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Revamping smart beta strategies with ESG principles

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As smart beta products fall out of favour, ESG investments are gaining traction. Is this the end of smart beta strategies? Hamza Bahaji, Head of Engineering and Solutions, Amundi, argues that although ESG investments are in, they’re no replacements for smart beta products, and sees some opportunities in applying ESG principles to smart beta strategies.

Once described as a disrupting innovation in investment management few years ago, smart beta is now facing many pressing challenges that might impede its progression. One revealing symptom of this decline is the rapid slowdown of smart beta product launches (see Eckett 2020) in the last couple of years. The most frequently evoked reason that led the smart beta business to slumber, in spite of the beauty of its underlying concept, is the mixed performance delivered by smart beta investment products that got investors disillusioned somehow. A recent research by Huang et al. (2020) has pointed for instance to the sharp deterioration of smart beta ETFs performance after they were launched. Such concerns might damage the credibility of smart beta as innovative strategies using alternative weighting schemes and deemed to have better cost-adjusted risk-return characteristics than traditional active strategies. Another relatedly evoked reason is that smart beta has slumbered since investment managers have moved on to developing other investment solutions in other parts of the market where they see rapidly growing investor demand. The most attractive segment is indubitably ESG investing.

The rate of ESG-oriented investing has risen significantly over the last years. Asset owners, institutional and individual investors, both active and passive, continue shifting capital in this direction as they recognise the growing risks of extra-financial factors. ESG is a large field that encompasses several aspects. Its Environmental area, including climate risk issues, was overwhelmingly named as having the most significant impact on the related investment decisions. This correlates with the top global risks reported by the 2020 World Economic Forum which found that, for the first time, environmental issues, usually referred to as the “green swan”, are the dominant concern.

According to some investment observers “Smart beta has become “passé” [] and the immediate challenge to broader smart beta growth is the emergence, and adoption, of [] ESG solutions” (see Eckett 2020). This statement reveals at first sight some misconceptions about the development of smart beta, and here is why. First of all, smart beta do not address the same investor needs as ESG, but their objectives are not incompatible though, which means that they can fairly coexist. Therefore, ESG investing is not a substitute to smart beta. Second, opposite to smart beta, ESG cannot be regarded as a disrupting innovation but, instead, as a broader structural shift in investment decision making that will reshape the whole financial industry. Like many other investment disciplines, smart beta is concerned by this large-scale shift and has to adapt to it in order to stay in investors’ sight. Many disruptive financial innovations have adapted to structural changes in their environments since they address persistently extendable needs (e.g. derivative products). In the case of smart beta, the development of ESG-friendly products might be the next move in this direction for instance. In the meantime, this idea raises important questions about how smart beta managers should position those products within the large ESG spectrum and how they should align their investment objectives and adapt their frameworks accordingly in order to achieve those outcomes in their portfolios. Are some smart beta strategies already ESG-friendly nonetheless?

A recent literature has pointed to the argument that because smart beta factors have a broader systematic effect, deliberate or inadvertent factor tilts in a portfolio strategy might be correlated with its ESG characteristics. This is supported for instance by the empirical finding in Breedt et al. (2019) that most of stocks’ ESG characteristics are captured by smart beta factors. It is also consistent with Ang et al. (2020) findings that there is strong positive relationships between fund alphas and their ESG scores components related to factors. This argument may lure some investors and lead them to believe that some smart beta factors are already ESG friendly and, therefore, comfort them in the idea that holding portfolios with balanced factor exposures will naturally provide them with positive exposures to ESG.

There are basically two hard facts that run against this idea. The first one stems from the empirical observation that factors have different but also time-varying ESG characteristics that lead, by construction, to time-varying ESG biases in a portfolio tilted towards them (Ang et al., 2020). The second fact merely recalls that some factor ESG aspects are inherently dependent on the construction of the factor itself. There is for instance a strong relationship between the carbon footprint of a factor and its industry exposures. By construction, some factors encompass positive active exposures to some carbon-intense industries, unless they are designed with a formal purpose to neutralise those exposures. This is the case for example of the low volatility factor. The factor has displayed a persistent bias toward utilities stocks which tend to have higher carbon footprints.

There are mainly three directions that smart beta managers should consider in gauging the extent to which their investment objectives can be aligned with ESG:

Considering ESG items as new smart beta factors:

Environmental and climate considerations in ESG encompass several risk aspects with assessable microeconomic implications and, therefore, impacts on the expected cash flows of the firm. Those aspects might be considered a priori as risk factors in this respect. Transition and physical risks are among them. As those considerations are growing mainstream and increasingly embraced by index providers, stocks of companies with the best environmental ratings and climate footprints are expected to attract higher inflows all things else being equal.

Using ESG signals in the design of factors:

Beyond considering some ESG aspects as additional smart beta factors, there are other alternative directions that smart beta managers aiming at embracing ESG could follow. To do so, they should formally assign ESG-specific objectives to their portfolio construction processes. One direction that has recently emerged in the literature consists of using ESG signals in the design of factors. Chan et al. (2020) suggest for instance to integrate sustainable signals in the definitions of factors themselves. They show more specifically how green intangible value and corporate culture quality enhance traditional financial value and quality factors respectively. This specific example shows indeed that some ESG aspects stem from an economic rational that adds to the criteria underlying the definition of some factors and, therefore, enrich their conception.

Extending the scope of risk mitigation to some ESG risks:

Another direction is to consider some ESG aspects as additional risk factors that should be mitigated in the portfolio construction process. Climate and environmental risks for instance are increasingly considered in this regard. Nevertheless, this direction suits better smart beta investment philosophies aiming at long-term alpha generation through risk mitigation. Those so-called “risk-based” or “risk-efficient” investment managers should examine how to extend their investment frameworks to encompass carbon risk mitigation for instance without affecting their market risk exposures and fundamental profiles.

Because ESG is a rapidly growing issue, there is still wide room for the broader picture to change depending on the prevailing regulatory and market developments. Therefore, regardless of which one of those directions is considered, smart beta managers should be keen on keeping some flexibility in their investment frameworks to adapt to any potential development. ESG challenges are also great opportunities for smart beta managers to revisit their processes and, more broadly, for the whole discipline to profoundly reshape itself.

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References

Ang, A., Madhavan A. and Sobczyk A. 2020. “Toward ESG Alpha: Analyzing ESG Exposures through a Factor Lens.” vol. 72, no.1: 15–20.

Chan, Y., K. Hogan, K. Schwaiger, and A. Ang. 2020, “ESG in Factors”. The Journal of Impact and ESG Investing, vol. 1 no.1: 26–45.

Breedt, A., S. Ciliberti, S. Gualdi, and P. Seager. 2019. “Is ESG an Equity Factor or Just an Investment Guide?”. The Journal of Investing, vol. 28, no.2: 32–42;

Eckett, T. 2020. “What is driving the rapid slowdown in smart beta ETF launches?”. ETF STREAM. Available at https://www.etfstream.com/features/what-is-driving-the-rapid-slowdown-in-smart-beta-etf-launches/#.

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