By Guido Giese
Historically, ESG indices have not attracted asset volumes comparable to smart beta index strategies. This could be attributed to the fact that market participants and academics alike have struggled to link ESG-based strategies with financial performance.
As researchers shift their focus from how to study ESG to how to integrate ESG data into products and indices, two key issues related with integrating ESG data have come to light that may be the reason some market participants investors have held back from taking the plunge.
- Aggregate ESG scores are highly correlated to existing allocation factors such as country, sector, or size and are even correlated to performance factors such as dividend yield and volatility. Therefore, the performance of any strategy or index that uses these ESG ratings as input will be dominated by these factor exposures, which has prevented these ESG ratings from being used as stand-alone performance factors.
- ESG ratings are broad in the sense that they aggregate hundreds of ESG indicators into one single rating. This is in contrast to common factors such as value or momentum, which are based on just a few data points. Integrating so many different indicators into an aggregate score creates the possibility of "diluting" a potential performance signal in the data, as some ESG indicators that do have performance potential will be aggregated with other indicators that are not necessarily linked to stock performance.
A new scoring approach called "Smart ESG" developed by RobecoSAM not only proves that ESG indicators can in fact be applied as stand-alone performance factors, but that they can also positively affect financial performance.
Smart ESG uses traditional ESG indicators as input, but it ensures that the aggregate score is uncorrelated to known factors and attributes the highest weight in the scoring process to those ESG indicators that have been found to predict stock performance, based on an in-depth and systematic factor testing of each individual ESG indicator per GICS® industry.
The outcome of this new scoring process is a set of so-called "ESG factor scores" that, when uploaded into a traditional factor model, show a positive information ratio of about 0.8 and are uncorrelated to all known factors.
This new ESG factor score is the basis of the new S&P ESG Index Series, a set of ESG indices launched in February 2016. The S&P ESG Index Series includes the S&P 1200 Global ESG Index, S&P 500® ESG Index, S&P Europe 350 ESG Index, and the S&P/TOPIX 150 ESG Index. This series is unique in the sense that it is the first global ESG index group that uses ESG as a smart beta factor. These indices are weighted only by their ESG factor scores and show strong performance figures when compared to their market-cap-weighted counterparts (see Exhibit 1).
Market participants may be attracted to these indices due to the possibility of receiving an attractive financial return while also receiving a "social" return by tilting their allocations toward more sustainable companies. This is a major step toward making ESG integration even more accessible to a broader range of market participants.