Factor investing and ESG: long-term strategies for a volatile world

Combining two increasingly popular investment themes, factor investing and ESG, within an equities strategy provides potential for sustained long-term outperformance relative to the market, writes Ramkumar RASARATNAM, Head of Sustainable Equity, Global Research with AXA Investment Managers (AXA IM).

The effects of irrational markets, extreme fear and jubilation were all played out in equity markets last year, making the pitfalls of a market cap-weighted approach to investment increasingly evident. Moreover,  2020 showed us how index returns could become highly concentrated in a very small group of the very largest companies: the FAANG stocks (Facebook, Apple, Amazon, Netflix and Google), for example, grew to almost a quarter of the S&P500 Index.

Traditional indices, as tracked by passive funds, such as Exchange Traded Funds (ETFs), are often blind to these issues. And while the use of passive investment styles has been gaining popularity, they also do not often consider companies’ broader impact on society or their underlying ESG risks.

At AXA IM, we believe that factor investing can provide investors with a low-cost solution that seeks to avoid some of these pitfalls. By taking an active approach to investing, building proprietary factors, and fully integrating ESG considerations, we strive to build and protect our clients’ wealth more sustainably.

What is factor investing?

Factor investing recognises that there is a historical relationship between stocks with specific characteristics and a risk-return outcome associated with those characteristics. We aim to offer investors a cost-effective and transparent way to improve risk and return, when compared to market indices, by selecting stocks with specific equity characteristics such as quality, low volatility, value, and momentum. Investors may choose to target just one factor or mix factors in a way that best matches their investment goals.

We have developed a proprietary approach to factor investing that is anchored in company fundamentals while including controls to avoid uncompensated investment risk.

Within our sustainable equity strategy, for example, we blend the low volatility and quality factors to build a strategy with lower total risk characteristics without giving up on the long-term return associated with equity investing.

Our research found that stocks with high volatility and low quality have been persistent sources of additional risk but not additional return. In contrast, stocks with low volatility and high quality have historically offered a long-term return premium with lower total risk, as shown in the charts below.

We use proprietary insights to create a sophisticated view of earnings quality today and how that may change in the future while capturing ESG insights into board diversity, which our research shows helps protect a company’s future profitability.

Source: Rosenberg Equities, December 2019. Volatility is based on a proprietary Rosenberg measure that combines beta and stock specific risk. Quality is based on a proprietary Rosenberg Equities measure of earnings quality. Low = bottom 30%, Middle = next 40%, High = top 30% according to a square-root-of-market cap (SRMC) weighting scheme within each region on a monthly basis. Universe is MSCI World. Returns do not include transaction costs and are gross of fees. Please note that these are not actual Rosenberg Equities portfolios. Past performance is no guide to future performance.

Factor investing and ESG

ESG investing has been gathering pace in recent years, and this was particularly the case during the COVID-19 pandemic. According to Morningstar, during the first quarter of 2020 ESG funds attracted record inflows of US$45.7 billion globally. This compares to outflows of $387.7 billion in the broader fund universe as markets fell in response to the pandemic1.

In our view, a key reason for this is that ESG funds which might consider issues such as governance, social risks and climate change remove some of the sectors that significantly underperformed during the pandemic, including tourism, fossil fuels and airlines.

In the post-pandemic environment, we believe investor appetite for ESG funds will continue. Today’s investors are far more aware of the effect of climate risk and social issues, such as workplace diversity and employee health and safety, and increasingly expect their investments to make positive contributions toward improving these, as well as meeting financial goals.

At AXA IM, we also believe that ESG data can be used in a way that can foster meaningful change in the global economy, and in the communities in which we live and work, while also creating sustainable value for our clients.

The integration of ESG is used to enhance traditional financial analysis by identifying potential risks and opportunities beyond technical valuations, providing data on issues such as reputational risk or identifying firms which are adapting to meet new market challenges.

We, therefore, believe that integrating ESG information into the investment process complements our fundamental insights and can improve investment outcomes, helping to reduce risks and improve long-term returns.

Selecting the right approach

There is a large body of academic research supporting the effectiveness of factors in investment strategies.

However, we believe that not all factor strategies are made equal, and investors need to consider the correlation between factors and beware of the pitfalls of generic factor products. These include, but are not limited to, price bubbles forming in factors when they are in high demand, as we saw in minimum volatility strategies in the first quarter of 2020.

Factor strategies should not be considered passive investments; it is an active decision to move away from standard indices, and active management is needed to address the pitfalls of naive factors. For this reason, we have developed controls to address risks such as speculative valuation, as well as deploying machine learned technology to identify stocks that are at risk of distress.

We believe that factor investing is an efficient way for investors to meet their investment goals while also contributing to sustainable objectives such as mitigating climate change. For investors that want the long-term growth of equities but with lower risk, our sustainable equity strategy is one way to potentially meet these dual objectives.

Sources:

[1] Morningstar Global Sustainable Funds Flow Report

 

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