on an investment philosophy articulated across risk management, ESG is a natural extension to the factors already there, says Taillardat.
Some factors are better than others
However, the partnership may not be quite as straightforward as it first seems.
For Carmine De Franco, head of fundamental research at Ossiam, investors need to start with two basic questions. What is the ESG policy to consider? And how far should it go/be implemented?
“If your ESG policy is something basically exclusionary – removing tobacco, for example – you can still build a strategy around factors. It is not much different,” he says.
“You still have a great universe of securities to choose from, so you’re not really modifying the strategy.”
Anthony Renshaw, director of index solutions at Axioma, agrees. “It only really eliminates controversial names. It is basically the same overall,” he says. “It is an ‘easy sell approach’ and you will see a lot of this over the next few years. It is a small step and it fits most people’s needs.”
ESG becomes more relevant when your policy is more ambitious.
“When you are only picking the best in class around certain ESG policies, the impact is dependent on the factor and must be approached on a sector-by-sector basis,” says De Franco.
Some factors react better than others to having an ESG filter applied. Quality and low volatility factors are well matched with ESG, for example.
Quality tends to favour companies with large profits relative to their asset base, says Eugene Barbaneagra, portfolio manager for the traditional strategies group at SEI.
“And having a high profit base tends to allow a company to afford to mitigate a lot of ethical issues.”
Style Analytics has been researching factor impacts in general market movements, according to chief commercial officer Damian Handzy. It has found that momentum is dominant. “It is easy to add ESG factors to momentum,” says Handzy. “It has also been shown to produce higher returns when you do.”
With the value factor, however, the relationship is complicated, according to De Franco. “The stock may be cheap from a value perspective, but it may fall out of an investor’s universe on ESG considerations.”
Take Volkswagen as an example, the share price of which collapsed following a scandal around its diesel emission testing.
“If I am a pure value investor and do not care about ESG, VW has issues, but the value factors are so attractive that I buy it anyway,” says Barbaneagra. “Buying something when it is cheap and holding on to it has been one of the most prolific and successful equity strategies. But, if you are an ESG investor, you have to sell that stock or not buy it in the first place.”
Taillardat at Amundi says ESG can favour or hinder some individual factors and underlying sub-criteria can have more impact on some factors than others.
“Individual factors have specific cycles of performance and should be built in order to exhibit different payoffs,” he adds. “Combining them is an efficient way to navigate in the equity markets for the long term.”
While these explanations may sound in line with expectations, for Renshaw at Axioma, there is still a lot of work to do.
“It is hard to look at the impact of ESG on the factors as we don’t have a lot of data to go on,” he says. “We’ve had 20 years of a bull market, which is not a great test. Once ESG has had time to perform in a variety of market conditions, we will know more.”
There could be false flags or positives, for example.
With a value strategy, stocks can be cheap for several reasons, Renshaw says. “The company might have had a crisis or be positioned to be set to grow to a higher price – or it might have been in the news for the wrong reasons. Or it could be a new company without enough data to make a call.”
Because of this, you have to be very careful about your ESG ambitions.
“An ESG overlay has to be designed with a factor in mind. The two have to be designed together,” says De Franco.
Value is a prime example of how a one-size-fits-all ESG policy cannot work for smart beta.
De Franco adds: “If you build your strategy around a factor and best-in-class basis, you are accessing the premium, but removing the bad guys.”
And by just removing these bad guys, you are significantly challenging your potential, according to Handzy. “When you constrain the list of securities, you make it more difficult to adhere to a strategy,” he says. “While the jury is out on whether ESG factors add alpha, by reducing the number of companies to choose from, you heighten the risk, so your Sharpe ratio goes down as you have a more concentrated portfolio.”
When markets make such artificial constraints, an abnormal return potential well above what the risk has implied can be the result, says De Franco.
Barbaneagra uses credit ratings as an analogy. “Consider an AAA-rating versus high yield,” he says. “It is true that the probability of default is higher for high yield, but you are well compensated compared to an investment grade portfolio. With ESG, it’s a similar approach. The companies that issue at a deep discount will compensate those willing to take the risk.”
Another constraint may come in the form of the European Union’s sustainable finance drive. “If they are to apply a strict taxonomy, it’s fair to say investors face constraints and what they cannot invest in will be exploited by people without them,” says Barbaneagra.
For Handzy at Style Analytics, the time might be now for those looking to make the most of the combination. “It is easier to construct ESG and smart beta now than it will be in five years,” he says. “At the moment, there is little consensus on what constitutes ESG. Should BP score highly because of its commitment to renewable power or low because of its oil and gas?”
That lack of consensus is likely to change.
Despite most asset managers claiming to take an ESG approach, few are likely to carry out the vast amount of detailed research across the full securities universe themselves. Third-party specialists are likely to do the heavy lifting.
No free lunch
Axioma’s Renshaw has begun to see the impact already. “Something appeared a few years ago, with people all investing in ESG-based strategies that are pushing up the price of some companies and creating their own alpha signal,” he says.
Without calling a bubble, Barbaneagra thinks the phenomenon will continue, but with a flex: “The implication is that the ESG proliferation will make cheap stocks cheaper and their future return will likely be greater.”
He urges investors to think carefully about blending ESG with their smart beta portfolio: “I do not want to destroy the planet, but a lot of the narrative in the media is that ESG is a free lunch – and it really isn’t.”
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