Sustainability and factor investing: A winning combination?

Sustainability is currently the buzzword in the investment industry. More and more asset managers include sustainability considerations in their investment decisions. This is triggered by the demands of modern investors as well as by the increasing regulatory pressure.

It is widely believed that by investing in more sustainable companies, the portfolios are better immunized against medium and long-term shocks. However, the effect of sustainability on the shorter term financial performance is not quite clear. Evidence is inconclusive: many studies, including our white paper published by Refinitiv [1], show that portfolios of more sustainable stocks perform worse in terms of immediate returns and Sharpe ratios, in the US and some Asian markets, and on par with the benchmarks in European markets.

Active managers are also exploring ways of adding sustainability metrics to their quantitative investment strategies, such as factor investing. But what is the best way to improve sustainability of your (multi)factor portfolios without sacrificing their financial performance? Recently, we performed a large-scale empirical investigation, involving all stocks in S&P500, STOXX600 and FTSE100 universe, to explore some possible choices.

Is sustainability a new investment factor?

The first thing that comes to mind (and is advocated by some researchers and practitioners) is to consider sustainability as a new “investment factor”. Sustainability of companies is often measured by the so-called ESG scores: rankings of companies in terms of their environmental (E), social (S) and governance (G) policies and performance. Then the “sustainability”, or “ESG” factor can be constructed in the way similar to other, traditional factors: ranking companies in terms of their ESG scores and forming a long-short portfolio of the best and worst ESG stocks. However, it turns out that such an “ESG” factor is quite a poor investment factor in the traditional sense: it does not show any positive abnormal return, it is highly correlated to the size factor (large companies generally have higher ESG scores) and it is redundant: the financial performance of multifactor strategies with and without this factor are virtually the same. So what other possibilities are there?

ESG as a risk overlay

A more effective approach is using ESG scores for stock selection (screening), prior to including them in multifactor strategies. Recall that, in many cases, sustainability considerations are integrated into investment strategies not so much to enhance returns (not in short term in any case), but to improve sustainability metrics of the entire portfolio - hopefully not at the cost of financial performance. By using ESG scores as the screening criteria – similar to the risk overlay – the ESG score of the resulting portfolio will be higher than any unscreened alternative, such as any other passive or active benchmark. The main questions then are: how aggressive should we screen stocks in terms of their ESG scores and how does this screening affect the financial performance of the multifactor strategies?

It turns out that, when we incorporate ESG as a risk overlay in S&P500 universe, the financial performance of the multifactor portfolio (in terms of return and Sharpe ratio) slightly improves. The higher is the screening aggressiveness, the higher is the return and the Sharpe ratio. When only 50% of best ESG-performing stocks are included in the factor strategy, the annualized return of the multifactor portfolio increases by 1.2%. Furthermore, the ESG stock selection contributes significantly to the reduction in portfolio volatility. It appears that, by screening stocks by their ESG scores, we exclude some highly volatile stocks. Thus, even with fewer stocks, the screened multifactor portfolio has a lower volatility than the unscreened one.

In STOXX600 universe, the situation is different: in EU, the overall level of ESG scores is higher than in the US, so aggressive ESG stock exclusion results in a lower return and Sharpe ratio compared to the unscreened multifactor strategy. For EU stocks, the relationship between a stock’s volatility and the ESG score is weak, so the volatility of the screened portfolio is higher than that of the unscreened one, because the portfolio volatility is dominated in this case by the number of included stocks and not their ESG scores.

ESG for sector rotation

Another way to use ESG scores in factor strategies, is to invest more into entire sectors which have higher average ESG scores. When such a sector tilt is added, the return and Sharpe ratio increase further. For example, in S&P500, for aggressive sector tilt (where we significantly overweight “good” and underweight “bad” ESG sectors), the return is 4.3% above the return of the traditional multifactor portfolio. Part of the reason for such a dramatic increase, however, is a high weight on the US tech sector, which has a high ESG rating and performed remarkably well in the last decade. In STOXX600 universe, the tech sector is not as dominant, and yet, sector-tilted strategy still have shown 1.5% higher return than the “usual” multifactor strategy.

The described stock selection/screening approach is not restricted to factor strategies: it can be used in addition to any other portfolio construction methods such as return-risk portfolio optimization a la Markowitz. Here, one should take care of proper sector diversification, as stocks in e.g., tech or healthcare sectors tend to have higher ESG scores and will be over-represented in resulting portfolios. The solution to this (undesired) sector tilt is to perform stock selection per sector and not simultaneously for the entire stock universe.

To conclude:

Although sustainability does not appear to be a driver of returns, there is emerging evidence that it mitigates risk of investments, especially in the long term. The aim of sustainable investment strategies should be not to gain alpha, but to achieve a higher sustainability profile of portfolios, without sacrificing other, traditional performance measures such as return and risk. A sustainable investment process should seek balance between improving sustainability metrics of portfolios, while still keeping an eye on the financial performance, and we have shown that this is a feasible objective. Screening the investment opportunities in terms of their sustainability scores can result in lower portfolio variance, also in the short term.

Stock screening and sector rotation using ESG scores performs quite well in addition to multifactor strategies, as we have seen. However, these are just two simple approaches of incorporating ESG metrics in quant strategies, and other options are possible. But in any case, incorporating sustainability considerations in your investment decision does not have to lead to inferior financial performance of your portfolios, be it a passive or active investment strategy.

References:

Borovkova, S.A., Wu, Y. (2020). ESG versus financial performance of large cap firms. Available at: ESG Score VS Financial Performance | Refinitiv

Borovkova, S.A., Wu, Y. (2021). Sustainable factor investing: ESG considerations in your factor strategies. Available at: ESG-multifactor-RE1437068_IA_Whitepaper.pdf (probability.nl)

Borovkova, S.A., Wu. Y. (2022). Portfolio selection: return, risk and sustainability. Available at: Portfolio Selection: Return, Risk and Sustainability | Refinitiv

This article was first published in our eMagazine.