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.