How to Implement ESG in Smart Beta

ADHI Why should investors think about implementing ESG in their Smart Beta portfolio?

TODD Similar to the way in which the benefits of investing in equity factors have been well documented, there have been over 2,200 studies conducted on the relationship between ESG and corporate financial performance. Over 90% of the empirical studies have shown better risk management and diversification at the portfolio level, without sacrificing performance. Furthermore, many studies have shown outperformance benefits by integrating ESG or “non-financial” data into the investment research process.1

Beyond the risk and performance benefits to investors, we find that sustainability is one of the most significant trends in financial markets over the last few decades. At the core of this trend is the idea that markets should allocate capital to those companies and entrepreneurs who are creating sustainable long-term value for shareholders—and creating benefits for the broader society. There are approximately

$22.89 trillion of assets being professionally managed under “sustainable” or “responsible” investment strategies.2

In relative terms, ESG related investments now account for approximately 26% of all professionally manage assets globally.3

ADHI How should investors think about implementing ESG generally and in Smart Beta portfolios? What options do they have?

TODD Like the evolution of best practices in factor investing, there has been an evolution in the way we think about ESG implementation in investment portfolios. ESG integration Version 1.0 involved exclusionary screening based on religious beliefs (Catholic or Sharia Law), or business and product involvement in alcohol, tobacco, and firearms. However, this approach decreases the opportunity set, and the exclusionary screening does not allow for investors to engage directly with the companies to change management practices for the better. ESG integration Version 2.0 is an attempt to develop innovate best practices using higher quality ESG data (both structured and unstructured), and integrate that data using the most advanced portfolio construction techniques, reweighting holdings based on best-in-class performance or internally defined materiality frameworks.

There are approximately $22.89 trillion of assets being professionally managed under “sustainable” or “responsible” investment strategies. In relative terms, ESG related investments now account for approximately 26% of all professionally manage assets globally.1

Regarding the specific options investors have for integrating ESG and Smart Beta, we define options on how passively managed indexed portfolios can be created using innovative data and SSGA’s portfolio construction methods. In general, there are three options we believe investors may want to consider for their core equity portfolios:

  1. Equity Core Beta (screened and cap weighted): Screen the universe based on ESG scores, removing the “worst” rated companies by ESG score, carbon emissions, or some targeted metric.
  2. Equity Core Beta (optimized): An optimization framework is employed to design a portfolio that achieves close to benchmark like returns through minimizing tracking error while simultaneously maximizing the ESG score (or minimizing the portfolio’s carbon footprint or some other targeted objective). However, there is a tradeoff between tracking error and ESG profile improvement which should be calibrated depending on the investor’s appetite for risk.
  3. Smart Beta Equity: Harness factor premia in a transparent portfolio (i.e. Smart Beta) while incorporating ESG. This construct is relevant for investors who have adopted a factor-oriented mindset. We think this is the most innovative approach and represents the best-in-class thinking on integrating ESG into Smart Beta equity portfolios.

ADHI Could you talk about your research and how you think about sustainable parameters in implementation?

TODD There are two central roadblocks to the future growth of sustainable investing. First, capital markets (regulators, exchanges, asset managers, and asset owners) need to address the availability of high-quality ESG or “non-financial” data. Second, capital markets need that data to be standardized by having companies report on material information across industries. My larger research agenda is focused on designing a new data architecture and investment research framework that explicitly addresses these roadblocks for sustainable investing, positioning SSGA for future ESG strategy and product development. We are designing an ESG data architecture that acknowledges that data is not required by formal regulation and not universally provided by public companies across global exchanges.

ADHI How do you see the evolution of ESG in Smart Beta playing out? Is it a lasting and evolving strategy?

TODD The general consensus is that the evolution of the industry rests on integrating the best ESG signal to capture factor premia and define a new ESG factor. The sourcing of ESG data and building a material ESG signal is where the leading asset managers will need to evolve to differentiate themselves. Every factor investment research team will have to work closely with their counterparts in sustainable investing, ESG research, and asset stewardship teams to ensure insights are shared across investment divisions. The leading asset managers will need to conduct their own ESG data due diligence in order to better understand what risk and return benefits are being achieved by including the ESG metrics, and how best to design the Smart Beta portfolio construction process using these new metrics.

The sourcing of ESG data and building a material ESG signal is where the leading asset managers will need to evolve to differentiate themselves.

The evolution of ESG in Smart Beta looks very promising but will take significant effort (leadership, R&D, and costs) across investment management organizations to integrate high quality ESG data, to model time-series long enough to capture the risk and performance benefits, and to attribute these benefits to ESG as a separate factor.

ADHI Which investment objectives should investors focus on when determining success in implementing ESG in their portfolios?

TODD At a minimum, investors should consider ESG strategies (including ESG and Smart Beta) to further diversify risk and manage their portfolios from the downside risks associated with severe ESG controversies— such as the BP oil spill, VW scandal, or Equifax data breach. As asset managers and asset owners become more sophisticated in integrating ESG, I would argue that investors should view ESG as a potential source of alpha in their portfolio allocation decision.

Finally, there is strong empirical argument to support the movement of impact oriented investors allocating capital into ESG strategies to take advantage of the high quality data on sustainable long-term management of public companies— including equity and bond vehicles—and ensure those companies are providing benefits to the broader society.

See, for example, Khan, Mozaffar, Sarafeim, George and Yoon, Aaron S. “Corporate Sustainability: First Evidence on Materiality.” The Accounting Review, Volume 91, 2016 and Clark, Cordon, Feiner, Andreas & Views, Michael. “From the Stockholder to the Stakeholder: How Sustainability Can Drive Financial Outperformance.” Arabesque Asset Management and Oxford University 2015.

GSIA, Global Sustainable Investment Review 2017.

3 2017 Global Sustainable Investment Review, Global Sustainable Investment Alliance.

Disclaimer

This material is solely for the private use of SSGA clients and Prospects and is not intended for public dissemination.

Investing involves risk including the risk of loss of principal.

The whole or any part of this work may not be reproduced, copied or transmitted or any of its contents disclosed to third parties without SSGA’s express written consent.

ESG risk: The returns on a portfolio of securities that excludes companies that do not meet the portfolio's specified ESG criteria may trail the returns on a portfolio of securities that includes such companies. A portfolio's ESG focus may result in the portfolio investing in securities or industry sectors that underperform the market as a whole.

Equity securities may fluctuate in value in response to the activities of individual companies and general market and economic conditions.

While diversification does not ensure a profit or guarantee against loss, investors in Smart Beta may diversify across a mix of factors to address cyclical changes in factor performance. However, factors may have high or increasing correlation to each other.

A Smart Beta strategy does not seek to replicate the performance of a specified cap-weighted index and as such may underperform such an index. The factors to which a Smart Beta strategy seeks to deliver exposure may themselves undergo cyclical performance. As such, a Smart Beta strategy may underperform the market or other Smart Beta strategies exposed to similar or other targeted factors. In fact, we believe that factor premia accrue over the long term (5-10 years), and investors must keep that long time horizon in mind when investing.

The views expressed in this material are the views of SSGA through the period ended July 31, 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.

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