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Portfolio > Portfolio Construction > ESG

Ignore the Myths: Factor and ESG Investing Work Together

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Environmental, social and governance investing now is in the trillions of dollars of assets, yet ideas about it hurting performance still persist, according to Guillermo Cano, executive director of Equity Solutions for MSCI, which just released a paper disproving three myths regarding ESG and factor investing.

One surprise of the findings, Cano told ThinkAdvisor, was how much ESG information was available on almost every stock. “We now have the ability to look at the ESG score exposure of virtually the entire MSCI universe,” he said.

He added that when it comes to portfolio construction to achieve a variety of different objectives, investors “don’t need to shy away from the space just because they may have preconceived notions of what ESG does and doesn’t bring to the table because what we’re saying here is there is enough depth of good ESG companies that can contribute to almost any type of portfolio.”

As both factor and ESG investing continue to grow in usage by managers, the study explored how both work together. The study used data from top-decile ESG manager portfolios between Dec. 31, 2013, and Dec. 31, 2017.

Myth #1: ESG is just another way of saying quality

A previous study showed positive correlations between quality-style factors and ESG scores, but they also found that ESG scores could “have been improved without a meaningful impact on exposure to the quality factor.”

Studying the active return of top ESG manager portfolios from 2013 through 2017, using the Barra Global Total Market Equity Model for Long-Term Investors, MSCI excluded and included ESG criteria.

By excluding ESG criteria, it was found the quality factor contributed 32 basis points to active return. However, when ESG was included, it returned 27 basis points while the quality return reduced slightly to 25 basis points. The conclusion was “while the return contribution from industry, specific and other style factors showed more meaningful shifts, the fact that the return from quality remained relatively stable suggests it is distinct from ESG.”

Cano said that “having ESG does not negate or wipe out the exposure to quality. It does reduce it a little bit because there may be some overlap with ESG and quality, but it doesn’t mean they are the same thing.”

Myth #2: Momentum and ESG are incompatible

While a previous study showed that the momentum factor “appeared” to have a very low correlation to ESG, Cano found return from momentum within a subset of the ESG portfolios studied.

In the study, looking at the same portfolios over the same time period, they compared cumulative return using risk models with and without ESG. The findings showed that without ESG, the model returned 2.3% versus the model that included ESG, which returned 2.2%. The conclusion was that “introducing ESG as an explanatory risk factor did not meaningfully impact the return from momentum — meaning momentum and ESG appear to have been compatible after all.”

In fact, Cano told ThinkAdvisor that “we’re saying momentum and ESG are negatively correlated … however one wouldn’t preclude the other.”

Myth #3: Smaller-cap stocks have low ESG ratings

Since 2009, mid-cap companies have been reporting ESG-related data, which larger companies previously dominated, according to Cano. Further, the paper states, enhancements were made to the MSCI ESG Ratings model, which eliminated an “inherent bias” toward large-cap companies. Both of these moves provide more ESG ratings info on smaller companies.

In the study, they found the mid-cap and low-size factors had meaningful exposure in the portfolios studied. In fact, over the time period studied, the portfolios had “virtually identical average active exposure to size compared to the MSCI World Equal Weighted Index (-.68 vs. -.67) and an average active mid-cap exposure of .24 vs. .52.” The paper concludes that that the “low-size factor could have been targeted within an ESG-oriented portfolio.”

Cano noted that the power of myths allow them to live on even after being disproved. “However,” he concluded, “given the importance of factor investing within managers’ investment process and the impact ESG criteria can play over the long term, there may be value in challenging preconceived notions when making decisions.”

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