For the time being, ESG investing is smart -- but is it smart beta?

As investing based on environmental, social and corporate governance issues grows, so too does the prospect of using ESG methodologies as a smart beta-style factor that delivers financial returns over time.

As asset managers offer more passive smart beta indexes and ESG-weighted strategies, more of the world’s assets are following them. According to recent FTSE Russell research, both smart beta and ESG strategies are becoming more popular with investors, especially in Europe, where 60 percent of the respondents in a 2017 study said they would be interested in applying ESG overlays to their smart beta strategies. In North America, just one in five investors said they would do the same.

“I think it’s too early to be able to define whether these are smart beta factors quantitatively,” says Komson Silapachai, vice president, research and portfolio strategy at Austin, Texas-based Sage Advisory. “Some of these ESG practices will materialize over longer time periods than just a quarter. Impacts from dealing with waste water or waste materials, or efficiency, or higher employee engagement are largely intangible and may take a very long time to show upon the balance sheet.”

Investors can’t be blamed for looking at ESG as a smart beta choice. Since the proliferation of indexes and ETFs using ESG ratings and rankings to weight their holdings, the two different kinds of investing have started to take on similarities to one another.

While ESG correlates with higher-risk adjusted returns, just as a smart beta factor would, it does not yet have a track record indicating persistence, says Abdur Nimeri, senior vice president and investment strategist at Northern Trust’s FlexShares.

“When I think of smart beta, I think of factor-based products using anything with a significantly long-return history with return premiums,” says Nimeri. “Things like value, size, momentum; they have been able to demonstrate through multiple cycles to have persistent return premiums.”

Early ESG strategies used a negative screen to avoid investing in polluters, poor corporate citizens and other bad actors. As interest in environmental stewardship and social responsibility has grown, the varieties of ESG products have as well, to the point where many ESG indexes now resemble smart beta indexes.

At Eaton Vance Management’s Calvert Research and Management Division, Anthony Eames, vice president and director of responsible investment strategy, believes that there is some merit that newer, “integrated” ESG strategies can be considered smart beta.

“We’re supportive of the view that ESG can be a factor that drives financial returns,” says Eames. “There’s a lot to it, especially the growing body of research that suggests companies with strong ESG performance also benefit from higher profit margins, higher profitability and lower cost of capital.”

Calvert offered one of the first ESG index funds, the Calvert Social Index. The firm now has a suite of seven ESG indexes addressing issues like water, energy, corporate governance and social responsibility.

Karina Funk, co-portfolio manager of Brown Advisory’s Large-Cap Sustainable Growth strategy, overlays ESG methodology on to bottom-up fundamental stock picking. While ESG can impact a firm’s fundamentals, financial returns are driven most by a company’s financial health and growth prospects, says Funk.

“Value is created in one of three ways: Increased revenue growth, improved cost structure, or enhanced franchise value,” says Funk. “Each of these areas can be impacted or driven in part by environmental, sustainable or socially responsible strategies. There’s a fourth element that comes in, which is understanding and managing risks, and that’s another area where sustainability adds to shareholder value.”

Simplistic screens and weightings based on ESG ratings can miss the biggest opportunity for returns driven by environmental, social and governmental factors, says Funk: Firms that need to improve their ESG stance.

Companies with a desire to move from lower ESG ratings to higher ESG ratings have the opportunity to create more value than a firm with already high ESG ratings, reasons Funk, thus smart beta-like weighted ESG indexes make little sense.

“If a company can consistently find ways to reduce its usage of water and other materials, or labor, then they’re providing a value proposition to the customer,” said Funk. “When does it ever go out of style to save money? Sustainability and efficiency are huge, persistent revenue growth opportunities.”

Many successful strategies are now identifying firms with room for ESG improvement, and encouraging progress via shareholder activism, another option that is lost to most indexers.

However, investing in companies who already boast high-ESG ratings is also a form of risk management, says Eames.

“A company managing its environmental impacts is going to face fewer lawsuits in the future and will have more resources at its disposal to handle regulatory change,” says Eames. “Companies who manage their workforce as a human resource should benefit from more motivated workforces with higher moral and lower absenteeism. Companies that have strong corporate governance and ethical business practices should be more conducive to long-term growth with fewer risks.”

Calvert’s venerable large-cap Social Index has slightly outperformed the Russell 1000 over the past decade, notes Eames.

Research released earlier this year from Greenwich, Conn.-based AQR Capital Management found a positive link between a company’s ESG exposure and the statistic risk of its equity. Stocks with poor ESG exposure had higher risk and higher beta as far as five years into the future, according to AQR.

While investors often emphasize environmental factors, AQR found that social and governance were most often correlated to risk. Investors might be able to use ESG to build more stable and risk-efficient portfolios, the firm concluded.

Yet ESG has still not earned the “smart beta” title, argues Nimeri.

ESG Metrics Not Consistent -- Yet

“As we’re starting to see returns attributed to non-financial disclosures, we have to realize that there’s still much work to be done to classify those as traditional factors,” says Nimeri. “For one thing, there’s no long-short view when it comes to the ESG space. There’s clearly small over large, or value over growth, or high momentum versus low momentum, but I have not seen a similar long-short representation in the ESG space.”

Smart beta strategies must be based on widely accepted metrics that explain factor exposure. For example, a value-based strategy should use a metric like price-to-earnings ratio or price-to-book to measure how much value each component within its index delivers.

Though there are several long-standing providers of ESG data, like MSCI and Sustainalytics, there are few settled upon metrics or ranking systems.  Until recently, only a handful of firms were rating investments based on ESG factors. As more researchers enter the ESG fray, like Morningstar, which introduced its Sustainability Rating for mutual funds in 2016, rating methodologies should gain broader acceptance.

“As ESG data has increased, it’s important to focus on the quality of that data,” says Jessica Ground, global head of stewardship at London-based Schroders. “For example, we’ve seen an explosion of indexes that are focused on lowering carbon footprint, but 40 percent of them are using data that’s still based on estimates of carbon production. You wouldn’t accept that kind of data quality if you were looking at a low-volatility model.”

Many ESG ratings providers are still using a “check-box” approach that uses qualitative assumptions, rather than quantitative measurements, says Ground, who also disputes ESG’s correlation with risk reduction.

When Schroders looked at firms’ ESG ratings before a headline controversy, Ground found that ratings were not a good predictor of whether or not firms were at risk because of their ESG policies, nor were they a predictor of whether a firm would continue to grow in value.

Reporting also remains a sticky issue for ESG investments. Nimeri says that it is difficult to attribute their performance to an ESG exposure, because it is difficult to isolate ESG exposures.

“You want to be able to make sure that returns are being driven by the ESG component,” says Nimeri. “Investors looking at broad allocation with limited tracking error and high diversification are better off going with a passive core product … If you have an ESG product that is style and sector neutral, it wipes out those other pieces and the return is generated purely by the ESG methodology.”

Active managers, to date, have also struggled to measure the return from impact investing, and to translate that impact in dollar terms.

As ESG becomes more “passive” within factor indexes, it risks becoming de-coupled from shareholder activism, a primary driver of investing impact. Firms like BlackRock, Vanguard and State Street have already been accused by not-for-profit groups like As You Sow for essentially acting as a rubber stamp to the whims of corporate executives.

While active managers have use proxy votes to display their impact, passive managers, for the most part, are just entering the impact investing arena.

“We’ve made better impact reporting one of our priorities, and we think that’s an area of improvement that the industry needs to focus on,” says Eames. “That’s a necessary step towards attributing a portion of these returns to ESG factors.”

Because it is such a nebulous category, ESG metrics and reporting are also fraught with subjectivity, notes Nimeri. “It is as yet unclear which elements of ESG are meaningful, and which elements are not as meaningful.”

Treating ESG like another smart beta factor also converts an ethical or moral judgment into a simple quantitative decision, separating the investor from the impact.

At this early stage, most adherents to ESG investing are still more driven by an interest in creating environmental, social and governmental change than they are in creating greater investment returns. As ESG rating methodologies and the products built on top of them mature, investors seeking alpha, or at least better beta, may turn to the ESG investing universe.

Advisors should be prepared.

“Advisors have to know their clients and the clients’ objectives,” says Silapachai. “Investors care about corporate practices, they’re aligning their money with their values, but ESG investing is a trend that advisors have to advance. There’s a lot more academic work to be put into this dual mandate of achieving the best financial returns with respect to ESG, so it’s important for advisors to stay on top of this stuff.”