Asset managers and index providers are increasingly using environmental, social and governance (ESG) performance scores in stock selection and weighting, in the same way they apply factor metrics. smart beta. But some experts now think this approach is flawed.
The first difficulty with using ESG performance scores in this way, according to Felix Goltz – an academic and research director at Scientific Beta, a data provider – is that there is confusion over the purpose.
âThe starting point for the industry is that people think ESG is a source of outperformance and, if it was [using the data in the same way as a factor-based approach], that would be a logical approach to follow, âhe said. However, research has shown that the correlation between a high ESG metric and outperformance decreases over time, he points out.
Style factors are used to construct smart beta indices of companies that score high on persistent performance drivers: for example, size (small, high growth companies) or quality (financially healthy groups).
But, while the purpose of including ESG factors was to provide only an ethical slant, rather than higher returns, the idea also has flaws, says Patrick Wood Uribe, managing director of Util, a UK supplier of data on sustainable investments.
Research d’Util shows that, when measured against the United Nations Sustainable Development Goals, sustainable funds minimize negative ESG impacts at best, but do not have significant positive effects.
Another concern is the quality of ESG data, according to Wood Uribe. “If you’re strict on smart beta, you need some really solid quantitative data – and the ESG, so far, has fallen short of that.”
Mark Northway, investment manager at Sparrows Capital, agrees: âWe don’t have enough knowledge or information about ESG-rated portfolios to draw an informed conclusion,â he says, noting that unlike style factors, most ESG data has not been collected consistently over the past decade.
However, questioning whether it is fair to use GSS alongside factors obscures the reality – the practice is common because metrics generate usable numbers.
âSmart beta tends to rely on quantitative models, and it’s easy to include a quantitative ESG score in these models,â explains Bruno Taillardat, head of smart beta and factor investing at Amundi, the most major asset manager in Europe.
Taillardat says it’s important to recognize that ESG can have correlations with factors like momentum (the idea that strong performance tends to persist), quality and value (when stocks are good. market versus a company’s core value), but it can still be a useful tool.
âThe ESG is evolving, which means it has no structural bias towards any other factor,â he says. âIt tends to be more correlated with quality than other factors, but it always changes over time. “
To complicate the picture, however, Amundi’s research has identified varying effects when using ESG alongside a factor approach, depending on whether it is added to a single-factor or multi-factor portfolio and where it is located. investments.
This research, published in May 2020, found that the introduction of ESG into an already well-diversified US multi-factor portfolio added little value, but was an important diversification factor in a multi-factor portfolio in the area euro.
Goltz maintains, however, that while âthe trend is definitely to use ESG scores and try to use them alongside other factor considerations,â it was not appropriate to do so.
âMost, in fact, use the ESG score as a factor even though there is no evidence that it is a factor,â he says. He says using ESG scores is easy, but that should be a separate consideration.
Northway says it could infuriate supporters of sustainable investing that ESG metrics were deemed inappropriate for use in a factor-based approach. But he suggests they keep the potential risks of doing so in mind.
âIt’s safer for investors to assume that shrinking the investment universe will increase focus and tracking error, without necessarily improving performance,â he says.
âThis does not take anything away from ESG investing, which is a socially responsible approach,â he adds. “But this emphasizes that the primary motivation for doing so should be social conscience rather than the naive expectation of higher returns.”