ESG in Smart Beta

The rise of factor investing in ESG

Consultancy firm ETFGI reports that smart beta exchange-traded funds and products had gathered $71.8bn in net new assets in 2017 – 32% more than net inflows than for 2016.
Total assets invested in smart beta strategies overtook $1trn in by the end of last year, according to Morningstar.
Broadly, smart beta uses strategies weighting securities on fundamental factors like value or momentum in an attempt to capture excess returns above those of traditional market-cap weighted indices.
A survey by FTSE Russell finds nearly half (46%) of global asset owners have an allocation to smart beta, and 41% of those using it or considering its use anticipate applying ESG considerations.
Managers are following these trends with a number of smart beta funds integrating ESG launching in recent months.
MSCI brought out the MSCI Factor ESG Target Index Series in November, a significant move for a big player in the factor and ESG index space. And Candriam, the €111bn asset manager owned by New York Live Investment Management, brought out a range of smart beta sustainable ETFs last summer. Speaking about the decision, Koen Van de Maele, Global Head of Investment Solutions, says it has a history in ESG and saw there was a lot of demand for ETFs. It decided against constructing pure market cap-weighted indices, says Van de Maele. “In one sense it is a very naïve and even a sub-optimal way of constructing a portfolio,” he says. “Implicitly, market cap indices weigh companies in terms of price earnings ratio. So companies that are the most expensive tend to have the highest weight. It’s the same for sectors. If you look at the weight of a sector based purely on market capitalisation before the financial crisis, the financial sector was really big. And before the previous crisis the technology and telecoms sector was really big. That’s not what the average person in the street would expect.”
Candriam’s sustainable ETFs have a broad universe with proprietary SRI screens paired with smart beta tilts such as low volatility, quality or value in a multi-factor approach.
Pax World Management, the US fund manager recently bought by Impax Asset Management Group, has two multi-factor smart beta ESG funds. The Pax ESG Beta Dividend Fund overweights a US large-cap portfolio towards stock with strong ESG credentials, high-dividend yields and other factors like profitability. And the Pax ESG Beta Quality Fund overweights US large-cap companies to strong ESG profiles, higher earnings quality and other factors.The funds integrate ESG based on Pax’s propriety sustainability score of companies in the Russell 1000, uniquely including a gender diversity measure.
Steve Falci, Chief Investment Officer at Pax, says: “It is our belief that combining a carefully selected mix of proven financial factors [such as earnings quality or profitability] with a proprietary ESG score would provide an unique and strong offering in the smart beta arena.” His philosophy is further outlined in the paper ESG – Expanding the Horizon of Smart Beta.

Even if ESG is only added as an overlay to smart beta strategies, some question the quality and consistency of ESG data

But some feel that ESG is not a factor in the same way as well-established factors such as momentum or value supported by a high volume of data and research, covering long periods and a number of market cycles. And even if ESG is only added as an overlay to smart beta strategies, some question the quality and consistency of ESG data.
Falci argues: “While quantification of ESG data to create a score is newer relative to financial factors, the ability of seasoned ESG analysts to evaluate and synthesise data available from multiple sources, sorting for quality and materiality, can create a robust, differentiating ESG score.”
Last year, German boutique manager Alpha Centauri, created a carbon ‘factor’ for some of its funds. The firm, with climate data house South Pole, analysed the performance of European equities over a six-year period, based on carbon exposure. It found that carbon-intensive companies have underperformed and that lower exposure receives a premium.
It looks likely that the combination of the two investment philosophies, smart beta and ESG, will continue through 2018 and beyond. HSBC’s pension fund recently shifted the remainder of its passive equities over to a fund tracking a smart beta, climate-focused index from FTSE – along with other, unnamed investors – while fellow index giant State Street is also reportedly lining up new products in the space.