This trend toward ESG is taking place at a time of major structural changes in investment styles with the rise of passive investment on one hand and smart beta approaches on the other. The move toward passive investment can be clearly observed by the massive increase in assets invested in exchange-traded funds. Smart beta approaches, while still smaller than passive investments, are gaining traction as investors can expose their portfolios to different investment styles and avoid excessive exposure to capitalization weighted indexes. The total assets under management of the asset management industry at USD 79.2 trillion in 2017. Of those, USD 16 trillion, i.e., approximately 20%, is passively managed. Smart beta is estimated at USD 430 billion but has been growing by 30% per year since 2012. An important question that arises is how ESG integration affects the nature of the passive and smart beta portfolios. A fundamental concern is that improving the score of the portfolio may result in the deterioration of its performance. For passive investors, integrating weights departing from market capitalization may increase the level of tracking errors with respect to the benchmark. For smart beta, the integration of ESG may reduce the efficiency of the factor that is targeted by the strategy.
In a study that covers worldwide equity markets over the 2007-2017 period, we show that the ESG profile of both passive portfolios and smart beta portfolios can be substantially improved without deteriorating their overall performance. Over the period under study, applying an ESG screening to an otherwise passive portfolio improves the portfolio ESG scores and records unchanged or improved Sharpe ratios. However, ESG screening also leads to substantial regional bets in multicountry portfolios, in favor of Europe and against the U.S. and emerging countries. This approach also implies large sectoral bets in favor of information technology stocks and against financial and energy stocks. Finally, the ESG screening amplifies some risk exposures relative to the standard benchmark portfolio. For instance, almost all the passive portfolios that we consider are negatively exposed to the small-minus-big factor because large firms usually have higher scores than small firms. Furthermore, we find that the popular smart beta approaches would have benefited from an ESG screening over the period. Even with aggressive exclusions, the targeted factors remain in place. We observe some reduction in the exposure to the targeted factor, but it appears to be compensated by an increase in the ESG profile of the portfolio.
Overall, our main result that the ESG profile of passive investment and smart beta strategies can be improved without deteriorating risk-return performances holds for most regions and for most ESG criteria. This outcome may be at least partly driven by the sample used for the analysis. The period corresponds to a massive transfer of funds toward ESG investing, a process that may have increased the value of firms with high ESG scores and therefore improved the performance of portfolios built upon ESG filters. The (possibly undesirable) exposure of ESG portfolios to some regional or sectoral tilts or to some risk factors may be mitigated by building algorithms that optimize the ESG profile while keeping the exposures to various risk factors under control.
Read more in the working paper by Profs. Alessandrini and Jondeau.