Research has shown that ESG-related factors, when measured or estimated consistently, are meaningful data when making investment decisions. Leading firms are accordingly now incorporating ESG factor data across their entire portfolios to improve forecasting and risk management.
For decades investors have selected securities based on identifiable ‘factors’ – those attributes shape a securities risk and return profile.[i] More recently, innovations such as factor ETFs and so-called ‘smart beta’ strategies have drawn broader attention to the concept of factors. Today, the rise of ESG investing has further expanded the boundaries of factor-based investing.
While an ‘ESG’ label is not a factor in itself, as its interpretation is too subjective, the growth of available ESG-related data – such as carbon emissions, corporate goals and policies, and energy efficiency – serves as a rich source of potential new factors that can provide insights into corporate performance.
A recent meta-analysis by the NYU Stern Center for Sustainable Business and Rockefeller Asset Management determined that “good corporate management of ESG issues typically results in improved operational metrics such as ROE, ROA, or stock price. For investors…some ESG strategies seem to generate market rate or excess returns…especially for long-term investors.”[ii] In other words, ESG data provides exactly the kind of meaningful information for which factor investors are searching.
As ESG data becomes more widely disclosed and standardized, firms are competing to best understand how to interpret and apply these factors to gain an edge, both within ESG-specific funds and across their broader portfolios.
Factor investing has generally divided factors into two camps: macroeconomic factors and style factors. Macroeconomic factors measure risks and exposures to economic themes, such as market risk (beta), interest rate sensitivity, and more. Style factors describe attributes of the security such as relative valuation, firm size, quality, and similar measures.[iii]
The hunt for factors related to ESG began in the 1970s and has intensified as research confirmed that certain ESG characteristics are correlated with greater returns and lower volatility. Although definitions of ESG can vary, a recent review of 2,200 studies on ESG investing found that 63% of the studies produced results correlating ESG-related factors with greater equity returns.
Other studies have found similar results for measures such as downside risk, credit default swap spreads, and credit ratings.[iv] This suggests that ESG characteristics do provide a valuable addition to the total mix of available information on a company.
The positive associations with ESG factors have helped drive the massive boom in ESG investment over the past several years, with inflows to ESG funds more than doubling between 2019 and 2021.[v] Furthermore, the development of funds based on ESG factors has advanced equally as quickly. Early ESG funds often used basic factors such as negative screening based on specific industries and ESG themes (e.g. divesting from fossil fuels, weapons, or tobacco companies) or relatively simple data (e.g. board-level diversity).
The proliferation of ESG data and ratings offered by third-party data service providers and rating agencies has made it easier for firms to screen investments based on ESG criteria – but also creates the risk of introducing additional subjectivity into an already vaguely-defined space, as ratings can diverge widely among raters.[vi] As the availability of underlying firm data has improved, however, the potential arises for more focused ESG screening.
Investors can now look at specific policies and actions and assess a firm’s progress over time, as well as identify sector leaders and laggards within ESG criteria. This allows more complicated strategies to be implemented, such as ‘best-in-class’ screenings, alternative weightings, ‘tilt’ strategies that add additional holdings to a benchmark index, and complicated quantitative alpha strategies. The evidence to date suggests that this kind of positive integration appears to outperform negative screening and that firms that improve their ESG performance over time can generate additional long-term alpha, even beating out established sector leaders.[vii]
An example of a product featuring complex usage of ESG factors is the ‘Green Transition Index Strategy’ offered by a major US asset manager. The strategy combines both negative and positive screening, utilizes qualitative and quantitative data, and employs a tilt strategy towards companies expected to benefit from the green energy transition.
The company claims this combination of factor-based strategies can reduce the carbon intensity of the initial index by 65% while providing exposure to emerging green leaders.[viii] Such a specific portfolio outcome would have been nearly unthinkable a decade ago but is just one example of the cutting-edge application of ESG factors to portfolio construction.
Even as the total assets invested in funds classified as ESG has exploded, the inclusion of ESG factors has begun to spread beyond dedicated portfolios. The expansion of climate accounting and disclosure regulations and standards – such as the Task Force on Climate-Related Disclosures (TCFD) framework – require or encourage firms to incorporate ESG factors into their firm-wide risk management processes to measure and manage them as they would any other risk factors.[ix]
Such regulations also increase the availability of ESG data, further enabling investors to incorporate them into decision-making. Some firms have found that by layering ESG factors, such as climate transition risks, into portfolio construction alongside traditional risk metrics, they can produce a more accurate view of their potential risks (and returns), particularly over long-term horizons.
Similarly, the inclusion of ESG data into the calculation of other data points used in traditional factor screening (such as forecasted revenues, project costs, or fair value) is also a growing practice[x] that can help improve the predictive power of these non-ESG factors. As one asset management executive noted: “Every portion of the portfolio should consider ESG factors to drive long-term risk and return. ESG shouldn’t be carved out as its section of the portfolio.”[xi]
There are challenges to incorporating ESG-factor data into the investment process. It can require extensive integration of new data sources, querying of the integrity of the data coupled with a strong understanding of how the data was originally sourced or calculated. Additional steps may be needed as well to fully unlock the value of available data. This process could include data cleansing, or utilizing machine learning to process and standardize data with inconsistent formats and definitions across a huge spread of topics, from carbon emissions to labor practices. [xii]
Increased global regulation around disclosure and industry agreements on standards may make this process easier in the future, but industry leaders are moving forward with the data currently available. Beyond acquiring data, firms must also educate portfolio managers to help them understand its use and power, and they may need to make cultural changes to embed consideration of ESG factors across the firm’s investment processes.
This outreach will be especially critical for firms attempting to integrate ESG data into non-ESG-specific products where managers may be resistant to non-traditional metrics. Strong change management across multiple stakeholders and communication practices to ensure consistency will be vital for consistency and authenticity in ESG best practices.
For most companies, the shift to including ESG factors will likely include several related projects, decisions, and enhancements spanning the strategy, technology, operations, and talent spaces. Selecting the right partners will be key. Capco was recently named the Best North American Consultancy in Data Management by the Data Management Insight Awards[xiii] and has deep expertise in change management and firm-wide outreach in companies across the financial services sector to help ensure the success of your ESG transformation.
[ii] Whelan, et al, https://www.stern.nyu.edu/sites/default/files/assets/documents/NYU-RAM_ESG-Paper_2021%20Rev_0.pdf
[iii] Chen, https://www.investopedia.com/terms/f/factor-investing.asp
[iv] Friede et al, https://www.tandfonline.com/doi/full/10.1080/20430795.2015.1118917
[v] Kerber and Jessop, https://www.reuters.com/markets/us/how-2021-became-year-esg-investing-2021-12-23/
[vi] Berg, https://www.wsj.com/articles/esg-ratings-investing-data-raters-11667229384
[vii] Whelan, et al, https://www.stern.nyu.edu/sites/default/files/assets/documents/NYU-RAM_ESG-Paper_2021%20Rev_0.pdf
[viii] Northern Trust, https://cdn.northerntrust.com/ma/am/Institutional/EMEA/EMS/nt-green-transition-index-fund-product%20Profile%20EMEA.PDF
[ix] TCFD, https://www.fsb-tcfd.org/recommendations/
[x] United Nations Principles for Responsible Investing, https://www.unpri.org/listed-equity/esg-integration-in-smart-beta-strategies/14.article
[xi] Institutional Investor https://www.institutionalinvestor.com/article/b1w8y22kswsrkf/how-esg-investments-impact-portfolio-construction
[xii] VentureBeat, https://venturebeat.com/ai/why-ai-is-critical-to-meet-rising-esg-demands/
[xiii] Data Management Insight Awards 2022, https://a-teaminsight.com/awards/data-management-insight-awards-usa/?section=winners