The power of smart beta and ESG, and why they matter to you

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Smart beta strategies have grown enormously in popularity over the past decade. In 2011 there were 350 products offered in the space worldwide, whilst today there are more than 1000. At the same time, global assets in smart beta ETFs have increased 10-fold, from $120bn to $1.2t.

Smart beta involves the systematic integration of investment style factors into the investment process, and in a transparent way. This is possible because these style factors have decades of research backing them.

But what about the new kid on the block, ESG?

ESG as a factor is backed by far less research, simply because ESG hasn’t been around as long. Furthermore, the data backing ESG strategies can be a lot more subjective.

That doesn’t mean ESG smart beta strategies aren’t worth pursuing. In this Expert Insights video, Yvette Murphy from State Street Global Advisors highlights how, with prudent diversification limits and controls, balance can be found between ESG objectives and risk.

Note: This interview took place Tuesday 2nd August 2022. You can watch the video or read an edited transcript below.

How does ESG compare to smart beta?

In some respects, they're exactly the same and in other ways they are nothing like each other. So let's start with the similarities. Both ESG and smart beta involve capturing a theme and that theme is expected to manifest itself over the long term. Another similarity is the way they are actually built, the portfolios are built. They both involve deviating from the market capitalization benchmark in pursuit of that theme. And some of the earliest smart beta strategies, and we're talking 6, 7, 8 years ago now, the index methodologies followed a very simple rules-based transparent methodology. They selected a theme, let's call it value, they ranked the universe by the value score, they selected the top 50% and they weighted them. And in many instances, some of the earliest ESG strategies, the index strategies, followed a similar sort of methodology and construction approach. They just subbed out value and replaced it with an ESG score. That's probably where the similarities end.

The differences are ultimately in the long-term objective, the investment objectives that they're trying to achieve. So if we think about smart beta, really what drives smart beta is exposure to risk premia or style factors. These factors - value, size, quality, momentum, low-vol - they are grounded in decades of academic research, almost a century worth of academic research. ESG is very different from that. Certainly, the academic foundations and the history for ESG is much shorter than factors. It's still there, but it's shorter. And then the data that we use to power ESG or climate strategies can be a lot more subjective.

It's well understood in the industry that there is quite a lot of dispersion between ESG data and the scores that are provided by different ESG ratings providers. Even the Paris-aligned benchmarks and the climate transition benchmarks that are being launched in Europe, they are using quite forward-looking climate metrics in their portfolio construction. So even those metrics compared to some of the earlier ESG metrics are less proven. By their very nature, they're forward-looking metrics, so they're not relying on decades worth of data crunching by asset managers and academics.

So there is a level of faith that we need to place in these metrics when forming our forward expectations of return and I think that's another important distinction between smart beta and ESG or climate strategies. Smart beta, because of that foundation, and because of the way we've seen them behave in different market cycles, we have a good sense of how they will return in future market cycles. And generally value strategies perform in concert with other value strategies, momentum strategies perform similarly. Not exact, but same directional trend. With ESG, we don't have that prima facie expectation because the choices that data providers make and the way they construct their ESG scores, and then the choices that product providers make in aggregating those scores up, can have a really meaningful impact on short term and long-term returns.

How can active risk be balanced against ESG objectives?

Many of the earlier smart beta or ESG index strategies that came to market five, six years ago, they relied on very simple, very intuitive, portfolio construction techniques. It was a simple, "Let's rank it by its carbon intensity score. Let's rank it by its ESG score and select the best in every sector or the best in the index." What this gave investors was a very easy to understand and intuitive portfolio. But what it also resulted in, in some instances, was pretty severe active weight exposures - heavily overweight tech or heavily underweight financials. And then in some instances, really quite concentrated stock positions. You could have 6, 7, 8 up to 10% of your index exposure in one name.

When we were designing this strategy, we wanted to deliver a core diversified exposure. And so that meant trading off between active risk and really meaningful climate and ESG improvements. And so what that meant was that we needed to set prudent diversification limits around countries, sectors, stock, currency. And so that allowed us to not only stay invested in the entire opportunity set of global equities, but by the choice of our climate metrics and ESG metrics in the portfolio itself, it allowed us to redeploy capital within those sectors. And that is how we are balancing risk a little bit more effectively relative to the ESG objectives.

So utilities is a really good example of sort of the conflict between managing risk and managing the achievement of carbon objectives. Utilities is a high carbon intensive sector and we are typically... We've tended to be underweight utilities, but not by a lot, not by our maximum amount. And when you go one step lower in the utilities, you realise that there are different types of utilities, there's electric utilities, which tend to be the highest carbon intensive names, but then there's also water utilities, which are companies that, relative to their peers, score well on the traditional carbon measures, but they also score really well on more of the adaptation metrics, their green revenue, their investment in climate transition work. And so that is one way that we can trade off those objectives.

Risk isn't the only thing that we consider in the construction though. There's things like turnover. When we are dealing with climate data and ESG data that is constantly evolving, we have to be aware of what that impact is on the portfolio. And so ensuring that we are sensibly controlling the turnover and so ultimately the transaction costs in the fund is really important. So how do we actually do all that, you may be asking? So we've chosen to use a more sophisticated portfolio construction technique called optimization, sort of a mathematical software programme that allows us to feed in multiple climate data metrics and set improvement targets. It allows us to feed in all of the other information around the sector weights and the country weights and then the risk estimates of those securities.

And so what we may give up in a little bit of transparency in the portfolio construction, we get much greater control around the diversification and achievement of those objectives in the fund.

Seeking climate exposure and capital growth?

State Street gives investors access to the most efficient trade-off between climate targets, ESG improvement, tracking error and diversification while seeking long-term returns broadly in line with the Index.

To learn more visit their website.

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