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Responsible investing: factor friend or foe?
David Barron, head of index equity and smart beta at Legal & General Investment Management
Can environmental, social and governance concerns (ESG) fit within a factor-based portfolio? In this article, we tackle ways to approach this developing field.
As growing numbers of investors seek to adopt the principles of responsible investing, the world of factor-based strategies is far from an exception: 55% of European asset owners surveyed in 2018 stated they were looking to inte- grate ESG considerations within their factor portfolios.
But no clear picture has emerged so far about how best to achieve this goal, despite extensive research in recent years. Should the ‘responsible’ portion of portfolios be managed separately or is it more effec- tive to integrate ESG considerations at the factor level?
Integrating ESG considerations in portfolios
Option 1: Bottom up with ESG as another ‘factor’ The bottom-up approach creates portfolios with strong factor exposures by assigning a multi-factor score to each security, which is then reconciled with the investment’s ESG score. This ensures that there is less dilution of target exposures, which is a risk with a top-down approach. It generally relies on a mar- ket capitalisation weights or tracking error constraints to minimise tracking error and concentration risk. In a ‘tilting’ approach, every security is assessed on ESG and multiple factor scores. A relatively simple ‘tilt’ is executed by multiplying the individual security scores by the market capitalisation weight. The result is an increased allocation to companies that score well on ESG and chosen factor scores and a reduced weight for that do not.
A second approach seeks the optimal way to combine ESG scores with factors. Usually, providers aim to achieve a target objective using an optimisation model, creating a composite score capturing desired portfolio attributes. The company with the highest aggregate score receives the largest weight, subject to constraints.
A drawback to these approaches is the difficulty of deriving attribution by decomposing security weights based on individual factor exposures. Also, as more factors are added, the universe narrows, increasing concentration. It becomes difficult to find stocks that outperform on all factors as well as the chosen ESG metrics. Therefore, time should be spent on determining the relative weight, or importance, each ESG factor has.
Option 2: Exclude, then run the factor portfolio as normal This option can be applied to a bottom-up or top-down portfolio construction process. The difference here from the methods above is that it does not allocate additional weight to companies with strong ESG scores. Instead, the laggards are removed, set at a pre-determined threshold. An important benefit of this approach is its simplicity. A fairly easy comparison can be made between pure factor and ESG- excluded portfolios. A concern with this approach is that it is difficult to engage with excluded companies to encourage them to improve their behaviour.
24 September 2019 portfolio institutional roundtable: Factor investing
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