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A Core with a Conscience: Integrating Smart Beta and ESG

Published June 05, 2018

With contributions from Emma Johnston, Smart Beta Product Manager

In a world of lower returns, investors face the challenge of meeting their return objectives without taking on too much risk or incurring significant costs. At the same time, a growing number of investors wish to ensure their underlying investments incorporate an awareness of environmental, social and governance (“ESG”) issues. Innovations in both Smart Beta and ESG investing are helping investors address this diverse set of requirements.

Smart Beta Investing

Smart Beta investing is based on the insight that factors—company attributes that have been shown to explain stock returns—are the underlying drivers of performance. Academic research demonstrates that factor-based investing can deliver returns in excess of cap-weighted benchmarks over time by capturing so-called “factor premia”. It also shows that multi-factor (as opposed to single factor) exposure can offer diversification benefits. At State Street, we use the five factors we believe represent the primary drivers of equity returns – value, size, volatility, momentum and quality. These diversified Smart Beta strategies are growing in popularity because they offer the potential to outperform a cap-weighted benchmark with lower fees compared with actively managed funds.

Why ESG Matters

Investment strategies with an ESG dimension are also increasingly prevalent. This style of investing can help to align an investor’s portfolio with their personal or institutional values, as well as with policy requirements. In the past, choosing values or performance was often presented as zero-sum, i.e., driving impact came at the cost of better returns. But many studies now suggest this is a false choice and that a company’s environmental actions, social behaviors and governance practices can have a meaningful impact on its financial performance.

 

The Integration Challenge

Our Smart Beta research team has found ways that investors can take full advantage of both Smart Beta and ESG investing within the same portfolio. Portfolio construction is critical, as there may be tradeoffs between targeted factor exposures and a favorable ESG profile. For example, companies with better ESG scores tend to be large, while factor premia are often found in small cap firms.[1] Fortunately, as both ESG profiles and factor exposures can be quantitatively measured, our team can aim to achieve balanced exposures through the use of optimization.                                                                                                        

Optimization-based portfolio construction methods offer a means of building a portfolio with the desired aggregate characteristics, while minimizing any unintended exposures such as currency or sector exposures. The result is a balanced and systematic method of integrating ESG exposure into a diversified Smart Beta strategy.

To find out more about how the team integrates ESG exposure into a diversified Smart Beta strategy, please contact your local State Street Global Advisors representative for a copy of our paper A Core with a Conscience: Integrating Smart Beta and ESG.

 

 

 

 

Definitions

Momentum: The momentum factor is a common driver of equity returns that is based investing in securities that have had higher recent price performance compared to other securities.

Quality: The quality factor is a common driver of equity returns that is based on the observation that healthy companies tend to outperform less healthy companies.

Size: The size factor is a common driver of equity returns that is based on the observation that stocks of small companies tend to earn greater returns than stocks of larger companies.

Value: The value factor is a common driver of equity returns that is based on the observation that inexpensive stocks tend to outperform more expensive stocks.

Volatility: The volatility factor is a common driver of equity returns that is based on the observation that lower volatility stocks tend to generate a higher risk-adjusted return than high volatility stocks.

 

Disclosures

The views expressed in this material are the views of Jennifer Bender and Todd Bridges through the period ended May 29, 2018 and are subject to change based on market and other conditions. This document contains certain statements that may be deemed forward-looking statements. Please note that any such statements are not guarantees of any future performance and actual results or developments may differ materially from those projected.

Investing involves risk including the risk of loss of principal.

All information has been obtained from sources believed to be reliable, but its accuracy is not guaranteed.

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The information provided does not constitute investment advice and it should not be relied on as such. It does not take into account any investor's particular investment objectives, strategies, tax status or investment horizon.  You should consult your tax and financial advisor.

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[1] State Street Global Advisors Q2 2017 Investment Quarterly