Will We Start Seeing ESG as a Component of Factor Investing?

Environmental, social and governance (ESG) has become a force in the investment arena as it continues to experience exponential growth, but can it become a factor? In the realm of smart beta investing, ESG could join value, growth, momentum, and other factors sometime in the future.

An article in Funds Europe posed an interesting question: “Nearly half of institutional investors had some form of ‘smart beta’ allocation last year and, separately, research also showed that ESG growth among the world’s largest asset managers was soaring. But could the two – smart beta and environmental, social and governance investing – be combined as a type of investment factor?”

“There is a very strong appetite for ESG combined to smart beta in funds,” said Bruno Taillardat, head of smart beta and factor investing at Amundi. “Smart beta funds rely on well-structured and disciplined investment processes.”

Furthermore, ESG could be used in concert with other factors like value and growth.

“We also hear that some investment factors react better than others to having an ESG filter applied to them, with ‘quality’ being well-matched with ESG,” the Funds Europe article noted. “The quality factor tends to favor companies with large profits relative to their asset base, says Eugene Barbaneagra, portfolio manager for the traditional strategies group at SEI, who adds that ‘having a high-profit base tends to allow a company to afford to mitigate a lot of ethical issues.’ Style Analytics found that ESG factors can be added to the momentum investment factor with ease – and doing this has also been shown to produce higher returns.”

ESG Adoption is Imperative

Now, it’s almost imperative that investment firms, large or small, embrace ESG or be subject to underperformance, according to index provider MSCI.

“We are sounding the alarm bells that if you are an investment institution and you’re not embracing this and taking it into account, it’s going to be at your own peril because your portfolios are going to underperform dramatically because there is a common repricing and common reallocation of assets around the world according to the ESG criteria,” said MSCI chairman and CEO Henry Fernandez on an episode of CNBC’s “Squawk on the Street.”

The rise of ESG has investors constantly asking for funds that support the initiatives of environmentally-sound practices. Additionally, it’s also drawing the scrutiny of the Securities Exchange Commission (SEC) at a time when ESG became one of the most searched financial terms in 2019, according to a 401(k) Specialist post.

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