By Matt Christensen
Both smart beta and responsible investment have garnered increasing attention from investors across the globe. Though seemingly unrelated, the two trends signal a move by investors away from unintentional and often uncompensated risks associated with traditional index-tracking strategies and a greater willingness to make their own determinations about desired exposures, risks and expected returns.
Responsible investment and smart beta investing share a philosophical aversion towards taking poorly compensated risks. However, to date there is little academic research on the incorporation of environmental, social and governance (ESG) considerations into smart beta strategies. While many institutional investors express an interest in smart beta they are mindful of the often explicit requirements to include ESG factors as part of a stated investment policy.
The main challenge in combining the two approaches stems from the fact that each corresponds to a different objective. Smart beta relies on pure financial measures, whereas responsible investment takes into account a broader range of measures regarding a company’s activities.
But what is the impact of these differences in practice? We constructed and back tested an ESG smart beta strategy to find out. We used an initial ‘vanilla’ equity smart beta portfolio with weightings adjusted according to each stock’s ESG score, based on different factors such as environmental risks and health and safety. Companies with the worst overall ESG profiles were excluded from the portfolio, while top scoring firms were up-weighted.
The ESG smart beta portfolio when back tested returned 3.22% on an annualised basis over nearly five years and outperformed the MSCI World Index (0.84%)[1]. The ESG portfolio matched the performance of the standard vanilla portfolio, but with important gains in ESG performance, and demonstrated higher annualised volatility (17.47%) than the vanilla portfolio (16.08%) but markedly less than the MSCI Index (19.56%)[2].
The most significant impact of the additional ESG filters was a decrease in energy holdings and consumer staples. The former was driven by ESG concerns often involving controversies, while the latter are often associated with issues around customer relationships and supply chain management. The ESG filter over-weighted financials, healthcare and information technology.
An ESG smart beta strategy can potentially offer lower total risk and higher return than index investing with improved diversification. But our research shows that stronger ESG performance came in exchange for somewhat higher volatility than the vanilla strategy. There are advantages and drawbacks of adopting an ESG smart beta strategy, but the strategies do overlap and their compatibility can be exploited by investors.
Matt Christensen is head of responsible investing at AXA Investment Managers
[1] Simulated back tested performance showed that on an annualised basis the vanilla SmartBeta portfolio would have returned 3.22%, the ESG SmartBeta portfolio 3.22% and the MSCI World 0.84%. The time period chosen was the beginning of February 2007 through to the end of December 2012. Annualised total risk for the vanilla and ESG SmartBeta portfolios was 16.1% and 17.5%, respectively, versus 19.6% for the MSCI World. All returns presented in USD, gross of fees. Past performance is not a guide to future performance.
[2] Back tested performance – beginning of February 2007 to end December 2012, MSCI as at July 2013.
Comments