Smart beta, also known as strategic beta and factor investing, continues to capture the attention of investors as a transparent, lower cost investment approach with the potential to deliver excess returns above those of traditional market capitalization weighted indices. Supported by academic and practitioner research, these strategies focus on factors that have demonstrated the ability to add value over market cycles.1 As of June 30, 2016, Morningstar estimated that $490 billion was invested in smart beta strategies in the US.2 The Financial Times reported that in the first quarter of 2017 smart beta funds continued to grow, attracting $24 billion in new money, nearly half the $57 billion raised in all of 2016.3
Initially focused primarily on single factors, smart beta strategies incorporating multiple factors, are now gaining significant traction. Morningstar estimates that there are almost 200 multifactor smart beta exchange traded funds (ETFs) with assets of $36 billion, and more than one-third of the 200 were launched in the last year.4 In their recent survey of asset owners on smart beta, FTSE Russell notes “the headline trend belongs to multifactor combinations: 64% of respondents who are currently implementing a smart beta index are using a multifactor strategy. That is more than triple the rate in the 2015 survey.”5
Similarly, integrating ESG issues into investment analysis and portfolio construction has gained significant traction in recent years. The growing interest in sustainable investing has been spurred by research that suggests ESG factors can contribute to better investment decisions (see below). US SIF, The Forum for Sustainable and Responsible Investment, estimates that assets managed in the U.S. that incorporate ESG in some fashion have grown from a little over $2 trillion in 2005 to approximately $8.1 trillion in 2016.6
At the intersection of these two trends, we believe there is a significant opportunity to further improve investment outcomes. Multifactor smart beta strategies are diversified and focus on longer-term investment horizons. They provide exposure to multiple drivers of return, in contrast to single factor smart beta strategies that are more narrowly focused and often used to gain shorter-term, tactical exposures. Similarly, one of the defining tenets of ESG integration is its investment materiality over the long term.
While ESG integration has received more traction in fundamental analysis, the increased ability to quantify ESG metrics through improving sources of data and systematic modeling of fundamental ESG research can lead to the creation of robust quantitative ESG scores.
We believe a well-constructed ESG score can buttress a sound multifactor smart beta strategy with an additional element of diversification and risk control and provide investors with a strong, unique option in the smart beta marketplace.
Smart beta refers to systematic strategies that weight securities based on fundamental factor(s)— rather than market cap—that have demonstrated the capacity to add value over the long term. This investment approach is an increasingly popular and attractive hybrid between active and passive management that brings some of the advantages of passive management as well as some of the advantages of market-tested factors or fundamental weightings vs. pure market capitalization weighted indices.
Smart beta strategies aim to exploit long-established anomalies in investment factors that have demonstrated the ability to add long-term value above market indices. These factors generally fall into six broad categories:
These factors are rooted in sound investment theses and are supported by robust academic and practitioner research. Foremost in this body of research is the work of Eugene Fama and Kenneth French that first established the grounding for size and value factors in the early 1990s. More recently they have expanded their model explaining stock returns to include quality-related factors focused on firm profitability and investment.1
Initially, smart beta strategies consisted primarily of mutual funds and ETFs that weighted holdings based on one factor. These funds and ETFs provided investors with an alternative to market capitalization weighted indices and a vehicle to tactically manage exposure to a factor in a larger portfolio or asset class. While demonstrating the ability to deliver outperformance over longer time periods, they can have significant near-term deviation from market benchmarks.
Factors can also become overvalued and can subject single factor strategies to significant periods of underperformance.
Multifactor smart beta strategies help address some of these challenges through:
As sustainable investors, we believe a multifactor approach to smart beta provides the opportunity to create sound investment strategies based on a creative combination of fundamental factors. The longer-time horizon implied by multifactor strategies is in-line with the horizon of sustainable investors and differentiated from single factor smart beta ETFs, which are often used to manage tactical portfolio exposures. As such, we believe they provide a solid foundation for the addition of an ESG score or scores that can provide an additional source of information and diversification.
“We believe a well-constructed ESG score can buttress a sound multifactor smart beta strategy with an additional element of diversification and risk control.”
Integrating ESG factors into portfolios has evolved over the last 15 years. Initially, ESG considerations emphasized investor’s values and were often incorporated into the investment process via exclusionary screens. More recently, sustainable investor focus has shifted to the materiality of ESG issues to a stock’s risk and opportunities. Integrating ESG considerations in fundamental analysis has provided an additional lens for analysts and portfolio managers to view risk and opportunities in security selection.
While the natural parallels between fundamental financial and ESG analysis first accelerated the evolution of ESG integration in fundamental investment processes, the increase in the quantity and quality of sustainability disclosure and the availability of ESG data has more recently provided a foundation for the integration of ESG factors in systematic portfolios. An extensive body of research now supports the investment merits of including ESG in investment processes and provides guideposts to evaluate, quantify and rank stocks based on their ESG profiles. Quantitative rankings of company ESG profiles facilitates the incorporation of ESG in the optimization process for a smart beta strategy.
Broad performance studies have established a solid philosophical grounding for the merits of including ESG in investment decisions.
While the above-mentioned studies reinforce the basic premise for ESG integration, another set of studies provides specific guidance on how investors can systematically integrate ESG to build better portfolios. These studies provide important insights on the relationship between ESG issues and indi- vidual company performance in addition to ESG integration as a potential source of risk reduction:
ESG and company performance. Two studies by Harvard Business School professors have shed important light on ESG and company performance.
ESG and risk. There is a substantial set of research focused on the relationship between ESG and risk. The following two notable studies by investment managers provide direction on the benefits of ESG as a potential source of portfolio risk reduction.
These studies not only support the potential benefits of including an ESG factor rating in a multi- factor smart beta portfolio, they also inform the development of a robust ESG scoring process. It is our belief that seasoned fundamental sustainability analysts can apply their experiences to research and evaluate data and weight it based on materiality and risk to construct effective ESG ratings.
Over the last few years, Pax has developed an ESG rating framework, the Pax Sustainability Score (the Score), to quantitatively rank the ESG profiles of companies in the Russell 1000 Index,13 allowing us to incorporate ESG information into factor-based portfolios. The Score is a proprietary ranking of companies’ ESG profiles developed by Pax’s Sustainability Research Team that combines multiple sources of third-party ESG data with original research and analysis. Importantly, the scoring framework is informed by key elements in the body of ESG research papers and shaped by the team’s 50 plus years of collective experience performing fundamental ESG research on how sustainability impacts a company’s financial performance. The Score is designed to capture material information regarding a company’s risk and performance potential. Key elements include:
“Integrating a proprietary ESG score with time tested fi nancial factors can provide an opportunity for investors to gain unique beta exposure in their equity allocations.”
Through our ESG-related advocacy and engagement and involvement in sustainable investing industry initiatives, we often gain insights into how ESG risks are evolving and how companies are responding to those challenges. When appropriate, we modify our scoring model to take these new issues into account.
Integrating a proprietary ESG score with time tested financial factors can provide an opportunity for investors to gain unique beta exposure in their equity allocations. A multifactor smart beta strategy with ESG integration is meant to serve as a long-term investment strategy that combines diverse financial factor exposures with an additional element of diversification and risk mitigation derived from ESG factors.
For example, when we worked with our partner the Aperio Group to design our first multifactor smart beta fund, the Pax ESG Beta Quality Fund, we sought to construct a large cap core strategy that was consistent with key elements of our investment philosophy including investing in higher quality, lower risk companies that are attractively priced. Through research and back-testing we designed a strategy with an emphasis on four factors—Earnings Quality, Profitability, Beta and Earnings Yield. By overweighting these factors, the portfolio is designed to be invested in companies that, in aggregate, have more consistent earnings, higher quality earnings, are more profitable, have lower risk and are reasonably priced. With the addition of the Pax Sustainability Score, the portfolio also tilts toward companies that demonstrate ESG strength. We believe the Score provides another source of diversification and risk management.
One way to evaluate the Score’s potential as a diversifying factor is to consider its correlation to financial factors used in the multifactor strategy. Table 1 provides a point in time look at the correlation of the Pax Sustainability Score to Barra risk factors.18 The low or negative correlation across the four factors (Earnings Quality, Profitability, Earnings Yield and Beta) in the Pax ESG Beta Quality Fund and the Pax Sustainability Score is a strong indication that integrating the ESG score provides an additional diversifying element to this multifactor strategy. Moreover, the low or negative correlations across all the Barra factors point to its potential as a diversifying element across a wide variety of multifactor strategies.
|Pax Sustainability Score|
|Long Term Reversal||0.00|
Represents factors included in Pax ESG Beta Quality Fund
Source: MSCI Barra, Aperio Group. As of 2/13/2017. Correlation values range from -1 and 1.19
There are also indications that the Pax Sustainability Score is a source of risk reduction. To examine this, we looked at 14 monthly observations of rankings since the Score’s inception in early 2016. We segmented the ESG Scores into quintiles (top quintile represents companies with the best ESG profiles) and used the Barra Risk model to forecast risk for each quintile using two measures of risk: forecast total risk and predicted beta.
The results in Table 2 show that the top two quintiles, the stocks with the highest Scores, have the lowest forecast total risk and lowest predicted beta. Conversely, the bottom two quintiles demonstrated the highest risk on both measures.
|Quintiles Pax Sustainability Score||% Absolute Total Risk||Portfolio Predicted Beta|
|Quintiles 1 (Best ESG)||18.46||0.96|
|Quintiles 2 (6 to 8 ESG)||17.31||0.98|
|Quintiles 3 (4 to 6 ESG)||19.49||1.01|
|Quintiles 4 (2 to 4 ESG)||20.73||1.04|
|Quintiles 5 (Poor ESG)||19.66||1.05|
Source: Barra, Pax World, Factset. Analysis based on average of 14 monthly observations from February 2016 to March 2017. Companies in the Russell 1000 Index are scored on a scale from 1-10 (10 is best).
While a limited sample size, these results are in-line with the academic and practitioner research that has shown ESG to be a source of risk reduction. Given that the Barra Risk model is used to forecast risk in the portfolio optimization process, the lower element of forecast risk embedded in the Score is incorporated in portfolio construction today. These results also support the strategy design decision to remove the higher risk, bottom quintile ESG stocks from the investable universe and optimize the portfolio to an aggregate Score of at least 7 out of 10.
While still in the early stages, we firmly believe the future is bright for the intersection of ESG and smart beta. As integration of ESG scores evolve, we look forward to exploring in more depth how ESG may be incorporated as an explicit factor in risk models and more precisely attributing ESG’s contribution to returns.
We are confident that multifactor strategies that are structured around a carefully selected mix of proven investment factors with an additional source of diversification and risk mitigation through the integration of a well-constructed, robust ESG score can provide investors with a unique, sound alternative to obtain smart beta exposure.
Profitability is a combination of profitability measures that characterize the efficiency of a firm’s operations and total activities.
Earnings Quality explains stock return differences due to uncertainty around company operating fundamentals (sales, earnings, cash flows) and the accrual components of their earnings.
Low Volatility explains common variations in stock returns due to different stock sensitivities to market or systematic risk that cannot be explained by the US Country factor.
Earnings Yield describes stock return differences due to various ratios of the company’s earnings relative to its price.
Dividend Yield captures differences in stock returns attributable to stock’s historical and predicted dividend-to-price ratios.
Management Quality captures common variation in stock returns of companies experiencing rapid growth or contraction of assets.
1Eugene Fama and Kenneth French, “The Cross Section of Expected Stock Returns,” Journal of Finance, June 1992.
Eugene Fama and Kenneth French, “A Five Factor Asset Pricing Model,” Journal of Financial Economics, Volume 16, Issue 1, April 2015.
2Morningstar, “A Global Guide to Strategic Beta Exchanged Traded Products,” September 2016.
3Financial Times, “2000% Rise in New Money Allocated to Smart Beta Funds,” May 14, 2017.
4Barron’s, “Multifactor ETFs are Gaining in Popularity,” July, 9 2016.
5FTSE Russell, “Smart Beta: 2017 global survey findings form asset owners,” May 2017.
6US SIF, “Report on Sustainable and Responsible and Impact Trends Investing 2016.”
7Morgan Stanley Institute for Sustainable Investing, “Sustainable Reality: Understanding the Performance of Sustainable Investment Strategies,” March 2015.
8Gunnar Friede, Timo Busch, Alexander Bassen, “ESG and Financial Performance: Aggregated Evidence from More Than 2000 Empirical Studies,” Journal of Sustainable Finance & Investment, October 2015.
9Robert G. Eccles, Ioannis Ioannou and George Serafeim “The Impact of a Corporate Culture of Sustainability on Corporate Behavior and Performance” 2015.
10Mozaffar Khan, George Serafeim and Aaron Yoon, “Corporate Sustainability: First Evidence on Materiality” 2015.
11Indrani De and Michelle R. Clayman “The Benefits of Socially Responsible Investing: An Active Manager’s Perspective,” 2014.
12Jeff Dunn, Shaun Fitzgibbons, and Lucasz Pomorski “Assessing Risk through Environmental, Social and Governance Exposures,” 2017.
13The Russell 1000 Index measures the performance of the 1,000 largest U.S. companies, as measured by market capitalization. It is a subset of the Russell 3000 Index, which measures the largest 3,000 companies. The Russell 1000 Index is comprised of over 90% of the total market capitalization of all listed U.S stocks. . One cannot invest directly in an index.
14Zoltan Nagy, Doug Cogan, Dan Sinnerich, “Optimizing ESG Factors in Portfolio Construction,” MSCI, December 2012. Zoltan Nagy, Altaf Kassam, Linda-Eling Lee “Can ESG Add Value?”, MSCI June 2015.
15See, for example, Francesca Lagerberg, “The value of diversity,” September 29, 2015, Grant Thornton; Morgan Stanley, “Why It Pays to Invest in Gender Diversity,” n.d.; Corinne Post and Kris Byron, “Women on Boards and Firm Financial Performance: A Meta-Analysis,” Academy of Management Journal, October 1, 2015; and the Credit Suisse Research Institute, “The CS Gender 3000: Women in Senior Management,” 2014.
16Return on Equity ( ROE) is the amount of net income returned as a percentage of shareholders equity. REO measures a corporation’s profitability by revealing how much profit a company generates with the money shareholders have invested.
17Return on invested capital (ROIC) is a profitability ratio. It measures the return that an investment generates for those who have provided capital, i.e. bondholders and stockholders. ROIC tells us how good a company is at turning capital into profits.
18The Barra Risk Factor Analysis is a multi-factor model created by Barra Inc., which is used to measure the overall risk associated with a security relative to the market.
19Correlation is a statistic that measures the degree to which two securities move in relation to each other. Correlation values range from -1 and 1. A perfect positive correlation of 1 implies that as one security moves, either up or down, the other security moves in lockstep, in the same direction. A perfect negative correlation means that two assets move in opposite directions, while a zero correlation implies no relationship at all.
Pax World Management LLC, investment adviser to Pax World Funds, is a pioneer in the field of sustainable investing. Pax World integrates environmental, social and governance (ESG) research into its investment process to better manage risk and deliver competitive long-term investment performance. For over 45 years, Pax World has made it possible for investors to align their investments with their values and have a positive social and environmental impact. Today, its platform of sustainable investing solutions includes a family of mutual funds, as well as separately managed accounts.
The statements and opinions expressed are those of the authors of this report. All information is historical and not indicative of future results and subject to change. This information is not a recommendation to buy or sell any security.