latamen
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.

  • Ruben Gabriel Feldman
    Ruben Gabriel
    Feldman
    Senior Quantitative Analyst at RobecoSAM

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
Stay informed on Sustainable Investing with monthly mail updates
Stay informed on Sustainable Investing with monthly mail updates
Subscribe

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.”

Important information

The Robeco Capital Growth Funds have not been registered under the United States Investment Company Act of 1940, as amended, nor or the United States Securities Act of 1933, as amended. None of the shares may be offered or sold, directly or indirectly in the United States or to any U.S. Person (within the meaning of Regulation S promulgated under the Securities Act of 1933, as amended (the “Securities Act”)). Furthermore, Robeco Institutional Asset Management B.V. (Robeco) does not provide investment advisory services, or hold itself out as providing investment advisory services, in the United States or to any U.S. Person (within the meaning of Regulation S promulgated under the Securities Act).

This website is intended for use only by non-U.S. Persons outside of the United States (within the meaning of Regulation S promulgated under the Securities Act who are professional investors, or professional fiduciaries representing such non-U.S. Person investors. By clicking “I Agree” on our website disclaimer and accessing the information on this website, including any subdomain thereof, you are certifying and agreeing to the following: (i) you have read, understood and agree to this disclaimer, (ii) you have informed yourself of any applicable legal restrictions and represent that by accessing the information contained on this website, you are not in violation of, and will not be causing Robeco or any of its affiliated entities or issuers to violate, any applicable laws and, as a result, you are legally authorized to access such information on behalf of yourself and any underlying investment advisory client, (iii) you understand and acknowledge that certain information presented herein relates to securities that have not been registered under the Securities Act, and may be offered or sold only outside the United States and only to, or for the account or benefit of, non-U.S. Persons (within the meaning of Regulation S under the Securities Act), (iv) you are, or are a discretionary investment adviser representing, a non-U.S. Person (within the meaning of Regulation S under the Securities Act) located outside of the United States and (v) you are, or are a discretionary investment adviser representing, a professional non-retail investor. Access to this website has been limited so that it shall not constitute directed selling efforts (as defined in Regulation S under the Securities Act) in the United States and so that it shall not be deemed to constitute Robeco holding itself out generally to the public in the U.S. as an investment adviser. Nothing contained herein constitutes an offer to sell securities or solicitation of an offer to purchase any securities in any jurisdiction. We reserve the right to deny access to any visitor, including, but not limited to, those visitors with IP addresses residing in the United States.

This website has been carefully prepared by Robeco. The information contained in this publication is based upon sources of information believed to be reliable. Robeco is not answerable for the accuracy or completeness of the facts, opinions, expectations and results referred to therein. Whilst every care has been taken in the preparation of this website, we do not accept any responsibility for damage of any kind resulting from incorrect or incomplete information. This website is subject to change without notice. The value of the investments may fluctuate. Past performance is no guarantee of future results. If the currency in which the past performance is displayed differs from the currency of the country in which you reside, then you should be aware that due to exchange rate fluctuations the performance shown may increase or decrease if converted into your local currency. For investment professional use only. Not for use by the general public.

I Disagree