August 27, 2018

Factor investing #7: Environmental, social and governance considerations

Since CN&CO is very involved in many aspects of the financial services industry, we often come across useful and informative articles that we believe our friends and partners will be interested in reading. The latest is a series of articles that unpack the concept of factor investing and how it’s used in different situations.

Factor investing is one of the tools used by portfolio managers to maximise returns in an investor’s portfolio. A few definitions are available here. This investment strategy has the ability to empower consultants, multi-managers and advisors to build client portfolios simply and efficiently. From 1) the transparent manner in which factor portfolios are systematically constructed, to 2) the capability of building tailored investment outcomes with greater diversification and predictability, to 3) the low fees, to 4) the reliability in consistently delivering a specific investment philosophy. Factor investing is beginning to revolutionise the investment industry.

While the potential impact of factor investing is transforming in nature, the level of adoption by clients varies by degree of simplicity, from ‘not allocating’ to ‘sophisticated allocation’. In this series we aim to highlight all applications of factor investing across this continuum.

This article is the seventh in the series published by Jason Swartz, head of portfolio solutions at Satrix, aimed at discussing practical ways to employ the power of factor investing and is the first in our next four articles carrying a more sophisticated level of application. In our previous article, we discussed employing factor investing in a more tactical manner in order to express an investment view in your portfolio. In this article, we specifically discuss how best to incorporate Responsible Investing (RI) or ESG principles into factor investing processes.

Integrating ESG into factor investing

By Jason Swartz

Client level of adoption/allocation:

Client level of adoption/allocation

Over the past decade, many global and domestic institutional investors have become increasingly concerned about social sustainability, and begun to incorporate environmental, social and governance (ESG) considerations into their portfolios. In South Africa, given the introduction of CRISA*, responsible investing has now evolved to a place where it is no longer merely a luxury, but an imperative consideration for investors.

Smart beta, similarly, has seen a comparable increase in attention, and while these two concepts may seem unrelated, we believe there is abundant synergy for both to work together well: factor investing lends itself well to socially responsible investors looking to prioritise responsible investing within their investment processes.

Figure 1: Selected factors/indicators of ESG investing

So the question is, how can one integrate a responsible investment approach with the power of factor investing? Two approaches are typically used here.

The first framework involves treating ESG as a separate systematic factor itself. Company data can be assigned numerical ESG scores which can then be easily transformed into exposures (eg: z-scores) that form the basis of a factor model.

This approach has to be considered cautiously, as

1) ESG scores historically have shown to be correlated with traditional factors such as Quality and Low Volatility

2) on a more philosophical note, ESG by definition is more an expression of an investment imperative, rather than capturing a well-understood driver of return that delivers a compensating premium above the market.

The second approach involves a framework where, based on ESG scores, an ESG universe is filtered and screened from a broad market universe and then forms the basis on which traditional factors are overlaid. We illustrate this approach in Figure 1 below, where we’ve taken a South African responsible investing universe (based on an ESG exclusion list) and constructed Momentum, Value and Quality portfolios from this universe since 2001 on a quarterly basis. When using this approach, it is important to understand the interaction between each factor and the selected ESG universe.

Factor porttfolios formed from South African ESG Universe

Globally, institutional investors have already started integrating responsible investing into their mainstream investment processes, formalising how they responsibly engage and manage their investments. In our view, adding an additional dimension of factor investing to this process will reflect positively on an ESG investment proposition, ultimately enhancing risk-adjusted returns over time for both investors and society.

For more information on this topic, or the details of our analysis, please feel free to contact us directly.

In our next part in the series, we will discuss an optimal approach to blending factors exposures, called multi-factor portfolio construction.

Watch the video below on integrating ESG into factor investing by head of portfolio solutions at Satrix, Jason Swartz.

* CRISA came into effect in 2012 and gives guidance on how institutional investors should execute investment analysis and activities, and exercise rights to promote sound governance. Its principles are aligned with those of the UN Principles for Responsible Investing (UNPRI). Application of CRISA is voluntary.