Integrating ESG Into Your Multi-Factor Investing Strategy

by: FTSE Russell

By Tom Goodwin, senior research director

In a previous post, I discussed how a tilt-tilt approach to multi-factor index construction can minimize the dilution of competing factors while still maintaining diversification. But there's yet another benefit to consider: the tilt-tilt approach can be extended to encompass environmental, social and governance (ESG) considerations.

While factor investing has been on the rise, so too has ESG-conscious investing. As investors are increasingly looking to incorporate ESG considerations into their investment approach, indexes using the tilt-tilt methodology offer a flexible and consistent solution. This is because ESG indexes have evolved such that investors are doing a sort of "tilting" already - they're tilting positively toward company activities that manage ESG risk exposures effectively, while at the same time tilting away from those companies that are behind the curve.

As such, the tilting idea naturally suggests analogues to factor scores: drawing on FTSE Russell's extensive database on a wide range of ESG-related metrics to create scores from 0 to 1 that can be used as additional "factors" in a multi-factor index. With this approach, stocks that may have been excluded by a negative screen instead have their weights reduced to the degree that the company demonstrates weak ESG practices. At the same time, those companies that have engaged in strong ESG practices would have their weights increased.

By design, the tilt-tilt methodology not only makes for easy integration of ESG measures, but also offers the ability to do so without sacrificing factor exposure strength. This is particularly true when compared to the composite approach to multi-factor index construction. As discussed in my previous post, the composite index approach is another widely used approach that simply takes the arithmetic average of the factors.

To illustrate this point, let's say an investor is looking to incorporate low carbon emissions measures into a value factor index. As stand-alone indexes, the Broad Value Factor Index has a negative 3% exposure to carbon emission reduction, and the CO2 Emission Index has no active value exposure.

As shown below, a composite approach results in reduced exposure to both the value factor and carbon emissions reduction when compared to their respective standalone indexes. However, the integrated tilt-tilt approach maintains both value factor exposure and carbon emissions reduction.

This demonstrates how the FTSE Russell tilt-tilt approach is not only a natural fit for integrating ESG considerations into a multi-factor index, but also enables investors to do so without compromising factor exposure strength. Please refer to our recently published research paper, "Multi-factor indexes: The power of tilting," for a deeper dive into this topic.

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