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.”

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