Factor Investing: The key to ESG?

The buzz word of the past five to ten years within the investment community: socially responsible investments (SRIs). While asset managers acknowledge that there is real demand and necessity to shift portfolios towards becoming more sustainable, the question now becomes: how can asset managers incorporate SRIs in their portfolios using a data-driven and objective method, while still adequately managing for risk factors?

The sustainable research and financial engineering teams at OFI AM have found a solution to address this question, and the performance of their OFI RS Equity Smart Beta fund is demonstrated success. Below Frédéric Daty and Yann Ferrat, part of the financial engineering team at OFI AM, explain how the use of factor investing in ESG integration can lead to superior performance while ensuring associated risk is mitigated.

A couple decades ago, only a few socially conscious investors had emitted concerns regarding ethics in business practices. This trend gave birth to socially responsible investments (SRI), which have evolved from margin to mainstream. Investors and stakeholders as well as numerous regulatory shifts and abundant media coverage have fueled the craze for responsible investments. This investment form differentiates itself by allowing investors to align their portfolios with their beliefs.

As the first crisis since the SRI era, the global pandemic has reemphasized the importance of environmental, social and governance (ESG) integration in financial investments. Responsible corporations have indeed been more resilient to this recent bear market. Among the main, reasons advanced, these firms are well managed, which makes them better equipped to face these exceptional economic phases.

With roughly 50% of professionally managed assets titled towards sustainability, the European markets have fully acknowledged the price of ethics. As illustrated in Panel A, the gap in returns between the most and the least responsible corporations has continued to grow over the last decade. ESG metrics complete financial analysis by accounting for risks and opportunities traditionally absent from conventional accounting, which explains the compelling returns.

Panel A: Cumulative Returns of Top and Bottom ESG Corporations in the Euro Zone

In this panel, we form two quarterly rebalanced equity portfolios based on their ESG rating and assess their performance relatively to the Euro Stoxx index from 31/12/2007 to 30/06/2020. Leaders are the corporations who display the highest sustainability standards, while Under Surveillance are those who fail to manage their extra-financial risks. The ESG Premium portfolio is formed financing the Leader portfolio by selling the Under Surveillance one. As displayed, significant returns may be achieved by the exposure to the ESG premium. The ESG ratings analyzed are the result of OFI AM’s rating methodology.

Accumulated evidence has shown that issuers with remarkable track records in managing extra-financial issues outperform those with high exposure to ESG risks as well as the broader market. Based on our analysis, a portfolio that would go long Leaders and short Under Surveillance corporations would have delivered an outstanding 96% over a twelve-year horizon. Contentions that the pool of sustainable stocks is superior to the pool formed by their less responsible counterparts appears founded.

In this spirit, both academics and practitioners have categorized ESG as a unique market anomaly, similarly to the traditional style factors. As displayed in Panel B, the significant over dispersion of the correlations to other risk premium makes ESG a proper factor. Hence, alpha generated by responsible investments is beyond exposures to traditional risk factors.

Panel B: Distribution of the Correlation between the ESG Risk Premium and Style Factors

In this panel, we assess the distribution of the twelve-month rolling correlation of ESG with traditional style factor from 31/12/2007 to 30/06/2020. Given the significant dispersion of historical correlations, we believe that ESG should be considered equally to the other risk premiums. All factors examined are constructed using OFI AM’s proprietary approach.

From this standpoint, OFI AM launched the OFI RS Equity Smart Beta fund. The approach employed combines ESG screening with equal risk contribution (ERC) sector allocation and equal weighting of securities within industries. In essence, this strategy gives investors to an exposure to the ESG, (low) volatility and size factors. As presented in Panel C, ESG integration and factor investing is a viable option. Our approach could have delivered an impressive 65% excess return in twelve years, while maintaining a risk profile in line with the Euro Stoxx.

Panel C: Analysis of ESG Integration in a Smart Beta Strategy

In this panel, we perform an examination of the factors that drive the excess return of OFI RS Equity Smart Beta from 31/12/2007 to 30/06/2020. As illustrated, combining ESG with equal risk contribution (ERC) and size factors delivers significant outperformance. Over the twelve-year sample, ESG, ERC and size factors contribute respectively for 26.76%, 25.99% and 11.82% of the excess return generated.

We believe the explanation of the excess return to be threefold: (1) an exposure to the size risk premium generates performance in bull markets, (2) the ERC sector allocation derives outperformance in stress phases, and (3) employing ESG screening enables us to eliminate controversial and poorly managed corporations. This triple factor combination generates a positive excess in most market configurations.