Investors are increasingly looking to integrate environmental, social and governance (ESG) criteria into their factor allocations, according to Stuart Doole (pictured), managing director and global head of new product development index research, MSCI, speaking during the MSCI annual conference on Global Investing and Risk Management on May 16 in London.
"The key in terms of factors is that it is about the explicit allocation," said Doole. Factors are not new and have been used Value at Risk (VAR) models for 40 years, according to Doole. "[Factors] have been embedded in active strategies for decades. It is really about making them available in a very explicit way through factor indices that's been very different in the last 10-years, in particular over the last five-years."
Factors are stock characteristics that explain portfolio performance over long horizons and are used by long term institutions in portfolio risk models and in traditional and quantitative investment strategies. "At MSCI we look at six long term factors on a strategic basis," said Doole. "The more defensive factors are low volatility, yield and quality while the high beta strategies, the more dynamic strategies, are momentum, value and size."
Asset owners are choosing to integrate ESG for multiple reasons, according to Doole. "With ESG integration, the key thing is the realisation that this is not about value, not about making a token investment, it's not about making a few exclusions," said Doole. "It is really about embedding an assessment throughout the investment process."
Whether it is about the credit portfolio and credit worthiness because of the state of your assets or where your assets are located, or whether it is about how you value companies, how much of your book is real, is part of that, said Doole. "[For example] an oil company, how much of that oil can you extract, how much of the reserves are real book, how much extra volatility will you see because of the way your business model is exposed to all aspects of ESG issues."
Increasingly it has become very important to investors to manage the headline risks, according to Doole. "Investment campaigns put a lot of pressure on all sorts of asset owners. A lot of asset managers are very focused on what would be the investment patterns of millennials for example."
Sixty-five percent of total global assets under management (AUM) could be influenced by ESG regulations, mandates, investor initiatives, or clarifications by regulators in the next five years, said Doole. "What is very striking is that it really is global in terms of regulatory pressures. Just as Factor investing is very global now and has seen significant allocations globally and equally when it comes to external pressures pushing investors towards ESG driven investing."
With ESG integration, when you look to build a dynamic strategy like value and momentum, the trade-off between ESG exposure and the factor exposure is very different from defensive strategies such as quality or low volatility, according to Doole. "We also try and dig under the surface. This is not just about performance, we are not trying to talk about how we found a new magic factor, it is really about ESG integration as a framework for the institutional investor and when they are allocating to factors as a third bucket for their capital," said Doole. "They are applying this framework to their perhaps passive investment in cap weighted equity, by doing it in their fund of funds with external managers, they have to do it in a consistent way when it comes to allocation of factors."
There are two dimensions which need to be managed when combining ESG and factor objectives in one index, according to Doole. "We need to improve our sustainability score, by providing higher exposure to ESG, gender diversity, low carbon, environment, however, at the same time we want to boost our factor exposure to improve our risk-adjusted returns."
When you assess if you have designed an index approach successfully it is important to realise that it is not just about performance, said Doole. "Performance comes and goes, factor performance is cyclical, we want to focus on exposures and we also want to focus on other measures of success, more granular ESG metrics and measures of diversification as well in terms of capturing ESG but also making sure there is not too much stock specific impact on our factor returns," said Doole.
"There is a simple way to do this," said Doole. "We are saying let's do it in a scalable way, in a flexible way to use optimisation, but as an actual benchmark we say I can also go out and get myself an all ESG index with a factor overlay on top."
Click the link to view the full presentation Integrating ESG into factor investing.
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