Answering a growing need: Combining smart beta and ESG

12 Sep 2019

Yvette Murphy, vice president, global head of smart beta portfolio strategists at State Street Global Advisors

Lately, in our conversations with clients and investors certain key themes arise. First, we know that there is a clear need for additional returns while being mindful of risk. Second, ESG considerations are becoming more imperative, from an aspirational point of view and also because of the potentially high cost impact of ESG-related risk. Broader stakeholders and regulators are also taking a keener interest in these topics and encouraging asset owners to take action.

Combining smart beta with the risk-mitigation benefits of ESG

To address these needs, our strategy uses sophisticated portfolio construction techniques to integrate smart beta’s performance potential and the positive characteristics of ESG into one easy-to-govern package.

Smart beta allows investors to capture the known drivers of return — smart beta factors — in a transparent, cost-efficient way.

Incorporating high ESG-scoring stocks into a portfolio typically translates into lessened ESG risk. Our ESG implementation takes care to include not only environmental scoring but also social and governance considerations. This results in an investment with broad-based ESG impact.

Getting implementation right

We’ve long been proponents of smart beta; our first smart beta strategy dates back to 1993 and we now manage more than $130bn in smart beta assets.

Our extensive research and experience has led us to believe that combining the factors, rather than using them individually, is the most effective implementation.

Whilst using multi-factor smart beta with ESG makes sense for many investors, it is not enough to simply bolt these together naively since higher ESG scores may not necessarily be aligned with the desired direction of factor exposures. This is why a careful bottom-up portfolio construction process is necessary, in order to ensure that any trade-offs are well managed and that factor and ESG exposures are attained most effectively.

To do this, we balance the portfolio to help ensure maximum factor exposure and minimise unintended risk while targeting meaningful improvements in ESG quality.

This strategy brings together two deeply experienced indexing practitioners to produce a unique product. MSCI is a renowned index provider with exceptional intellectual property in the space, with more than 150 ESG analysts globally and $8bn of assets benchmarked to MSCI ESG indexes.

SSGA has industry-leading expertise as an index manager. With more than $200bn in ESG AUM and 30 years’ experience, ESG investing is also a core competency. We worked extensively with MSCI to help develop the index used in this strategy.

The final methodology for factor selection, factor exposure and turnover constraints are a result of this collaboration. The end result is that we are able to efficiently balance risk and returns by targeting the most effective blend of ESG characteristics and smart beta factors.

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