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The value proposition for factoring in ESG




Much has been made of factor investing, with significant attention being paid to SmartBeta. But what role do environmental, social and governance (ESG) factors have for investors looking for low cost, broad-based sustainable equity products?

Lesson 1: Set clear objectives and expectations

In the alphabet soup that is the world of institutional investing, SmartBeta can learn from responsible investment. In the 1970s, “responsible investment” meant investing ethically and excluding products or sectors that failed the ethical standards of specific client groups. While this was a noble approach to investing, investors saw lower returns when the market was more defensive. For example, funds that excluded tobacco, alcohol and gambling often suffered when investors flooded to these more defensive sectors. Over the long-term, these lower returns might be compensated by more quality stocks, but meanwhile, investors may suffer lower returns. Similarly for SmartBeta, a strategy focused on investing in quality companies may suffer when the market favours value stocks. Some strategies address this by running SmartBeta strategies that focus on multiple factors simultaneously. As with ESG factors investors should ask themselves, when do they expect the strategy to outperform and underperform and why?

Lesson 2: The devil is in the detail

Responsible investment has been criticised from time to time for investing in, what some perceive to be, irresponsible business practices. For example, a fund manager that has signed up to the UN PRI may be found to have invested in a company that relies on sweatshop labour in its supply chain to produce its goods. One might censure the manager for false marketing. At the same time, the manager may be engaging with the company and trying to encourage it to improve its labour practices. The lesson here is transparency is key, as is reading the fine print. If the fund manager never promised to exclude, then the criticism is unfounded. Potential investors in SmartBeta should be encouraged to read the fine print to understand how factors are integrated and what that might mean. Investors should be aware that any factor can underperform for significant periods of time, and too much money invested in narrow strategies could lead to a stampede out of the factor if it underperforms significantly. And if an ESG overlay is added too, why is it being added and what is the expected outcome? For example, a low carbon overlay would reduce your exposure to the energy and materials sector, whereas an ESG overlay focused on a best-in-sector approach would yield more balanced results.

Lesson 3: Don’t confuse correlation and causation

It is notoriously difficult to separate the question of correlation and causation. While many backtests have been done on both SmartBeta and Responsible Investment portfolios, as the adage says, past performance is no guarantee of future performance. Some pundits have suggested that companies with a strong ESG profile won’t outperform the wider market since the bar has been raised around stakeholder expectations of a responsible business. In fact, evidence coming out of the London Business School suggests that more value would be derived from investing in companies with a poor ESG profile and engaging them to improve. SmartBeta investors would be wise to consider where the tipping point is, at which factor-based investing ceases to add value and becomes overcrowded. Perhaps combining SmartBeta with an ESG overlay focused on engagement would deliver more value than simply tilting to the best ESG performers in a market.

Alexis Cheang is principal, responsible investment at Mercer
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