Factor investing debates: Should sustainability be considered a factor?

Factor investing debates: Should sustainability be considered a factor?

20-07-2020 | インサイト

Factor investing and sustainability can make a good combination. Given the rules-based nature of quantitative models, it is a relatively straightforward step to integrate additional variables that represent sustainability. Yet this does not necessarily mean sustainability should be treated as just another factor.

  • Yann Morell Y Alcover
    Morell Y Alcover
    Investment Writer

Speed read

  • Integrating sustainability has become increasingly important 
  • ‘Sustainable investing’ means many things to many people 
  • Not all approaches to sustainability aim to deliver alpha

In recent years, investors – both institutional and retail – have increasingly been asking for more sustainably managed investment solutions, as they seek to see their values reflected in their portfolios, make a specific impact on society through their investments, or simply avoid sustainability-related financial risks and potentially stranded assets.

But while sustainable investing may seem to be the obvious way to align investors’ interests with broader societal objectives, this is far from easy in practice. The concept of ‘sustainable investing’ is open to different interpretations and constantly evolving. Moreover, naive requirements in terms of sustainability scores can have far-reaching consequences for portfolios, altering risk-return profiles or increasing turnover.

These challenges are particularly acute for quantitative investment strategies. Sustainability integration has historically been associated with fundamental active investing and, given the systematic and rules-based nature of quantitative strategies, integrating oft-changing and complex sustainability criteria is frequently considered an insurmountable challenge.1 

But this perception is slowly changing as a growing number of quantitative asset managers are now integrating environmental, social and governance (ESG) criteria into some of their investment strategies, going well beyond the implementation of basic exclusions lists. In fact, quantitative models and sustainability can make a good combination.

The rules-based nature of quantitative models makes it relatively easy to integrate additional quantifiable variables into the security selection and portfolio construction process. From this perspective, integrating sustainability criteria into investment methodology can be similar to a standard factor-based approach, where securities are selected based on their factor characteristics.

But the advent of sustainable factor-based solutions has now left investors with a new burning question: should sustainability be seen as just another factor, or should it be considered separately? In other words, should investors view sustainability another component of a multi-factor model – like value, momentum or quality – or should it be treated differently?

The deeper question here is whether systematically allocating money based on sustainability criteria can be expected to lead to better risk-adjusted returns in the long run. Unfortunately, the answer to these questions is anything but clear, and the results of empirical studies backing one camp or the other tend to be highly sensitive to the methodology used.

For example, a 2019 article in the Journal of Investing2 found that incorporating ESG criteria into a global market-neutral equity portfolio, using an ‘off-the-shelf’ third-party database, yields no additional return, as any benefit from tilting towards a better ESG-rated portfolio is already captured by other well-known factors. Therefore, the paper concluded, ESG should not be considered an equity factor.

Some empirical studies even argue that integrating ESG can have a detrimental effect on return and risk.4 And yet, many other academic papers do find consistently positive potential effects from taking ESG characteristics into account,5  thus making a case for sustainability – or at least ESG information – to be considered an additional factor6  in stock or bond selection models.

These contradictory findings reflect the difficulty academics, product providers and investors have in finding common ground regarding the concept of ESG investing’

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Sustainability increasingly crucial for investors

Ultimately, these contradictory findings reflect the difficulty academics, product providers and investors have in finding common ground regarding the concept of ESG investing7  – and more generally sustainable investing. While most empirical studies on this topic focus on the integration of ESG information into investment processes, the concept of sustainable investing encompasses much more than that (see Figure 1).

In fact, sustainable investing means many things to many people. For some investors, it may simply be about removing controversial sectors from the investable universe, while for others it may be about reducing a portfolio’s carbon footprint, promoting a circular economy, or engaging proactively with companies. In all these cases, the quest for long-term alpha may not be the main focus.

So, while sustainability may play an increasingly important role in investing, it is difficult to consider it as a factor, comparable to value, quality or momentum, for example. Another crucial takeaway from this debate is that, while sustainable investing can be executed successfully without dragging down returns, simplistic or generic approaches often prove disappointing and can even backfire. 

For instance, naive exclusions of unethical companies can result in unintentional bets against time-tested factors.8  Another example has to do with well-established providers of public ESG indices, that often need to sacrifice sustainability improvements to prevent a surge in tracking error9  – relative to classic market capitalization-weighted market indices. Or, their methodology may be able to limit tracking error but leads to high turnover and, therefore, potentially lower returns.

These types tradeoffs are sometimes referred to as sustainable investment dilemmas. They illustrate how passive and sustainable investing are concepts that are fundamentally at odds with each other.10  Solving these dilemmas will typically require a sophisticated approach that aims to provide high sustainability levels, a low tracking error and low turnover at the same time. In the case of factor-based strategies, a high exposure to the target set of factors should also be ensured at all times.

What investors should do about it

The starting point for investors interested in both factor and sustainable investing would be to clearly define their sustainability goals. They should then consider whether these goals are compatible with their financial objectives, and how they would be achieved. Figure 1 below lists the most common approaches to sustainability.

Figure 1: Global assets under management for different sustainable investing approaches

Source: Global Sustainable Investment Alliance, 2018 Global Sustainable Investment Review.

Investors should then look for the best factor-based sustainable solution available, bearing in mind that not all asset managers can provide efficient sustainable and/or factor strategies. Another key element to consider is future flexibility. As mentioned, the concept of sustainability is not static and continues to evolve over time.

As a result, current approaches to sustainability will likely need to be adjusted in the future, just as active factor managers continually enhance their investment models, for example using new technologies such as big data and artificial intelligence. The debate over the role these can play in the future of factor investing will be addressed in the next and final article in this series.

1See for example: “Moral Money Davos special: Climate change threatens quant funds”, Financial Times, 21 January 2020.
2Breedta, A., Cilibertia, S., Gualdia, S., Seagera, P., 2019, “Is ESG an equity factor or just an investment guide?”, The Journal of Investing.
3For other studies coming to similar conclusions, see for example: Kumar, R., 2019, “ESG: alpha or duty?”, The Journal of Index Investing.
4See for example: Garvey, G.T., Kazdin, J., LaFond, R., Nash J., and Safa, H., 2017, “A pitfall in ethical investing: ESG disclosures Reflect vulnerabilities, not virtues”, Journal of Investment Management. See also: Kaiser, L. and Welters, J., 2019, “Risk-mitigating effect of ESG on momentum portfolios”, Journal of Risk Finance.
5See for example: Peiris, D. and Evans, J., 2010, “The Relationship Between Environmental Social Governance Factors and U.S. Stock Performance”, The Journal of Investing. See also: Friede, G., Busch, T. and Bassen, A., 2015, “ESG and financial performance: aggregated evidence from more than 2000 empirical studies”, Journal of Sustainable Finance & Investment. See also: Giese, G., Ossen, A. and Bacon, S., 2016, “ESG as a Performance Factor for Smart Beta Indexes”, The Journal of Index Investing. See also: Nagy, Z., Kassam, A. and Lee, L.-E., 2016, “Can ESG add alpha? An analysis of ESG tilt and momentum Strategies”, Journal of investing. See also: Giese, G., Lee, L.-E., Melas, D., Nagy, Z. and Nishikawa, L., 2019, “Foundations of ESG investing: how ESG affects equity valuation, risk, and performance”, The Journal of Portfolio Management. See also: Polbennikov, S., Desclée, A., Dynkin, L. and Maitra, A., 2016, ‘ESG Ratings and Performance of Corporate Bonds, The Journal of Fixed Income.
6Pollard, J. L., Sherwood, M. W. and Klobus, R. G., 2018, “Establishing ESG as Risk Premia”, Journal of Investment Management.
7See for example: Li, F. and Polychronopoulos, A., 2020, “What a Difference an ESG Ratings Provider Makes!”, working paper.
8Blitz, D. C. and Fabozzi, F. J., 2017, “The Sin Stocks Revisited: Resolving the Sin Stock Anomaly “, The Journal of Portfolio Management.
9See for instance: Iversen, M. E., 2019, “Doing well by doing good?: an empirical study of 69 S&P Dow Jones ESG Indices 2009-2019”, Master’s thesis.
10Blitz, D.C. and Swinkels, L., 2020, “Is Exclusion Effective?”, The Journal of Portfolio Management.


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