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ESG is often mis-implemented in portfolios

ESG is often mis-implemented in portfolios

05-10-2017 | Insight

Sustainability principles are often mis-implemented in portfolios due to biases to certain factors, says quant specialist Ruben Feldman.

Speed read

  • Simple ESG measures leads to bias for picking large stocks 
  • Focusing purely on ESG takes the situation out of context 
  • Broader approach needed for portfolio implementation

The rise of factor investing has led many investors to focus on stocks that display low volatility, value, momentum, quality or size. In parallel, the rise of sustainability investing has enabled investors to simultaneously chase companies with strong environmental, social and governance (ESG) credentials. Some investors now question whether ESG should be a factor in its own right.

However, experience has shown that some factors such as size and quality have a more natural bias towards ESG than others, says Feldman, Senior Quantitative Analyst at RobecoSAM. And while it is an important consideration, ESG also doesn’t tell the whole story about why a company is successful or not, he told a recent Responsible Investor conference in London.

Taking it out of context

“ESG generally is mis-implemented throughout the investment industry,” he says. “When you rank companies according to pure ESG criteria, and you take that out of context without allowing for anything else, you end up with huge biases.”

“For example, first generation ESG indices, launched over 15 years ago when data was too limited to identify ESG data biases, use scoring and rank companies according to their sustainability directly. Subsequently there is a very significant overweight to Switzerland, for example. Most of the return there doesn’t just come from ESG, but according to how well the Swiss economy is doing, the strength of the Swiss franc versus the US dollar, and so on.”

“Similarly, the index has a huge bias towards Europe, and a bias towards large caps, because they’re often able to report their information in a better way, which means it’s easier for us to find it. So all these biases mean you’re no longer investing in ESG, but in some sort of random mix of extraneous factors which may be good or bad, producing positive or negative results.”

Smart beta biases

Meanwhile, the ‘smart beta’ factors also generate their own biases, he says. “If you invest in an ESG portfolio you will get a strong bias to the style factors that are positively geared towards ESG such as size and quality. If you have fewer problems at a company, then the quality factor obviously means that the company is more sustainable.”

“But if you have so much quality or size in your portfolio, then you’re not really exposed to ESG, but to those factors instead. We did some research that showed ESG has sometimes over 20% risk exposure to the size factor, which is hugely significant. If size does well, then ESG does well, and vice versa.”

“ESG can be rules based, but it can’t be pure data processing. At some point you need to have someone estimate whether a corporate governance scheme is good or bad, or somewhere in-between. It’s not as simple as assigning exposure to value where one can just take price-to-book or similar.”

“There are a lot of different themes as well. Corporate governance, for example, is more important in certain sectors; health & safety is always going to be more important for a materials company than a financial firm, for example. You have to make allowances for certain things. So it can be rules based, but there is still the requirement of sustainability research expertise.”

You can still cut risk

So is it still worth doing? “I think integrating ESG can be very beneficial, even if it doesn’t yet have the same academic grounding as other factors,” he says. “It doesn’t have the same grounding because it’s not as easy to interpret; the ESG data isn’t simple. Indices generally only take into account the general ESG scores, which have huge biases.”

“Once you extract the pure ESG signal by getting rid of the unintended biases, you actually get an independent source of risk that is totally autonomous of the other sources of risk, and integrating that into your portfolio means that the actual idiosyncratic (unattributed) risk in your portfolio is reduced. More of your portfolio risk is explained by an additional factor, and since that factor actually has positive long-term returns, your overall portfolio returns will be better in the long term.”

RobecoSAM’s research shows that ESG as a factor can provide an additional risk factor, independent of factors usually present in models, with significant explanatory power and a positive Information Ratio. This means that bringing this into a model would enable the user to benefit from information that is otherwise ignored, and it facilitates the creation and control of portfolios with better risk-adjusted returns.

“Therefore, if it’s calculated well and integrated well, then it can actually benefit your portfolio,” Feldman says. “Information is key, and using it properly is even more important.”

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