In a world of lower returns, investors face the challenge of meeting their return objectives without taking on too much risk or incurring significant costs. At the same time, a growing number of investors wish to ensure their underlying investments incorporate an awareness of environmental, social and governance(“ESG”) issues. Innovations in both Smart Beta and ESG investing are helping investors address this diverse set of requirements.
Smart Beta Investing
Smart Beta investing is based on the insight that factors—company attributes that have been shown to explain stock returns—are the underlying drivers of performance. Academic research demonstrates that factor-based investing can deliver returns in excess of cap-weighted benchmarks over time by capturing so-called “factor premia”. It also shows that multi-factor (as opposed to single factor) exposure can offer diversification benefits. We use the five factors we believe represent the primary drivers of equity returns – value, size, volatility, momentum and quality. These diversified Smart Beta strategies are growing in popularity because they offer the potential to outperform a cap-weighted benchmark with lower fees compared with actively managed funds.
Why ESG Matters
Investment strategies with an ESG dimension are also increasingly prevalent. This style of investing can help to align an investor’s portfolio with their personal or institutional values, as well as with policy requirements. In the past, choosing values or performance was often presented as zero-sum, i.e., the tilt towards ESG came at the cost of better returns. But many studies now suggest this is a false choice and that a company’s environmental actions, social behaviours and governance practices can have a meaningful impact on its financial performance.
The Integration Challenge
Our Smart Beta research team has found ways that investors can take full advantage of both Smart Beta and ESG investing within the same portfolio. Portfolio construction is critical, as there may be trade-offs between targeted factor exposures and a favourable ESG profile. For example, companies with better ESG scores tend to be large, while factor premia are often found in small cap firms. Fortunately, as both ESG profiles and factor exposures can be quantitatively measured, our team can aim to achieve balanced exposures through the use of optimisation.
Optimization-based portfolio construction methods offer a means of building a portfolio with the desired aggregate characteristics, while minimizing any unintended exposures such as currency or sector exposures. The result is a balanced and systematic method of integrating ESG exposure into a diversified Smart Beta strategy.
Authors: Jennifer Bender, Director of Research and Todd Arthur Bridges, ESG Research with State Street Global Advisors. To find out more about State Street Global Advisors talk to your financial adviser
The views expressed in this material are the views of Jennifer Bender and Todd Bridges through the period ended May 29, 2018 and are subject to change based on market and other conditions. This document contains certain statements that may be deemed forward-looking statements. Please note that any such statements are not guarantees of any future performance and actual results or developments may differ materially from those projected.
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