By Jenn Bender, Todd Bridges & Emma Johnston – State Street Global Advisors
The investment landscape is changing
In this lower-return world, investors are increasingly challenged to achieve their return objectives while appropriately balancing risk, fees and returns.
At the same time, more and more investors must meet these challenges while ensuring that their underlying investments incorporate an awareness of environmental, social and governance (ESG) issues.
Innovations in both Smart Beta and ESG investing are helping investors to address this diverse set of requirements.
Smart Beta Investing
Smart Beta investing is based on the insight that factors—company attributes that have been shown to explain stock returns—are the underlying drivers of security performance. Academics have been studying factors for over half a century, and their research demonstrates that factor-based investing has the potential to deliver returns in excess of cap-weighted benchmarks over time.
Investment strategies which take advantage of these factor premia—commonly referred to as ‘Smart Beta’ strategies—are becoming a more common part of investors’ portfolios. In the most recent Smart Beta survey from FTSE Russell, the percentage of asset owners allocating to Smart Beta strategies had risen from 26% from 46% over the last two years. One reason these strategies are appealing is because they offer the potential to outperform a cap-weighted benchmark with lower fees compared with active strategies.
Over fifty years of academic literature has demonstrated that excess returns associated with factors have proven to be persistent over time. This is because factors are hypothesised to capture risks which cannot be diversified away, such as systematic risk, behavioural biases, or market structure issues.
Extending Smart Beta to a Multifactor Approach
Early Smart Beta offerings focused on portfolios that targeted a single factor, but single- factor portfolios can suffer from the cyclicality of factor performance.
Multifactor portfolios are an increasingly popular alternative.
In the FTSE Russell survey, among respondents who are already using Smart Beta strategies, the adoption of multifactor portfolios has tripled, from 20% in 2015 to 64% in 2017.1 One reason for their increased popularity is that multifactor portfolios historically benefit from the diversification provided by low correlations between factors.
The multifactor approach can give exposure to factors which are outperforming based on the economic cycle, mitigating the impact of other factors that are experiencing underperformance. This can help deliver to factor premia over the long term.
The low correlations between factor excess returns can provide diversification benefits over the long term.
Why ESG Matters
Investment strategies which give consideration to ESG dimensions are also increasingly prevalent. This style of investing can help to align investors’ portfolios with their personal or institutional values, as well as policy requirements. A company’s environmental actions, social behaviours and governance practices can have a meaningful impact on performance. The chart below describes the intuition behind ESG investing.
In the past, choosing values or performance was often presented as zero-sum—that is to say that driving impact came at the cost of better returns. Research in recent years suggests that that this can be a false choice.
Recent studies have found that companies’ ESG practices can positively impact their long-term performance. A 2015 Oxford University meta-study2, which reviewed over 200 academic studies, industry reports, books and articles, showed a positive relationship between sustainability factors and economic performance. Even more recent research from MSCI3 demonstrated that positive ESG characteristics can lead to financially significant effects by examining how that ESG information finds its way to the equity market.
The Integration Challenge
For investors to take full advantage of Smart Beta and ESG investing, portfolio construction is critical. The inherent tension in constructing an ESG integrated multifactor portfolio is balancing the trade-offs that might occur between targeted factor exposures and a favourable ESG profile. A security with a high ESG exposure might capture some unwanted factor characteristics. Our research team studied how ESG ratings can interact with other factors. One relationship demonstrated that the highest rated ESG stocks tended to have larger capitalisations. Since research indicates there is a factor premia associated with smaller cap stocks, there appears to be a trade-off between a security with a better ESG profile and a favourable size exposure.
Fortunately, both the ESG profile and factor exposures can be quantitatively measured. This allows us to consider a company’s ESG score alongside other factors scores to try to achieve balanced exposures through the use of optimisation. Optimisation-based portfolio construction methods offer a way for investors to achieve a portfolio with the desired aggregate characteristics, while minimising any unintended exposures such a currency or sector exposures. The result is a balanced and systematic approach to integrating ESG exposure into a diversified Smart Beta strategy.
Combining the Benefits: Core Factors ESG
We’ve leveraged our years of experience in Smart Beta portfolio construction and ESG expertise to create a portfolio with exposure to a diversified set of factors and to positive ESG characteristics.
Our integrated ESG and Smart Beta solution—Core Factors ESG—seeks to provide diversified exposure to the five factors which we believe represent the primary drivers of equity returns—value, size, volatility, momentum and quality—while simultaneously integrating positive ESG characteristics. The diversified factor portfolio helps to mitigate the cyclicality associated with some factors in the short term so that durable factor premia can be captured in the long term.
We achieve positive ESG exposure in the portfolio through assigning an ESG score to each security, giving equal consideration to ESG characteristics. While we remove securities with the greatest exposure to severe ESG controversies—such as controversial weapons or those in breach of UN Global Compact Principles—we believe that integrating ESG considerations can deliver a portfolio with a more meaningful exposure to desirable ESG characteristics. This two-stage approach ensures that the strategy eliminates companies with ESG liabilities, and provides positive exposure to those with compelling ESG attributes.
Core Factors ESG then employs the use of an optimiser to help balance the desired factor and ESG exposures. The optimiser can adjust factor exposures based on economic regimes to maximise exposure per unit of tracking error. It also helps to balance other competing objectives associated with multifactor portfolios such as turnover, as well as to minimise unintended exposures not related to factors. The result is a balanced portfolio with meaningful exposures to all 5 factors and an integrated ESG component.
By harnessing the power of factors, a multifactor ESG strategy aims to deliver benchmark-relative outperformance while maintaining cost efficiency. Diversification of factors serves to minimise the cyclicality of performance that can be associated with single-factor Smart Beta investing, with the potential to deliver premia over time.
Explicitly integrating ESG characteristics within this approach helps to align investors’ values or policy requirements to the portfolio, with the potential to provide additional premia over the long term.
These elements are combined though thoughtful portfolio construction to balance any trade-offs between factor and ESG exposures. For investors, the result is a socially conscious, diversified investment solution.